|
|
|
|
|
|
|
|
|
|
Arch
Portfolio(1)
|
|
Benchmark
Return
|
|
Pre-tax total return (before investment expenses):
|
|
|
|
|
|
|
|
Year ended December 31, 2012
|
|
|
5.88
|
%
|
|
4.90
|
%
|
Year ended December 31, 2011
|
|
|
3.81
|
%
|
|
4.80
|
%
|
Year ended December 31, 2010
|
|
|
7.00
|
%
|
|
6.38
|
%
|
-
(1)
-
Our
investment expenses were approximately 0.22%, 0.22% and 0.19%, respectively, of average invested assets in 2012, 2011 and 2010.
Ratings
Our ability to underwrite business is dependent upon 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 competitive positions 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 have become an increasingly important factor in
establishing the competitive position of insurance and reinsurance companies. These ratings 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. A.M.
Best Company ("A.M. Best") maintains a letter scale rating system ranging from "A++" (Superior) to "F" (In Liquidation). Moody's maintains a letter scale rating from "Aaa" (Exceptional) to "NP" (Not
Prime). S&P maintains a letter scale rating system ranging from "AAA" (Extremely Strong) to "R" (Under Regulatory Supervision). Fitch Ratings ("Fitch") maintains a letter scale rating system ranging
from "AAA" (Exceptionally Strong) to "C" (Distressed).
Our
reinsurance subsidiaries, Arch Re U.S., Arch Re Bermuda, Arch Re Europe (S&P and Fitch only) and Arch Mortgage (S&P only), and our principal insurance subsidiaries, Arch Insurance,
Arch E&S, Arch Specialty, Arch Insurance Company Europe and Arch Insurance Canada (S&P and A.M. Best only), each currently has a financial strength rating of "A+" (Excellent, the second highest
out of fifteen rating levels) with a stable outlook from A.M. Best, "A1" (Good, the fifth highest out of 21 rating levels) with a stable outlook from Moody's, "A+" (Strong, the fifth highest
out of 21 rating levels) with a stable outlook from S&P, and "A+" (Strong, the fifth highest out of 24 rating levels) with a stable outlook from Fitch. A.M. Best has assigned a financial
strength rating of "NR-3" (Rating Procedure Inapplicable") to Arch Indemnity, which is not writing business currently. Lloyd's has financial strength ratings of "A" (Excellent) with a
stable outlook from A.M. Best, "A+" (Strong) with a stable outlook from S&P and "A+" (Strong) with a stable outlook from Fitch.
ACGL
has received counterparty (issuer) credit ratings of "A-" (seventh highest out of 21 rating levels) with a stable outlook from S&P, "A3" (seventh highest out of 21
rating levels) with a stable outlook from Moody's and "A" long term issuer rating (sixth highest out of 23 rating levels) with a stable outlook from Fitch. A counterparty credit rating provides an
opinion on an issuer's overall capacity and willingness to meet its financial commitments as they become due, but is not specific to a particular financial obligation.
20
Table of Contents
The financial strength ratings assigned by rating agencies to insurance and reinsurance companies represent independent opinions of financial strength and ability
to meet policyholder obligations and are not directed toward the protection of investors, nor are they recommendations to buy, hold or sell any securities. We can offer no assurances that our ratings
will remain at their current levels, or that our security will be accepted by brokers and our insureds and reinsureds. A ratings downgrade or the potential for such a downgrade, or failure to obtain a
necessary rating, could adversely affect both our relationships with agents, brokers, wholesalers and other distributors of our existing products and services and new sales of our products and
services. In addition, under certain of the reinsurance agreements assumed by our reinsurance operations, upon the occurrence of a ratings downgrade or other specified triggering event with respect to
our reinsurance operations, such as a reduction in surplus by specified amounts during specified periods, our ceding company clients may be provided with certain rights, including, among other things,
the right to terminate the subject reinsurance agreement and/or to require that our reinsurance operations post additional collateral. In the event of a ratings downgrade or other triggering event,
the exercise of such contract rights by our clients could have a material adverse effect on our financial condition and results of operations, as well as our ongoing business and operations. See
"Management's Discussion and Analysis of Financial Condition and Results of OperationsFinancial Condition, Liquidity and Capital ResourcesLiquidity and Capital Resources."
Competition
The worldwide reinsurance and insurance businesses are highly competitive. We compete, and will continue to compete, with major U.S.
and non-U.S. insurers and reinsurers, some of which have greater financial, marketing and management resources than we have and have had longer-term relationships with insureds
and brokers than us. We compete with other insurers and reinsurers primarily on the basis of overall financial strength, ratings assigned by independent rating agencies, geographic scope of business,
strength of client relationships, premiums charged, contract terms and conditions, products and services offered, speed of claims payment, reputation, employee experience, and qualifications and local
presence.
In
our insurance business, we compete with insurers that provide specialty property and casualty lines of insurance, including: ACE Limited, Alleghany Corporation, Allied World Assurance
Company, Ltd., American International Group, Inc., AXIS Capital Holdings Limited, Berkshire Hathaway, Inc., Chubb Corporation, CNA, Endurance Specialty Holdings Ltd., The
Hartford Financial Services Group, Inc., HCC Insurance Holdings, Inc., Ironshore Inc., Liberty Mutual Insurance, Lloyd's, Markel Insurance Company, RLI Corp., The Travelers
Companies, W.R. Berkley Corp., XL Group plc and Zurich Insurance Group. In our reinsurance business, we compete with reinsurers that provide property and casualty lines of reinsurance,
including ACE Limited, Alleghany Corporation, Alterra Capital Holdings Limited, Argo International Holdings, Ltd., AXIS Capital Holdings Limited, Berkshire Hathaway, Inc., Endurance
Specialty Holdings Ltd., Everest Re Group Ltd., Hannover Rückversicherung AG, Lloyd's, Montpelier Re Holdings Ltd., Munich Re Group, PartnerRe Ltd., Platinum
Underwriters Holdings, Ltd., RenaissanceRe Holdings Ltd., Swiss Reinsurance Company, Validus Holdings Ltd and XL Group plc. We do not believe that we have a significant
market share in any of our markets.
Enterprise Risk Management
Enterprise Risk Management ("ERM") is a key element in our philosophy, strategy and culture. We employ an ERM framework that includes
underwriting, reserving, investment, credit and operational risks. Risk appetite and exposure limits are set by our executive management team, reviewed with our board of directors and board level
committees and routinely discussed with business unit management. These limits are integrated into our operating guidelines and the exposures are
21
Table of Contents
aggregated
and monitored periodically by our corporate risk management team. The reporting, review and approval of risk management information is integrated into our annual planning process, capital
modeling and allocation, reinsurance purchasing strategy and reviewed at insurance business reviews, reinsurance underwriting meetings and board level committees. For a discussion of our risk
management policies, see "Management's Discussion and Analysis of Financial Condition and Results of OperationsCritical Accounting Policies, Estimates and Recent Accounting
PronouncementsCeded Reinsurance" and "Risk FactorsRisks Relating to Our IndustryThe failure of any of the loss limitation methods we employ could have a material
adverse effect on our financial condition or results of operations."
Regulation
The Insurance Act 1978 of Bermuda and Related Regulations (the "Insurance Act").
As a holding company, ACGL is not subject to Bermuda
insurance
regulations; however, its wholly-owned subsidiary, Arch Re Bermuda, is subject to the Insurance Act. The Insurance Act provides that no person shall carry on any insurance business in or from within
Bermuda unless registered as an insurer under the Insurance Act by the Bermuda Monetary Authority (the "BMA"), which is responsible for the day-to-day supervision of insurers.
Under the Insurance Act, insurance business includes reinsurance business. We believe that we are in compliance with all applicable regulations under the Insurance Act.
The
Insurance Act imposes solvency and liquidity standards and auditing and reporting requirements on Bermuda insurance companies and grants to the BMA powers to supervise, investigate
and intervene in the affairs of insurance companies. Certain significant aspects of the Bermuda insurance regulatory framework are set forth below.
Classification of Insurers.
The Insurance Act distinguishes between insurers carrying on long-term business, insurers carrying on
general
business and insurers carrying on special purpose business. There are six general business classifications (Classes 1, 2, 3, 3A, 3B and 4), five long-term business classifications
(Classes A, B, C, D and E) and one classification of special purpose insurer.
As
Arch Re Bermuda carries on both long-term and general business, it is required to be registered as both a long-term and as a general business insurer under the
Insurance Act. Accordingly, Arch Re Bermuda is registered as a Class 4 general business insurer and as a Class C long-term insurer. Class 4 insurers are regarded as
large commercial underwriters and are subject to the strictest regulation. Class C insurers are regarded as small commercial underwriters and are subject to less stringent regulation.
Minimum Paid-Up Share Capital.
Arch Re Bermuda is required to maintain fully paid-up share capital of $1.25 million.
Principal Representative and Principal Office.
An insurer is required to maintain a principal office and to appoint and maintain a
principal
representative in Bermuda. It is the duty of the principal representative upon reaching the view that there is a likelihood of the insurer for which the principal representative acts becoming
insolvent or that a reportable "event" has, to the principal representative's knowledge, occurred or is believed to have occurred, to immediately notify the BMA and to make a report in writing to the
BMA within 14 days of the prior notification setting out all the particulars of the case that are available to the principal representative.
Where
there has been a significant loss which is reasonably likely to cause the insurer to fail to comply with its enhanced capital requirement (in respect of its general business, as
described in more detail below), the principal representative must also furnish the BMA with a capital and solvency
22
Table of Contents
return
reflecting an enhanced capital requirement prepared using post-loss data. The principal representative must provide this within 45 days of notifying the BMA regarding the
loss.
Furthermore,
where a notification has been made to the BMA regarding a material change to an insurer's business or structure (including a merger or amalgamation), the principal
representative has 30 days from the date of such notification to furnish the BMA with unaudited interim statutory financial statements in relation to such period if so requested by the BMA,
together with a general business solvency certificate in respect of those statements.
Approved Independent Auditor.
All insurers must appoint an independent auditor who annually audits and reports on the insurer's
financial statements
prepared under generally accepted accounting principles ("GAAP") or international financial reporting standards ("IFRS") and statutory financial statements and the statutory financial return of the
insurer, all of which, in the case of Arch Re Bermuda, are required to be filed annually with the BMA. The independent auditor must be approved by the BMA.
Approved Actuary.
As a Class C insurer, Arch Re Bermuda is required to submit an annual actuary's certificate when filing its
statutory
financial returns. The actuary, who is normally a qualified life actuary, must be approved by the BMA.
Approved Loss Reserve Specialist.
As a Class 4 insurer, Arch Re Bermuda is required to submit an opinion of its approved loss
reserve
specialist with its statutory financial return in respect of its loss and loss expense provisions. The loss reserve specialist, who will normally be a qualified casualty actuary, must be approved by
the BMA.
Annual Financial Statements, Annual Statutory Financial Return and Annual Capital and Solvency Return.
Arch Re Bermuda must prepare
annual statutory
financial statements as prescribed in the Insurance Act with respect to both its general business and its long-term business. The statutory financial statements are distinct from the
annual GAAP basis financial statements referred to below. The statutory financial return for a Class 4 insurer shall include a report of the approved independent auditor on the statutory
financial statement of such insurer, solvency certificates, the statutory financial statements for the general business, the opinion of the loss reserve specialist and a schedule of reinsurance ceded.
The statutory financial return for a long-term insurer shall include a report of the approved independent auditor on the statutory financial statements of such insurer, the statutory
financial statements related to the long-term business, a declaration of the statutory ratios, the long-term business solvency certificate and a certificate from the approved
actuary. Arch Re Bermuda is also required to file audited GAAP basis annual financial statements, which must be available to the public. In addition, Arch Re Bermuda is required to file a
capital and solvency return in respect of its general business and long-term business. The capital and solvency return for its general business includes its relevant regulatory
risk-based capital model, a schedule of fixed income investments by ratings categories, a schedule of net reserves for losses and loss expense provisions by line of business, a schedule of
premiums written by line of business, a schedule of risk management and a schedule of fixed income securities, a schedule of commercial insurer's solvency self assessment, a schedule of catastrophe
risk return, a schedule of loss triangles or reconciliation of net loss reserves and a schedule of eligible capital. The capital and solvency return for its long-term business includes its
regulatory risk-based capital model for long-term business.
Minimum Solvency Margins.
Arch Re Bermuda, as a Class 4 insurer, must ensure that the value of its general business assets exceeds
the amount
of its general business liabilities by an amount greater than the prescribed minimum solvency margins and enhanced capital requirement pertaining to its general business. Accordingly, Arch Re Bermuda
is required, with respect to its general business, to maintain a minimum solvency margin equal to the greatest of (i) $100 million, (ii) 50% of net premiums written (being gross
premiums written less any premiums ceded by Arch Re Bermuda, but
23
Table of Contents
Arch
Re Bermuda may not deduct more than 25% of gross premiums when computing net premiums written), and (iii) 15% of net discounted aggregate losses and loss expense provisions and other
insurance reserves. As a long-term insurer, Arch Re Bermuda is also required, with respect to its long-term business, to maintain a minimum solvency margin equal to 50%, 75%
and 100% of the greater of $500,000 or 1.5% of its assets for 2011, 2012 and 2013, respectively. For the purpose of this calculation, assets are defined as the total assets pertaining to its
long-term business reported on the balance sheet in the relevant year less the amounts held in a segregated account.
Enhanced Capital Requirement.
As a Class 4 insurer, Arch Re Bermuda is required to maintain available statutory capital and
surplus pertaining
to its general business at a level equal to or in excess of its enhanced capital requirement ("ECR") which is established by reference to either the BSCR model ("BSCR") or an approved internal capital
model. The BSCR is a risk-based capital model which provides a method for determining an insurer's capital requirements (statutory capital and surplus) by taking into account the risk
characteristics of different aspects of the insurer's business. While not specifically referred to in the Insurance Act, the BMA has also established a target capital level ("TCL") for
each Class 4 insurer equal to 120% of its ECR. While a Class 4 insurer is not currently required to maintain its statutory capital and surplus at this level, the TCL serves as an early
warning tool for the BMA, and failure to maintain statutory capital at least equal to the TCL will likely result in increased regulatory oversight.
Eligible Capital.
To enable the BMA to better assess the quality of the insurer's capital resources, as a Class 4 insurer, Arch Re
Bermuda is
required to disclose the makeup of its capital in accordance with the 3-tiered capital system that came into operation on January 1, 2013. Under this system, all of the insurer's
capital instruments will be classified as either basic or ancillary capital, which in turn will be classified into one of three tiers based on their "loss absorbency" characteristics. Highest quality
capital will be classified Tier 1 Capital, lesser quality capital will be classified as either Tier 2 Capital or Tier 3 Capital. The maximum amount of Tier 1, Tier 2
or Tier 3 Capital that may be used to support Arch Re Bermuda's minimum solvency margin, ECR and TCL will be determined in accordance with the current insurance eligible capital rules.
Tier 1, Tier 2 and Tier 3 Capital may, until January 1, 2024, include capital instruments that do not satisfy the requirement that the instrument be
non-redeemable or settled only with the issuance of an instrument of equal or higher quality upon a breach, or if it would cause a breach, of the ECR. Where the BMA has previously approved
the use of certain instruments for capital purposes, the BMA's consent must be obtained if such instruments are to remain eligible for use in satisfying the minimum solvency margin pertaining to its
general business and its ECR.
Minimum Liquidity Ratio.
Arch Re Bermuda is required to maintain a minimum liquidity ratio for general business equal to the value of
its relevant
assets at not less than 75% of the amount of its relevant liabilities. Relevant assets include cash and time deposits, quoted investments, unquoted bonds and debentures, first liens on real estate,
investment income due and accrued, accounts and premiums receivable and reinsurance balances receivable. The relevant liabilities are total general business insurance reserves and total other
liabilities less deferred income tax and sundry liabilities (by interpretation, those not specifically defined).
Restrictions on Dividends and Distributions.
Arch Re Bermuda is prohibited from declaring or paying any dividends during any financial
year if it is
in breach of its enhanced capital requirement or its general business or long-term solvency margins or its minimum liquidity ratio or if the declaration or payment of such dividends would
cause such a breach. If it has failed to meet its minimum solvency margins or minimum liquidity ratio on the last day of any financial year, Arch Re Bermuda will be prohibited, without the approval of
the BMA, from declaring or paying any dividends during the next financial year. In addition, Arch Re Bermuda is prohibited from declaring or paying in any financial year dividends of more than 25% of
its total statutory capital and surplus (as shown on its previous
24
Table of Contents
financial
year's statutory balance sheet) unless it files (at least seven days before payment of such dividends) with the BMA an affidavit stating that it will continue to meet the required margins.
Reduction of Capital.
Without the approval of the BMA, Arch Re Bermuda is prohibited from reducing by 15% or more its total statutory
capital as set
out in its previous year's financial statements and any application for such approval must include an affidavit stating that it will continue to meet the required margins.
Long-Term Business Fund.
An insurer carrying on long-term business is required to keep its accounts in respect of its
long-term business separate from any accounts kept in respect of any other business. All receipts of its long-term business form part of its long-term business
fund. No payment may be made directly or indirectly from an insurer's long-term business fund for any purpose other than a purpose related to the insurer's long-term business,
unless such payment can be made out of any surplus certified by the insurer's approved actuary to be available for distribution otherwise than to policyholders. Arch Re Bermuda may not declare or pay
a dividend to any person other than a policyholder unless the value of the assets in its long-term business fund, as certified by its approved actuary, exceeds the extent (as so certified)
of the liabilities of the insurer's long-term business. In addition, the amount of such dividend shall not exceed the aggregate of that excess and any other funds properly available for
payment of dividends, being funds arising out of business of the insurer other than its long-term business.
Restrictions on Transfer of Business and Winding-Up.
As a long-term insurer, Arch Re Bermuda may only transfer
long-term business, other than long-term business that is reinsurance business, with the sanction of the applicable Bermuda court. A long-term insurer may only be
wound-up or liquidated by order of the applicable Bermuda court.
Fit and Proper Controllers.
The BMA maintains supervision over the controllers of all registered insurers in Bermuda. A controller
includes:
(i) the managing director of the registered insurer or its parent company; (ii) the chief executive of the registered insurer or of its parent company; (iii) a shareholder
controller; and (iv) any person in accordance with whose directions or instructions the directors of the registered insurer or of its parent company are accustomed to act. The definition of
shareholder controller is set out in the Insurance Act, but generally refers to (i) a shareholder who holds 10% or more of the shares carrying rights to vote at a shareholders' meeting of the
registered insurer or its parent company, or (ii) a shareholder who is entitled to exercise 10% or more of the voting power at any shareholders' meeting of such registered insurer or its parent
company, or (iii) a shareholder who is able to exercise significant influence over the management of the registered insurer or its parent company by virtue of its shareholding or its
entitlement to exercise, or control the exercise of, the voting power at any shareholders' meeting. A shareholder controller that owns 10% or more but less than 20% of the shares as described above is
defined as a 10% shareholder controller; a shareholder
controller that owns 20% or more but less than 33% of the shares as described above is defined as a 20% shareholder controller; a shareholder controller that owns 33% or more but less than 50% of the
shares as described above is defined as a 33% shareholder controller; and a shareholder controller that owns 50% or more of the shares as described above is defined as a 50% shareholder controller.
Where
the shares of the shareholder of a registered insurer, or the shares of its parent company, are traded on a recognized stock exchange, and such shareholder becomes a 10%, 20%, 33%
or 50% shareholder controller of the insurer, that shareholder shall, within 45 days, notify the BMA in writing that such shareholder has become such a controller. Any person or entity who
contravenes the Insurance Act by failing to give notice or knowingly becoming a shareholder controller before the required 45 days has elapsed is guilty of an offense and liable to a fine.
25
Table of Contents
The
BMA may file a notice of objection to any shareholder who has become a controller of any description where it appears that such shareholder is, or is no longer, a fit and
proper shareholder to be a controller of the registered insurer. Any person who continues to be a controller of any description after having received a notice of objection shall be guilty of an
offense.
Notification by Registered Person of Change of Controllers and Officers.
All registered insurers are required to give written notice to
the BMA of
the fact that a person has become, or ceased to be, a controller or officer of the registered insurer within 45 days of becoming aware of such fact. An officer in relation to a registered
insurer means a director, chief executive or senior executive performing duties of underwriting, actuarial, risk management, compliance, internal audit, finance or investment matters.
Notification of Material Changes.
All registered insurers are required to give notice to the BMA of their intention to effect a
material change
within the meaning of the Insurance Act. For the purposes of the Insurance Act, the following changes are material: (i) the transfer or acquisition of insurance business being part of a scheme
falling under section 25 of the Insurance Act or section 99 of the Companies Act; (ii) the amalgamation with or acquisition of another firm; (iii) engaging in unrelated
business that is retail business, (iv) the acquisition of a controlling interest in an undertaking that is engaged in non-insurance business which offers services and products to
persons who are not affiliates of the insurer, (v) outsourcing all or substantially all of the company's actuarial, risk management and internal audit functions, (vi) outsourcing all or
a material part of an insurer's underwriting activity, (vii) the transfer other than by way of reinsurance of all or substantially all of a line of business, and (viii) the expansion
into a material new line of business.
No
registered insurer shall take any steps to give effect to a material change unless it has first served notice on the BMA that it intends to effect such material change and before the
end of 14 days, either the BMA has notified such company in writing that it has no objection to such change or that period has lapsed without the BMA having issued a notice of objection. Any
insurer who fails to give the required notice or which effects a material change, or allows such material change to be effected, before the prescribed period has elapsed or after having received a
notice of objection from the BMA shall be guilty of an offense.
Insurance Code of Conduct.
Arch Re Bermuda is subject to the Insurance Code of Conduct (the "Insurance Code"), which establishes duties
and standards
which must be complied with to ensure it implements sound corporate governance, risk management and internal controls. Failure to comply with the requirements under the Insurance Code will be a factor
taken into account by the BMA in determining whether an insurer is conducting its business in a sound and prudent manner as prescribed by the Insurance Act. Failure to comply with the requirements of
the Insurance Code could result in the BMA exercising its powers of intervention and will be a factor in calculating the operational risk charge applicable in accordance with that insurer's risk based
capital model.
Cancellation of Insurer's Registration.
An insurer's registration may be canceled by the BMA on certain grounds specified in the
Insurance Act,
including failure of the insurer to comply with its obligations under the Insurance Act or if, in the opinion of the BMA, the insurer has not been carrying on business in accordance with sound
insurance principles.
Group Supervision.
The BMA may, in respect of an insurance group, determine whether it is appropriate for it to act as its group
supervisor. An
insurance group is defined as a group of companies that conducts exclusively, or mainly, insurance business. The BMA may make such determination where it ascertains that (i) the group is headed
by a "specified insurer" (that is to say, it is headed by either a Class 3A, Class 3B or Class 4 general business insurer or a Class C, Class D or Class E
long term insurer or another class of insurer designated by order of the BMA); or (ii) where the insurance group is not headed by a "specified insurer", where it is headed by a parent company
which is incorporated in
26
Table of Contents
Bermuda
or (iii) where the parent company of the group is not a Bermuda company, in circumstances where the BMA is satisfied that the insurance group is directed and managed from Bermuda or the
insurer with the largest balance sheet total is a specified insurer.
Where
the BMA determines that it should act as the group supervisor, it shall designate a specified insurer that is a member of the insurance group to be the designated insurer (the
"Designated Insurer") and it shall give to the Designated Insurer and other competent authorities written notice of its intention to act as group supervisor.
In
2011, the BMA notified Arch Re Bermuda that it intended to act as group supervisor and that it had designated Arch Re Bermuda as the "Designated Insurer" of our group of insurance and
reinsurance companies. Pursuant to its powers under the Insurance Act, the BMA will maintain a register of particulars for every insurance group for which it acts as the group supervisor detailing,
among other things, the names and addresses of the Designated Insurer; each member company of the insurance group falling within the scope of group supervision; the principal representative of the
insurance group in Bermuda; other competent authorities supervising other member companies of the insurance group; and the insurance group auditors. The Designated Insurer must notify the BMA of any
changes to the above details entered on the register of an insurance group.
As
group supervisor, the BMA will perform a number of supervisory functions including (i) coordinating the gathering and dissemination of information which is of importance for
the supervisory task of other competent authorities; (ii) carrying out a supervisory review and assessment of the insurance group; (iii) carrying out an assessment of the insurance
group's compliance with the rules on solvency, risk concentration, intra-group transactions and good governance procedures; (iv) planning and coordinating, with other competent authorities,
supervisory activities in respect of the insurance group, both as a going concern and in emergency situations; (v) coordinating any enforcement action that may need to be taken against the
insurance group or any of its members; and (vi) planning and coordinating meetings of colleges of supervisors (consisting of insurance regulators) in order to facilitate the carrying out of the
functions described above.
In
carrying out its functions, the BMA may make rules for (i) assessing the financial situation and the solvency position of the insurance group and/or its members and
(ii) regulating intra-group transactions, risk concentration, governance procedures, risk management and regulatory reporting and disclosure.
Group Solvency and Group Supervision.
The current insurance group supervision and insurance group solvency rules (together, "Group
Rules") will apply
to Arch Re Bermuda so long as the BMA remains our group supervisor. The BMA has implemented and imposed many of the additional requirements
described in this section as part of its efforts to gain equivalence under Solvency II. Due to the delays in the implementation of Solvency II in Europe, it is not expected that the European
Commission will take a final decision on whether or not it will recognize the regime in Bermuda to be equivalent to that laid down in Solvency II until 2013, at the earliest. If the European
Commission does not recognize the regime in Bermuda, this could mean that Arch Re Bermuda and its European Union-regulated affiliates may be subject to group supervision in Bermuda and the European
Union, respectively. In addition, through the Group Rules, the BMA may take action which affects ACGL. A summary of the Group Rules is set forth below.
-
-
Annual Group Financial Statements.
Every insurance group
is required to prepare and submit, on an annual basis, Group financial statements prepared in accordance with either IFRS or GAAP, together with group statutory financial statements.
The
group GAAP financial statements must be audited annually by the group's approved auditor who is required to prepare an auditor's report thereon in accordance with generally accepted auditing
standards. In addition, every insurance group must prepare group statutory financial statements (which will include, in statutory form, a group balance sheet, a group income statement, a group
statement of capital and surplus, and notes thereto). The Designated Insurer is required to file with the BMA the group statutory financial statements and the audited group GAAP financial statements
with the BMA within five months from the end of the relevant financial year (unless specifically extended).
27
Table of Contents
-
-
Annual Group Statutory Financial Return and Annual Capital and Solvency
Return.
Every insurance group is required to prepare an annual group statutory financial return which shall include, among other things,
a report of the approved group auditor (for the GAAP financial statements only), an insurance group business solvency certificate, the opinion of a group actuary (exempt for 2012 filing), an insurance
group capital and solvency certificate (and a declaration, optional for the 2012 filing, signed by two directors of the Designated Insurer and either the chief risk or chief financial officer of the
parent company declaring that the return fairly represents the financial condition of the insurance group in all material respects), particulars of ceded reinsurance comprising the top ten
unaffiliated reinsurers for which the group has the highest recoverable balances and any reinsurer with recoverable balances exceeding 15% of the insurance group's statutory capital and surplus, a
list of non-insurance financial regulated entities owned by the group and summary details of all adjustments applied to the group financial statements in the form of a reconciliation of
amounts reported as total group assets, total group liabilities, net group income and total group statutory capital and surplus. Both the annual group statutory financial return and the group capital
and solvency return must be submitted to the BMA by the Designated Insurer within five months after its financial year end (unless specifically extended).
-
-
Quarterly Group Financial Statements.
The Designated
Insurer is required to prepare and file quarterly group financial returns with the BMA on or before the last day of the months May, August and November of each year. The quarterly group financial
returns consist of (i) quarterly group unaudited (consolidated) financial statements for each financial quarter (which must minimally include a balance sheet and income statement and must also
be recent and not reflect a financial position that exceeds two months) and (ii) a list and details of material intra-group transactions and risk concentrations (including, where applicable,
exposure value (face value and market value, if the latter is available), counterparties involved (including their location), summary details of the purpose, terms, costs, duration and performance
triggers relating to the transaction), details surrounding all intra-group reinsurance and retrocession arrangements (including aggregated values of the exposure limits by counterparties, aggregated
premium flows and the proportion of the group's insurance business exposure covered by internal reinsurance, retrocession and other risk transfer arrangements) and details of the top ten
counterparties and any other counterparty exposures exceeding 10% of the insurance group's statutory capital and surplus.
-
-
Group Solvency Self Assessment ("GSSA").
Group Rules
require the board of directors of the parent company of the insurance group (the "Parent Board") to establish solvency self assessment procedures for the group that factors in all the foreseeable
reasonably material risks. Such procedures should be carried out at least annually and assess the quality and quantity of the capital required to adequately cover the risks to which the insurance
group is exposed. Such procedures must also be an integral part of the group's risk management framework and be reviewed and evaluated on a regular basis by the Parent Board. In particular, the GSSA
should, among other things, demonstrate consideration of the relationship between risk management, the quality and quantity of capital resources, the impact of risk mitigation techniques and
diversification and correlation effects between material risks; a description of the group's risk appetite; be forward-looking; include appropriate stress and scenario testing and appropriately
reflect all assets and liabilities, material off-balance sheet arrangements, material intra group transactions, relevant managerial practices, systems and controls and a valuation basis
that is aligned with the risk characteristics and business model of the group.
-
-
Minimum Group Solvency Margin and Group Enhanced Capital Requirement ("Group
ECR").
Effective January 1, 2013, the Designated Insurer must ensure that the value of the insurance group's assets exceeds the
amount of the group's liabilities by the aggregate minimum margin of
28
Table of Contents
solvency
of each qualifying member of the group (the "Group MSM"). A member is a qualifying member of the insurance group if it is subject to solvency requirements in the jurisdiction in which it is
registered.
Where
the parent company exercises control in relation to any member of the group, the minimum margin of solvency of such member shall be its individual minimum solvency margin. Where the parent
company exercises significant influence on any member of the group, the minimum margin of solvency applicable to that member for purposes of calculating the Group MSM shall be an amount equal to the
parent company's percentage shareholding in the member multiplied by that member's minimum margin of solvency. "Control" and "significant influence" shall be determined in accordance with either the
IFRS or GAAP used to prepare the insurance group's IFRS or GAAP financial statements.
Effective
December 31, 2013, the group will be required to maintain available group capital and surplus at a level equal to 50% of the Group ECR and this requirement will increase by increments
of 10% in each of the following five years until 100% ECR is required in 2018. This phasing in schedule is conditioned upon the BMA making further adjustments that would be either needed or
appropriate once the effective date of Solvency II capital requirements is finalized.
Similar
to the BSCR for individual insurers, the Group BSCR model is a risk-based capital model which provides a method for determining an insurer's capital requirements (statutory capital
and surplus) by taking into account the risk characteristics of different aspects of the insurance group's business. The Group BSCR formulae establish capital requirements for eight categories of
risk: fixed income investment risk, equity investment risk, interest rate/liquidity risk, premium risk, reserve risk, credit risk, catastrophe risk and operational risk. For each category, the capital
requirement is determined by applying factors to asset, premium, reserve, creditor, probable maximum loss and operation items, with higher factors applied to items with greater underlying risk and
lower factors for less risky items.
-
-
Group Eligible Capital.
To enable the BMA to better assess
the quality of the group's capital resources, the Designated Insurer is required to disclose the makeup of its group's capital in accordance with a '3-tiered capital system'. The eligible
capital requirements come into effect on January 1, 2014, and under the current proposed system, all of the insurance group's capital instruments will be classified as either basic or ancillary
capital which in turn will be classified into one of 3 tiers based on their "loss absorbency" characteristics. Highest quality capital will be classified Tier 1 Capital, lesser quality capital
will be classified as either Tier 2 Capital or Tier 3 Capital. Under this regime, not more than certain specified percentages of Tier 1, Tier 2 and Tier 3 Capital
may be used to satisfy the Group's MSM and Group ECR requirements. Tier 1, Tier 2 and Tier 3 Capital may, until January 1 2024, include capital instruments that do not
satisfy the requirement that the instrument be non-redeemable or settled only with the issuance of an instrument of equal or higher quality upon a breach, or if redemption would cause a
breach, of the Group ECR.
-
-
Group Governance.
Group Rules require the Parent Board to
establish and effectively implement corporate governance policies and procedures, which it must be periodically review to ensure they continue to support the overall organizational strategy of the
group. In particular, the Parent Board must:
-
-
ensure that operational and oversight responsibilities of the group are clearly defined and documented and that the
reporting of material deficiencies and fraudulent activities are transparent and devoid of conflicts of interest;
29
Table of Contents
-
-
establish systems for identifying on a risk sensitive basis those policies and procedures that must be reviewed annually
and those policies and procedures that must be reviewed at other regular intervals;
-
-
establish a risk management and internal controls framework and ensure that it is assessed regularly and such assessment
is reported to the Parent Board and the chief and senior executives;
-
-
establish and maintain sound accounting and financial reporting procedures and practices for the group; and
-
-
establish and keep under review group functions relating to actuarial, compliance, internal audit and risk management
functions which must address certain specific requirements as set out in the Group Rules.
Designated Insurer Notification Obligations.
The Designated Insurer must notify the BMA upon reaching a view that there is a likelihood
of the
insurance group or any member of the group becoming insolvent or that a reportable "event" has, to the Designated Insurer's knowledge, occurred or is believed to have occurred. Examples of a
reportable "event" include a failure by the insurance group or any member of the group to comply substantially with a requirement imposed upon it under the Group Rules relating to its solvency
position, governance and risk management or supervisory reporting and disclosures; failure by the Designated Insurer to comply with a direction given to it under the Insurance Act in respect of the
group or any of its members; a criminal conviction imposed upon any member of the group whether in Bermuda or abroad; material breaches of any statutory requirements by any member of the group located
outside of Bermuda that could lead to supervisory or enforcement action by a competent authority; or a significant loss that is reasonably likely to cause the insurance group to be unable to comply
with its Group ECR. Within 30 days of such notification to the BMA, the Designated Insurer must furnish the BMA with a written report setting out all the particulars of the case that are
available to it and within 45 days it must furnish a group capital and solvency return that reflects the Group ECR that has been prepared using post-loss data and unaudited
financial statements for such period as the BMA shall require together with a declaration of solvency in respect thereof. The Designated Insurer must also notify the BMA in writing within
14 days of becoming aware that a requirement of the Group Rules conflicts with the laws of another jurisdiction where a member of the insurance group operates.
Except
in circumstances where another member of the group is regulated by a competent authority in an equivalent jurisdiction and the Designated Insurer has within 90 days
provided the BMA with written notice of the same, the Designated Insurer shall not permit another member of the group to give effect to a material change unless it has first served notice on the BMA
that a member of the group intends to effect such material change and before the end of 14 days, either the BMA has notified the Designated Insurer in writing that it has no objection to such
change or that period has lapsed without the BMA having issued a notice of objection. The following events constitute material group changes that must be notified to the BMA: (i) the
amalgamation with or acquisition of another firm, (ii) engaging in unrelated business that is retail business, (iii) the acquisition of a controlling interest in an undertaking that is
engaged in non-insurance business which offers services and products to persons who are not affiliates of the insurer, (iv) outsourcing all or substantially all of the company's
actuarial, risk management and internal audit functions, (v) outsourcing all or a material part of an insurer's underwriting activity, (vi) the transfer other than by way of reinsurance
of all or substantially all of a line of business, and (vii) the expansion into a material new line of business.
In
respect of the parent company of an insurance group, the Designated Insurer is required to give written notice to the BMA of the fact that a person has become, or ceased to be, a
controller or officer of the parent company of the insurance group within 45 days of becoming aware of such fact. An officer in relation to the parent company of the insurance group means a
director, chief executive or
30
Table of Contents
senior
executive performing duties of underwriting, actuarial, risk management, compliance, internal audit, finance or investment matters.
If
it appears to the BMA that the Designated Insurer is in breach of any provision of the Insurance Act or the Group Rules, the BMA may give the Designated Insurer such directions as
appear to the BMA to be desirable for safeguarding the interests of policyholders and potential policyholders of the insurance group.
BMA's Powers of Intervention, Obtaining Information, Reports and Documents and Providing Information to other Regulatory Authorities.
The BMA may, by
notice in writing served on a registered person or a Designated Insurer, require the registered person or a Designated Insurer to provide such information and/or documentation as the BMA may
reasonably require with respect to matters that are likely to be material to the performance of its supervisory functions under the Insurance Act. In addition, it may require such person's auditor,
underwriter, accountant or any other person with relevant professional skill to prepare a report on any aspect pertaining thereto. In the case of a report, the person so appointed shall immediately
give the BMA written notice of any fact or matter of which he becomes aware or which indicates to him that any condition attaching to his registration under the Insurance Act is not or has not or may
not be or may not have been fulfilled and that such matters are likely to be material to the performance of its functions under the Insurance Act. If it appears to the BMA to be desirable in the
interests of the clients of a registered person or relevant insurance group, the BMA may also exercise these powers in relation to subsidiaries, parent companies and other affiliates of the registered
person or designated insurer.
If
the BMA deems it necessary to protect the interests of the policyholders or potential policyholders of an insurer or insurance group, it may appoint one or more competent persons to
investigate and report on the nature, conduct or state of the insurer's or the insurance group's business, or any aspect thereof, or the ownership or control of the insurer or insurance group. If the
person so appointed thinks it necessary for the purposes of his investigation, he may also investigate the business of any person who is or has been at any relevant time, a member of the insurance
group or of a partnership of which the person being investigated is a member. In this regard, it shall be the duty of every person who is or was a controller, officer, employee, agent, banker,
auditor, accountant, barrister and attorney or insurance manager to produce to the person appointed such documentation as he may reasonably
require for purposes of his investigation, and to attend and answer questions relevant to the investigation and to otherwise provide such assistance as may be necessary in connection therewith.
Where
the BMA suspects that a person has failed to properly register under the Insurance Act or that a registered person or designated insurer has failed to comply with a requirement of
the Insurance Act or that a person is not, or is no longer, a fit and proper person to perform functions in relation to a regulated activity, it may, by notice in writing, carry out an investigation
into such person (or any other person connected thereto). In connection therewith, the BMA may require every person who is or was a controller, officer, employee, agent, banker, auditor, accountant,
barrister and attorney or insurance manager to make a report and produce such documents in his care, custody and control and to attend before the BMA to answer questions relevant to the BMA's
investigation and to take such actions as the BMA may direct. The BMA may also enter any premises for the purposes of carrying out its investigation and may petition the court for a warrant if it
believes a person has failed to comply with a notice served on him or there are reasonable grounds for suspecting the completeness of any information or documentation produced in response to such
notice or that its directions will not be complied with or that any relevant documents would be removed, tampered with or destroyed.
The
BMA has the power to assist other regulatory authorities, including foreign insurance regulatory authorities, with their investigations involving insurance and reinsurance companies
in Bermuda if it is satisfied that the assistance being requested is in connection with the discharge of regulatory responsibilities and that such cooperation is in the public interest. The grounds
for disclosure
31
Table of Contents
by
the BMA to a foreign regulatory authority without consent of the insurer are limited and the Insurance Act provides for sanctions for breach of the statutory duty of confidentiality.
ACGL and Arch Re Bermuda are incorporated in Bermuda as "exempted companies." As a result, they are exempt from Bermuda laws
restricting the percentage of share capital that may be held by non-Bermudians, but they may not participate in certain business transactions, including (i) the acquisition or
holding of land in Bermuda (except that required for their business and held by way of lease or tenancy for terms of not more than 50 years) without the express authorization of the Bermuda
legislature, (ii) the taking of mortgages on land in Bermuda to secure an amount in excess of $50,000 without the consent of the Minister of Finance, (iii) the acquisition of any bonds
or debentures secured by any land in Bermuda, other than certain types of Bermuda government securities or (iv) the carrying on of business of any kind in Bermuda, except in furtherance of
their
business carried on outside Bermuda or under license granted by the Minister of Finance. While an insurer is permitted to reinsure risks undertaken by any company incorporated in Bermuda and permitted
to engage in the insurance and reinsurance business, generally it is not permitted without a special license granted by the Minister of Finance to insure Bermuda domestic risks or risks of persons of,
in or based in Bermuda.
ACGL
and Arch Re Bermuda also need to comply with the provisions of The Bermuda Companies Act 1981, as amended (the "Companies Act") regulating the payment of dividends and making
distributions from contributed surplus. A company shall not declare or pay a dividend, or make a distribution out of contributed surplus, if there are reasonable grounds for believing that:
(i) the company is, or would after the payment be, unable to pay its liabilities as they become due; or (ii) the realizable value of the company's assets would thereby be less than its
liabilities. See "Management's Discussion and Analysis of Financial Condition and Results of OperationsFinancial Condition, Liquidity and Capital ResourcesLiquidity and
Capital Resources" and note 20, "Statutory Information," of the notes accompanying our financial statements.
Under
Bermuda law, only persons who are Bermudians, spouses of Bermudians, holders of a permanent resident's certificate or holders of a working resident's certificate ("exempted
persons") may engage in gainful occupation in Bermuda without an appropriate governmental work permit. Our success may depend in part upon the continued services of key employees in Bermuda. Certain
of our current key employees are not exempted persons and, as such, require specific approval to work for us in Bermuda. A work permit may be granted or extended upon showing that, after proper public
advertisement, no exempted person is available who meets the minimum standards reasonably required by the employer.
U.S. Insurance Regulation
General.
In common with other insurers, our U.S. based subsidiaries are subject to extensive governmental regulation and supervision in
the various
states and jurisdictions in which they are domiciled and licensed and/or approved to conduct business. The laws and regulations of the state of domicile have the most significant impact on operations.
This regulation and supervision is designed to protect policyholders rather than investors. Generally, regulatory authorities have broad regulatory powers over such matters as licenses, standards of
solvency, premium rates, policy forms, marketing practices, claims practices, investments, security deposits, methods of accounting, form and content of financial statements, reserves and provisions
for unearned premiums, unpaid losses and loss adjustment expenses, reinsurance, minimum capital and surplus requirements, dividends and other distributions to shareholders, periodic examinations and
annual and other report filings. In addition, transactions among affiliates, including reinsurance agreements or arrangements, as well as certain third party transactions, require prior regulatory
approval from, or prior notice to and no disapproval by, the
32
Table of Contents
applicable
regulator under certain circumstances. Certain insurance regulatory requirements are highlighted below. In addition, regulatory authorities conduct periodic financial, claims and market
conduct examinations. Arch Insurance Company Europe is also subject to certain governmental regulation and supervision in the various states where it has been approved as an excess and surplus lines
insurer.
Several
years ago, a number of brokers and insurers entered into settlements with state and federal agencies arising out of the investigation by the New York Attorney General and others
into contingent commission payments to brokers (and the disclosures relating to such payments), alleged "bid-rigging," alleged "steering," and other practices in the insurance industry. We
cannot predict the effect these settlements, the pending civil litigation that arose out of the investigations or any current or future government investigations or prosecutions and/or resulting
changes in insurance practices (including future legislation and/or regulations that may become applicable to our business) will have on the insurance industry, the regulatory framework or our
business. See "Risk FactorsRisks Relating to Our IndustryOur reliance on brokers subjects us to their credit risk." Although certain brokers have announced new fee structures
in response to the industry investigations and, as part of these new initiatives, have requested that our insurance subsidiaries enter into standardized payment arrangements, we have determined to
negotiate payment arrangements with our brokers on a case by case basis. However, this has not affected certain agreements between our insurance subsidiaries and managing general agents providing for
the payment to such agents of additional commissions based upon the profitability of the business produced by those agents.
Credit for Reinsurance.
Arch Re U.S. is subject to insurance regulation and supervision that is similar to the regulation of licensed
primary
insurers. However, except for certain mandated provisions that must be included in order for a ceding company to obtain credit for reinsurance ceded, the terms and conditions of reinsurance agreements
generally are not subject to regulation by any governmental authority. This contrasts with admitted primary insurance policies and agreements, the rates and terms of which generally are regulated by
state insurance regulators. As a practical matter, however, the rates charged by primary insurers do have an effect on the rates that can be charged by reinsurers.
Certain
provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Dodd-Frank Act"), which became effective on July 21,
2011, provide that only the state in which a primary insurer is domiciled may regulate the financial statement credit for reinsurance taken by that primary insurer; other states will no longer be able
to require additional collateral from unauthorized reinsurers or otherwise impose their own credit for reinsurance laws on primary insurers that are only licensed in such other states.
A
primary insurer ordinarily will enter into a reinsurance agreement only if it can obtain credit for the reinsurance ceded on its U.S. statutory-basis financial statements. In general,
credit for reinsurance is allowed in the following circumstances:
-
-
if the reinsurer is licensed in the state in which the primary insurer is domiciled;
-
-
if the reinsurer is an "accredited" or otherwise approved reinsurer in the state in which the primary insurer is
domiciled;
-
-
in some instances, if the reinsurer (a) is domiciled in a state that is deemed to have substantially similar credit
for reinsurance standards as the state in which the primary insurer is domiciled and (b) meets certain financial requirements; or
-
-
if none of the above applies, to the extent that the reinsurance obligations of the reinsurer are collateralized
appropriately, typically through the posting of a letter of credit for the benefit of the primary insurer or the deposit of assets into a trust fund established for the benefit of the primary insurer.
33
Table of Contents
As
a result of the requirements relating to the provision of credit for reinsurance, Arch Re U.S. and Arch Re Bermuda are indirectly subject to certain regulatory requirements imposed by
jurisdictions in which ceding companies are domiciled.
Arch
Re U.S. is licensed or is an accredited or otherwise approved reinsurer in 50 states and the District of Columbia. Arch Insurance is licensed as an insurer in 50 states, the
District of Columbia, Puerto Rico, the U.S. Virgin Islands and Guam with a branch office in Canada (authorized to underwrite until December 31, 2012). Arch Specialty is licensed in one state
and approved as an excess and surplus lines insurer in 49 states, the District of Columbia, Puerto Rico and the U.S. Virgin Islands. Arch E&S is licensed in one state and approved as an excess and
surplus lines insurer in 47
states and the District of Columbia. Arch Indemnity is licensed as an insurer in 49 states and the District of Columbia. Arch Insurance Company Europe is approved as an excess and surplus lines
insurer in 27 states and the District of Columbia. Neither Arch Re Bermuda nor Arch Re Europe expects to become licensed, accredited or so approved in any U.S. jurisdiction.
In
November 2011, the National Association of Insurance Commissioners ("NAIC") adopted amendments to its Credit for Reinsurance Model Law and Regulation (the "NAIC Credit for Reinsurance
Model Act"). In states that have enacted legislation adopting the amendments to the NAIC Credit for Reinsurance Model Act, full credit is to be allowed to U.S. ceding insurers for reinsurance ceded to
qualified non-U.S. reinsurers based upon less than 100% collateralization. Under the amended NAIC Credit for Reinsurance Model Act, collateral requirements may be reduced for international
reinsurers meeting certain criteria as to financial strength and reliability that are domiciled in countries that are found to have strong systems of domestic insurance regulation. Such reinsurers
would be eligible to apply for "certified reinsurer" status in the states that have adopted the amendments to the NAIC Credit for Reinsurance Model Act and approved reinsurers would be permitted to
post collateral at reduced levels. The new collateral levels apply on a prospective basis only. These new standards can only come into effect on a state-by-state basis. A state
legislature must enact the amendments to the NAIC Credit for Reinsurance Model Act before the standards can become operative in that state. Prior to the adoption of the amendments to the NAIC Credit
for Reinsurance Model Act, four states (Florida, Indiana, New York and New Jersey) enacted legislative amendments authorizing full financial statement credit for reinsurance ceded to unauthorized
reinsurers that meet criteria similar to those included in the NAIC Credit for Reinsurance Model Act. Arch Re Bermuda is approved in Florida and New York to post reduced collateral.
Holding Company Acts.
All states have enacted legislation that regulates insurance holding company systems. These regulations generally
provide that
each insurance company in the system is required to register with the insurance department of its state of domicile and furnish information concerning the operations of companies within the holding
company system which may materially affect the operations, management or financial condition of the insurers within the system. All transactions within a holding company system affecting insurers must
be fair and reasonable. Notice to the state insurance departments is required prior to the consummation of certain material transactions between an insurer and any entity in its holding company
system. In addition, certain of such transactions cannot be consummated without the applicable insurance department's prior approval, or its failure to disapprove after receiving notice. The holding
company acts also prohibit any person from directly or indirectly acquiring control of a U.S. insurance company unless that person has filed an application with specified information with the
insurance company's domiciliary commissioner and has obtained the commissioner's prior approval. Under most states' statutes, including Missouri and Nebraska, acquiring 10% or more of the voting
securities of an insurance company or its parent company is presumptively considered an acquisition of control of the insurance company, although such presumption may be rebutted. Accordingly, any
person or entity that acquires, directly or indirectly, 10% or more of the voting securities of ACGL without the prior approval of the commissioner will be in violation of these laws and may be
subject to injunctive action requiring the disposition or seizure of those securities by
34
Table of Contents
the
commissioner or prohibiting the voting of those securities, or to other actions that may be taken by the commissioner. In 2010, the NAIC adopted amendments to the Insurance Holding Company System
Regulatory Act and Regulation, which, among other changes, introduce the concept of "enterprise risk" within an insurance holding company system. If and when the amendments are adopted by a particular
state, the amended Insurance Holding Company System Regulatory Act and Regulation would impose more extensive informational requirements on parents and other affiliates of licensed insurers or
reinsurers with the purpose of protecting them from enterprise risk, including requiring an annual enterprise risk report by the ultimate controlling person identifying the material risks within the
insurance holding company system that could pose enterprise risk to the licensed companies. The amended Insurance Holding Company System Regulatory Act also requires any controlling person of a U.S.
insurance company seeking to divest its controlling interest in the insurance company to file with the commissioner a confidential notice of the proposed divestiture at least 30 days prior to
the cessation of control; after receipt of the notice, the commissioner shall determine those instances in which the parties seeking to divest or to acquire a controlling interest will be required to
file for or obtain approval of the transaction. The amended Insurance Holding Company System Regulatory Act and Regulation must be adopted by the individual states for the new requirements to apply to
U.S. domestic insurers and reinsurers. To date, only ten states (California, Connecticut, Indiana, Kentucky, Louisiana, Nebraska, Pennsylvania, Rhode Island, Texas and West Virginia) have enacted
legislation adopting the amended Insurance Holding Company System Regulatory Act. It is not clear if and when other states will adopt these changes; however, the NAIC is seeking to make the amendments
part of its accreditation standards for state solvency regulation, which would motivate states to adopt the amendments promptly.
Enterprise Risk.
The NAIC has increased its focus on risks within an insurer's holding company system that may pose enterprise risk to
the insurer.
"Enterprise risk" is defined as any activity, circumstance, event or series of events involving one or more affiliates of an insurer that, if not remedied promptly, is likely to have a material
adverse effect upon the financial condition or the liquidity of the insurer or its insurance holding company system as a whole. As noted above, the NAIC recently adopted amendments to its Model
Insurance Holding Company System Regulatory Act and Regulation, which include, among other amendments, a requirement for the ultimate controlling person to file an enterprise risk report. In 2012, the
NAIC adopted the Risk Management and Own Risk and Solvency Assessment ("ORSA") Model Act, which requires domestic insurers to maintain a risk management framework and establishes a legal requirement
for domestic insurers to conduct an ORSA in accordance with the NAIC's ORSA Guidance Manual. The ORSA Model Act provides that domestic insurers, or their insurance group, must regularly conduct an
ORSA consistent with a process comparable to the ORSA Guidance Manual process. The ORSA Model Act also provides that, no more than once a year, an insurer's domiciliary regulator may request that an
insurer submit an ORSA summary report, or any combination of reports that together contain the information described in the ORSA Guidance Manual, with respect to the insurer and/or the insurance group
of which it is a member. If and when the ORSA Model Act is adopted by a particular state, the ORSA Model Act would impose more extensive filing requirements on parents and other affiliates of domestic
insurers.
Regulation of Dividends and Other Payments from Insurance Subsidiaries.
The ability of an insurer to pay dividends or make other
distributions is
subject to insurance regulatory limitations of the insurance company's state of domicile. Generally, such laws limit the payment of dividends or other distributions above a specified level. Dividends
or other distributions in excess of such thresholds are "extraordinary" and are subject to prior regulatory approval. Such dividends or distributions may be subject to applicable withholding or other
taxes. See "Management's Discussion and Analysis of Financial Condition and Results of OperationsFinancial Condition, Liquidity and Capital ResourcesLiquidity and Capital
Resources" and note 20, "Statutory Information," of the notes accompanying our financial statements.
35
Table of Contents
Insurance Regulatory Information System Ratios.
The NAIC Insurance Regulatory Information System ("IRIS") was developed by a committee
of state
insurance regulators and is intended primarily to assist state insurance departments in executing their statutory mandates to oversee the financial condition of insurance companies operating in their
respective states. IRIS identifies 13 industry ratios (referred to as "IRIS ratios") and specifies "usual values" for each ratio. Departure from the usual values of the IRIS ratios can lead to
inquiries from individual state insurance commissioners as to certain aspects of an insurer's business. Certain of our U.S.-based subsidiaries generate IRIS ratios that are outside of the usual
values. To date, none of these subsidiaries has received any notice of regulatory review regarding the IRIS ratios but there is no assurance that we may not be notified in the future.
Accreditation.
The NAIC has instituted its Financial Regulation Accreditation Standards Program ("FRASP") in response to federal
initiatives to
regulate the business of insurance. FRASP provides a set of standards designed to establish effective state regulation of the financial condition of insurance companies. Under FRASP, a state must
adopt certain laws and regulations, institute required regulatory practices and procedures, and have adequate personnel to enforce such items in order to become an "accredited" state. If a state is
not accredited, other states may not accept certain financial examination reports of insurers prepared solely by the regulatory agency in such unaccredited state. The respective states in which Arch
Re U.S., Arch Insurance, Arch E&S, Arch Specialty and Arch Indemnity are domiciled are accredited states.
Risk-Based Capital Requirements.
In order to enhance the regulation of insurer solvency, the NAIC adopted in December 1993 a formula
and
model law to implement risk-based capital requirements for property and casualty insurance companies. These risk-based
capital requirements are designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policyholder obligations. The risk-based capital model
for property and casualty insurance companies measures three major areas of risk facing property and casualty insurers:
-
-
underwriting, which encompasses the risk of adverse loss developments and inadequate pricing;
-
-
declines in asset values arising from credit risk; and
-
-
declines in asset values arising from investment risks.
An
insurer will be subject to varying degrees of regulatory action depending on how its statutory surplus compares to its risk-based capital calculation. For equity
investments in an insurance company affiliate, the risk-based capital requirements for the equity securities of such affiliate would generally be our U.S.-based subsidiaries' proportionate
share of the affiliate's risk-based capital requirement.
Under
the approved formula, an insurer's total adjusted capital is compared to its authorized control level risk-based capital. If this ratio is above a minimum threshold, no
company or regulatory action is necessary. Below this threshold are four distinct action levels at which a regulator can intervene with increasing degrees of authority over an insurer as the ratio of
surplus to risk-based capital requirement decreases. The four action levels include:
-
-
insurer is required to submit a plan for corrective action;
-
-
insurer is subject to examination, analysis and specific corrective action;
-
-
regulators may place insurer under regulatory control; and
-
-
regulators are required to place insurer under regulatory control.
Each
of our U.S. subsidiaries' surplus (as calculated for statutory purposes) is above the risk-based capital thresholds that would require either company or regulatory
action.
Guaranty Funds and Assigned Risk Plans.
Most states require all admitted insurance companies to participate in their respective
guaranty funds which
cover certain claims against insolvent insurers.
36
Table of Contents
Solvent
insurers licensed in these states are required to cover the losses paid on behalf of insolvent insurers by the guaranty funds and are generally subject to annual assessments in the states by
the guaranty funds to cover these losses. Participation in state-assigned risk plans may take the form of reinsuring a portion of a pool of policies or the direct issuance of policies to insureds. The
calculation of an insurer's participation in these plans is usually based on the amount of premium for that type of coverage that was written by the insurer on a voluntary basis. Assigned risk pools
tend to produce losses which result in assessments to insurers writing the same lines on a voluntary basis.
Federal Regulation.
Although state regulation is the dominant form of regulation for insurance and reinsurance business, the federal
government in
recent years has shown some concern over the adequacy of state regulation. It is not possible to predict the future impact of any potential federal regulations or other possible laws or regulations on
our U.S. based subsidiaries' capital and operations, and such laws or regulations could materially adversely affect their business. In addition, a number of federal laws affect and apply to the
insurance industry, including various privacy laws and the economic and trade sanctions implemented by the Office of Foreign Assets Control ("OFAC"). OFAC maintains and enforces economic sanctions
against certain foreign countries and groups and prohibits U.S. persons from engaging in certain transactions with certain persons or entities. OFAC has imposed civil penalties on persons, including
insurance and reinsurance companies, arising from violations of its economic sanctions program.
Terrorism Risk Insurance Program Reauthorization Act of 2007.
The Terrorism Risk Insurance Act of 2002 was amended and extended by the
Terrorism Risk
Insurance Extension Act of 2005 and amended and extended again by the Terrorism Risk Insurance Program Reauthorization Act of 2007 ("TRIPRA") through December 31, 2014. TRIPRA provides a
federal backstop for insurance related losses resulting from any act of terrorism on U.S. soil or against certain U.S. air carriers, vessels or foreign missions. Under TRIPRA, all U.S. based property
and casualty insurers are required to make terrorism insurance coverage available in specified commercial property and casualty insurance lines. Under TRIPRA, the federal government will pay 85% of
covered losses after an insurer's losses exceed a deductible determined by a statutorily prescribed formula, up to a combined annual aggregate limit for the federal government and all insurers of
$100 billion. If an act (or acts) of terrorism result in covered losses exceeding the $100 billion annual limit, insurers with losses exceeding their deductibles will not be responsible
for additional losses. An insurer's deductible for each year is based on the insurer's direct commercial earned premiums for property and casualty insurance, excluding certain lines of business such
as commercial auto, surety, professional liability and earthquake lines of business, for the prior calendar year multiplied by 20%. The specified percentages for prior periods were 15% for 2005, 17.5%
for 2006, 20% for 2007, 20% for 2008 through 2012.
Our
U.S.-based property and casualty insurers, Arch Insurance, Arch Specialty, Arch E&S and Arch Indemnity, are subject to TRIPRA. TRIPRA specifically excludes reinsurance business and,
accordingly, does not apply to our reinsurance operations. Our insurance group's deductible for 2012 was approximately $220 million (i.e., 20.0% of earned premiums). Based on 2012 direct
commercial earned premiums, our insurance group's deductible for 2013 will be approximately $239 million (i.e., 20.0% of such earned premiums). TRIPRA extends through 2014.
The Gramm-Leach-Bliley Act.
The Gramm-Leach-Bliley Act of 1999 ("GLBA"), which implements fundamental changes in the regulation of the
financial
services industry in the United States, was enacted on November 12, 1999. The GLBA permits mergers that combine commercial banks, insurers and securities firms under one holding company, a
"financial holding company." Bank holding companies and other entities that qualify and elect to be treated as financial holding companies may engage in activities, and acquire companies engaged in
activities, that are "financial" in nature or "incidental" or "complementary" to such financial activities. Such financial activities include acting as principal, agent or broker in the underwriting
and sale of life, property, casualty and other forms of insurance and annuities.
37
Table of Contents
Until the passage of the GLBA, the Glass-Steagall Act of 1933 had limited the ability of banks to engage in securities-related businesses, and the Bank Holding
Company Act of 1956 had restricted banks from being affiliated with insurers. Since passage of the GLBA, among other things, bank holding companies may acquire insurers, and insurance holding
companies may acquire banks. The ability of banks to affiliate with insurers may affect our U.S. subsidiaries' product lines by substantially increasing the number, size and financial strength of
potential competitors.
The Dodd-Frank Wall Street Reform and Consumer Protection Act.
The Dodd-Frank Act creates the Federal Insurance Office
("FIO") within the Department of Treasury, which is not a federal regulator or supervisor of insurance, but will monitor the insurance industry for systemic risk, administer the TRIPRA, consult with
the states regarding insurance matters and develop federal policy on aspects of international insurance matters. The FIO has sought comment from the insurance industry in connection with the
preparation of reports, which have not yet been released, on (i) modernization of the insurance regulatory system and (ii) the global reinsurance market and the regulation of
reinsurance. The Dodd-Frank Act also created a uniform system for non-admitted insurance premium tax payments based on the home state of the policyholder and provides for
single state regulation for financial solvency and credit for reinsurance as discussed above.
Legislative and Regulatory Proposals.
From time to time various regulatory and legislative changes have been proposed in the insurance
and
reinsurance industry. Among the proposals that have in the past been or are at present being considered are the possible introduction of federal regulation in addition to, or in lieu of, the current
system of state regulation of insurers. In addition, there are a variety of proposals being considered by various state legislatures. One initiative that has been ongoing for several years is the
Solvency Modernization Initiative ("SMI"), which is a self-examination of the U.S. insurance solvency regulation framework being undertaken by the NAIC. This includes a review of
international developments regarding supervision, banking supervision, international accounting standards and their potential use in U.S. insurance regulation. The SMI is focusing on five key areas:
capital requirements, governance and risk management, group supervision, statutory accounting and financial reporting and reinsurance.
We
are unable to predict whether any of these proposed laws and regulations will be adopted, the form in which any such laws and regulations would be adopted, or the effect, if any,
these developments would have on our operations and financial condition. See "U.S. Insurance RegulationGeneral."
General.
The Financial Services Authority (the "FSA") regulates insurance and reinsurance companies and firms carrying on insurance
mediation
activities operating in the U.K. under the Financial Services and Markets Act 2000 (the "FSMA"). In May 2004, Arch Insurance Company Europe was licensed and authorized by the FSA. It holds the
relevant permissions for the classes of insurance business which it underwrites in the U.K. In 2009, AUAL was licensed and authorized by the FSA and the Lloyd's Franchise Board. AUAL holds the
relevant permissions for the classes of insurance business which are underwritten in the U.K. by Arch Syndicate 2012. Arch Syndicate 2012 has one member, Arch Syndicate Investments Ltd. Arch
Risk Partners was licensed and authorized by the FSA in February 2012 to conduct insurance mediation activities. All U.K. companies are also subject to a range of statutory provisions, including the
laws and regulations of the Companies Acts 2006 (as amended) (the "U.K. Companies Acts").
The
primary statutory goals of the FSA are to maintain and promote confidence in the U.K. financial system, secure the appropriate degree of protection for consumers and reduce financial
crime. The FSA regulatory regime imposes risk management, solvency and capital requirements on U.K. insurance companies. The FSA has broad authority to supervise and regulate insurance companies and
38
Table of Contents
firms
carrying on insurance mediation which extends to enforcement of the provisions of the FSMA and intervention in the operations of an insurance company. The FSA regime is based on principles from
which all of its rules and guidance derive. Among these principles, the FSA increasingly emphasizes a "culture of compliance" in those firms it regulates. The FSA carries out regular Advanced Risk
Responsive Operating Framework ("ARROW") assessments of regulated firms to ensure compliance with its rules and guidance. The FSA conducted risk assessments of Arch Insurance Company Europe in 2006
and 2008 and of Arch Insurance Company Europe and AUAL in 2011. The assessments provided the FSA's views on Arch Insurance Company Europe's and AUAL's risk profile and regulatory
capital requirements. In some cases, the FSA may require remedial action or adjustments to a company's management, operations, capital requirements, claims management or business plan. The U.K.
government announced in 2010 that the FSA will be replaced by two new agencies, the Prudential Regulation Authority ("PRA") and the Financial Conduct Authority ("FCA"). The legislation effecting this
change, the Financial Services Act 2012, will come into effect on April 1, 2013, at which point the PRA and FCA will take over regulatory responsibility for the insurance and reinsurance
industries in the U.K. The objectives of the PRA are to promote the safety and soundness of all firms it supervises and to secure an appropriate degree of protection for policyholders. The objectives
of the FCA are to ensure customers receive financial services and products that meet their needs, to promote sound financial systems and markets and to ensure that firms are stable and resilient with
transparent pricing information and which compete effectively and have the interests of their customers and the integrity of the market at the heart of how they run their business. The current
responsibilities of the FSA will be split so that the PRA will assume responsibility for prudential regulation of banks and insurers, while the FCA will assume responsibility for the conduct of
business regulation in the wholesale and retail markets. Both the PRA and FCA entered into consultation processes in the fall of 2012 regarding proposed changes to existing regulatory rules. The
results of those consultation processes have not yet been published. The PRA and FCA will adopt methods of assessing firms under their supervision. Where reference is made to the FSA in this document,
the PRA or FCA, as applicable, will assume responsibility on April 1, 2013. Arch Insurance Company Europe and AUAL, will be subject to regulation by both the PRA and FCA. Arch Risk Partners
will be subject to regulation by the FCA only.
Lloyd's Supervision.
The operations of AUAL and related Arch Syndicate 2012 and its corporate member, Arch Syndicate
Investments Ltd
("ASIL"), are subject to the byelaws and regulations made by (or on behalf of) the Council of Lloyd's, and requirements made under those byelaws. The Council of Lloyd's, established in
1982 by Lloyd's Act 1982, has overall responsibility and control of Lloyd's. Those byelaws, regulations and requirements provide a framework for the regulation of the Lloyd's market, including
specifying conditions in relation to underwriting and claims operations of Lloyd's participants. Lloyd's is also subject to the provisions of the FSMA and is itself authorized and regulated as an
insurer by the FSA (and will be subject to regulation by the PRA and FCA). Those entities acting within the Lloyd's market are required to comply with the requirements of the FSMA and provisions of
the FSA's rules, although the FSA has delegated certain of its powers, including some of those relating to prudential requirements, to Lloyd's. ASIL, as a member of Lloyd's, is required to contribute
0.5% of Arch Syndicate 2012's premium income limit for each year of account to the Lloyd's central fund. The Lloyd's central fund is available if members of Lloyd's assets are not sufficient to meet
claims for which
the member is liable. As a member of Lloyd's, ASIL may also be required to contribute to the central fund by way of a supplement to a callable layer of up to 3% of Arch Syndicate 2012's premium income
limit for the relevant year of account. In addition, AUAL, on behalf of Arch Syndicate 2012, is approved to underwrite excess and surplus lines insurance in most states in the U.S. through Lloyd's
licenses. Such activities must be in compliance with the Lloyd's requirements.
Financial Resources.
Arch Insurance Company Europe, AUAL (on behalf of itself, Arch Syndicate 2012 and ASIL) and Arch Risk Partners are
each required
to demonstrate to the FSA that each has adequate financial assets to meet the financial resources requirement for its category. When the FSA is
39
Table of Contents
split
into the PRA and FCA, Arch Insurance Company Europe and AUAL (on behalf of itself, Arch Syndicate 2012 and ASIL) will each be required to demonstrate the adequacy of its financial assets to the
PRA, while Arch Risk Partners will be required to demonstrate the adequacy of its financial assets to the FCA. On a periodic basis, Arch Insurance Europe is required to provide the FSA and Lloyd's
with its own risk-based assessment of its capital needs, taking into account comprehensive risk factors, including market, credit, operational, liquidity and group risks to generate a
revised calculation of its expected liabilities which, in turn, enable the FSA and Lloyd's to provide individual capital guidance and requirements to Arch Insurance Europe. When the FSA is split into
the PRA and FCA, similar requirements from the PRA will take effect. Arch Insurance Europe's surplus is above the risk-based capital threshold allowed by the FSA's individual capital
assessment of Arch Insurance Europe. The FSA requires that Arch Insurance Europe maintain a margin of solvency calculation based on the classes of business for which it is authorized and within its
premium income projections applied to its worldwide general business.
Reporting Requirements.
Like all U.K. companies, Arch Insurance Europe and Arch Risk Partners must file and submit their annual audited
financial
statements in accordance with IFRS and related reports to the Registrar of Companies under the U.K. Companies Acts together with an annual return of certain core corporate information and changes from
the prior year. This requirement is in addition to the regulatory returns required to be filed annually with the FSA for Arch Insurance Company Europe, AUAL and Arch Risk Partners and, in the case of
AUAL and ASIL, Lloyd's.
Financial Services Compensation Scheme.
The Financial Services Compensation Scheme ("FSCS") is a scheme established under FSMA to
compensate eligible
policyholders of insurance companies who may
become insolvent. FSCS is funded by levies it has the power to impose on all insurers. Arch Insurance Europe and/or Arch Risk Partners could be required to pay levies to FSCS.
Restrictions on Acquisition of Control.
Under FSMA, the prior consent of the FSA is required before any person can become a controller
or increase
its control over any regulated company, including Arch Insurance Company Europe, AUAL and Arch Risk Partners, or over the parent undertaking of any regulated company. Therefore, the FSA's prior
consent is required before any person can become a controller of ACGL. Prior consent is also required from Lloyd's before any person can become a controller or increase its control over a corporate
member or a managing agent or a parent undertaking of a corporate member or managing agent. A controller is defined for these purposes as a person who holds (either alone or in concert with others)
10% or more of the shares or voting power in the relevant company or its parent undertaking.
Restrictions on Payment of Dividends.
Under English law, all companies are restricted from declaring a dividend to their shareholders
unless they
have "profits available for distribution." The calculation as to whether a company has sufficient profits is based on its accumulated realized profits minus its accumulated realized losses. U.K.
insurance regulatory laws do not prohibit the payment of dividends, but the FSA requires that insurance companies and insurance intermediaries maintain certain solvency margins and may restrict the
payment of a dividend by Arch Insurance Company Europe, AUAL, ASIL or Arch Risk Partners. See "Management's Discussion and Analysis of Financial Condition and Results of
OperationsFinancial Condition, Liquidity and Capital ResourcesLiquidity and Capital Resources" and note 20, "Statutory Information," of the notes accompanying our
financial statements.
European Union Considerations.
Through their respective authorizations in the U.K., a Member State of the European Union ("EU"), Arch
Insurance
Company Europe's, AUAL's and Arch Risk Partners' authorizations are recognized throughout the European Economic Area ("EEA"), subject only to certain notification and application
requirements. This authorization enables Arch Insurance Company Europe, AUAL and Arch Risk Partners to establish a branch in any other Member State of the EU, where such entity will be subject to the
insurance regulations of each such Member State with
40
Table of Contents
respect
to the conduct of its business in such Member State, but remain subject only to the financial and operational supervision by the FSA. The framework for the establishment of branches in Member
States of the EU other than the U.K. was generally set forth, and remains subject to, directives adopted
by the European Council, the legislative body of the EU, which directives are then implemented in each Member State. Arch Insurance Company Europe currently has branches in Denmark, Germany, Italy,
Spain and Sweden and may establish branches in other Member States of the EU in the future. Further, through its authorizations in an EU Member State, Arch Risk Partners, Arch Insurance Company Europe
and AUAL have the freedom to provide insurance services anywhere in the EEA subject to compliance with certain rules governing such provision, including notification to the FSA.
On
November 25, 2009, the EU adopted a new directive directed at insurance and reinsurance companies known as Solvency II. Solvency II is a new regulatory regime which will impose
economic risk-based solvency requirements across all EU Member States and consists of three pillars: (1) Pillar Iquantitative capital requirements, based on a
valuation of the entire balance sheet; (2) Pillar IIqualitative regulatory review, which includes governance, internal controls, enterprise risk management and supervisory
review process; and (3) Pillar IIImarket discipline, which is accomplished through reporting of the insurer's financial condition to regulators and the public. Secondary
legislation under Solvency II is currently being discussed by the European Parliament and Council and by the European Commission, and the directive will then have to be implemented in the U.K. by the
U.K. Government, the PRA and the FCA (and in all other EU jurisdictions by their respective governments and insurance supervisors). The Solvency II directive is currently due to be transposed into
national law by EU Member States on June 30, 2013 and will apply to firms on January 1, 2014, although this date may be further postponed. Arch Insurance Company Europe, AUAL and
Syndicate 2012 will be required to comply with Solvency II requirements.
The Canadian branch of Arch Insurance, as well as Arch Insurance Canada, the newly formed Canadian company which commenced underwriting
on January 1, 2013, are subject to federal, as well as provincial and territorial, regulation in Canada. The Office of the Superintendent of Financial Institutions ("OSFI") is the federal
regulatory body that, under the Insurance Companies Act (Canada), regulates federal Canadian and non-Canadian insurance companies operating in Canada. The primary goal of OSFI is to
supervise the safety and soundness of insurance companies with the aim of securing the appropriate level of protection of insureds by imposing risk management, solvency and capital requirements on
such companies. Arch Insurance Canada is subject to regulation in the provinces and territories in which it underwrites insurance, and the primary goal of insurance regulation at the provincial and
territorial levels is to govern the market conduct of insurance companies. Arch Insurance Canada is licensed to carry on insurance business by OSFI and in each province and territory.
Under
the Insurance Companies Act (Canada), the Canadian branch office is required to maintain an adequate margin of assets over liabilities in Canada, calculated in accordance with a
test promulgated by OSFI called the Branch Adequacy of Assets Test. In addition, under the Insurance Companies Act (Canada), Arch Insurance Canada is required to maintain an adequate amount of capital
in Canada, calculated in accordance with a test promulgated by OSFI called the Minimum Capital Test ("MCT"). Arch Insurance Canada and the branch operation of Arch Insurance are required to file
financial
information with OSFI on an ongoing basis, including annual audited financial statements in accordance with Canadian generally accepted accounting principles and other returns and quarterly unaudited
financial statements. The appointed actuary of our Canadian operations must report annually on the adequacy of their reserves. OSFI's continuing supervision includes analysis of this information and
periodic examinations of the Canadian branch office. OSFI has implemented a risk-based methodology for assessing insurance companies operating in Canada known as its
41
Table of Contents
"Supervisory
Framework". In applying the Supervisory Framework, OSFI considers the inherent risks of the business and the quality of risk management for each significant activity of operating entity.
General.
The Central Bank of Ireland ("CBOI") regulates insurance and reinsurance companies authorized in Ireland. We have two Irish
operating
subsidiaries: Arch Re Europe and Arch Mortgage. Arch Re Europe was licensed and authorized by the CBOI as a non-life reinsurer in October 2008 and as a life reinsurer in November 2009.
Arch Mortgage was licensed and authorized by the CBOI as a non-life insurer in December 2011.
Both
Arch Re Europe and Arch Mortgage are subject to the regulation and supervision of the CBOI. Arch Re Europe must comply with the European Communities (Reinsurance) Regulations, 2006,
rules made thereunder and, insofar as relevant to reinsurance, the Irish Insurance Acts 1909 to 2009, regulations promulgated there under, regulations relating to reinsurance business promulgated
under the European Communities Act 1972, the Irish Central Bank Acts 1942 to 2011 as amended, regulations promulgated there under and directions, guidelines and codes of conduct issued by the CBOI.
Irish authorized reinsurers, such as Arch Re Europe, are also subject to the general body of Irish laws and regulations including the provisions of the Companies Acts 1963-2012. Arch
Mortgage must comply with the Irish Insurance Acts 1909 to 2009, regulations promulgated thereunder, regulations relating to insurance business promulgated under the European Communities Act 1972, the
Irish Central Bank Acts 1942 to 2011, as amended, regulations promulgated thereunder and directions and guidelines and codes of conduct issued by the CBOI.
Financial Resources.
Both Arch Re Europe and Arch Mortgage are required to maintain reserves, particularly in respect of underwriting
liabilities and
a solvency margin as provided for in the Irish insurance acts and regulations mentioned above. Arch Re Europe must maintain assets constituting statutory reserves which must comply with principles
including obligations to secure sufficiency, liquidity, security, quality, profitability and currency matching of investments. An appointed actuary must opine on the adequacy of the statutory reserves
of both Arch Re Europe and Arch Mortgage annually.
Reporting Requirements.
Like most Irish companies, Arch Re Europe and Arch Mortgage must file and submit their annual audited financial
statements in
accordance with Irish generally accepted accounting principles and related reports to the Registrar of Companies ("Registrar") under the Companies Acts 1963-2012 together with an annual
return of certain core corporate information. Changes to core corporate information during the year must also be notified to the Registrar. These requirements are in addition to the regulatory returns
required to be filed annually with the CBOI.
Restrictions on Payment of Dividends.
Under Irish company law, Arch Re Europe and Arch Mortgage are permitted to make distributions
only out of
profits available for distribution. A company's profits available for distribution are its accumulated, realized profits, so far as not previously utilized by distribution or capitalization, less its
accumulated, realized losses, so far as not previously written off in a reduction or reorganization of capital duly made. Further, the CBOI has powers to intervene if a dividend payment were to lead
to a breach of regulatory capital requirements. See "Management's Discussion and Analysis of Financial Condition and Results of OperationsFinancial Condition, Liquidity and Capital
ResourcesLiquidity and Capital Resources" and note 20, "Statutory Information," of the notes accompanying our financial statements.
European Union Considerations.
As a reinsurance company authorized in Ireland, a Member State of the EU, Arch Re Europe's authorization
is recognized
throughout the EEA, subject only to any notification requirements imposed by other EU Member States. This authorization enables Arch Re Europe to provide reinsurance services, or to establish a
branch, in any other Member State of the
42
Table of Contents
EEA.
Although, in doing so, it may be subject to the laws of such Member States with respect to the conduct of its business in such Member State, company law registrations and other matters, it will
remain subject to financial and operational supervision by the CBOI only. Arch Re Europe has a branch in Denmark, Arch Re Accident & Health ApS ("Arch Re Denmark"), which is an underwriting
agency underwriting accident and health business for Arch Re Europe. Arch Re Europe also has a branch in the U.K., which underwrites non-life reinsurance risk for Arch Re Europe. Finally,
Arch Re Europe also has a branch outside the EEA, Arch Reinsurance Europe Underwriting Limited, Dublin (Ireland), Zurich Branch ("Arch Re Europe Swiss Branch").
As
an insurance company authorized in Ireland, a Member State of the EU, Arch Mortgage's authorization is recognized throughout the EEA, subject to certain notifications requirements
imposed under the European Directives and there being no objection from the CBOI and the Member States concerned, and it may establish branches and provide insurance services in all EEA Member States.
In November 2006, Arch Re Bermuda opened Arch Reinsurance Ltd., Hamilton (Bermuda), European Branch Zurich ("Arch Re Bermuda
Swiss Branch"). In December 2008, Arch Re Europe opened Arch Re Europe Swiss Branch as a branch office. Upon the opening of this branch in the fourth quarter of 2008, the operations of Arch Re Bermuda
Swiss Branch were transferred to Arch Re Europe Swiss Branch. Arch Re Bermuda Swiss Branch was formally de-registered from the commercial register of the Canton of Zurich in early 2009. As
both Arch Re Europe and Arch Re Bermuda are domiciled outside of Switzerland and their activities were and are limited to reinsurance, their respective branches in Switzerland were and are not
required to be licensed by the Swiss insurance regulatory authorities.
The single system established in the EU for regulation and supervision of the general insurance sector and its single passport regime
had until 2007 applied only to direct insurance, and there was no common regulation of reinsurance in the EU. However, direct insurers established in a Member State of the EEA who were also authorized
by their domestic regulatory authorities to transact reinsurance have had freedom to establish branches in and provide insurance services to all EEA states and that freedom has in practice been
extended to their reinsurance activities. In December 2005, the EU published the Reinsurance Directive (the "Directive") as a first
step in harmonization of reinsurance regulation in the single market. Member States of the EU and the EEA were required to implement the Directive by December 2007. Pure reinsurers established in a
Member State of the EU now have freedom to establish branches in and provide services to all EEA states under a regime comparable to that enjoyed by direct insurers, and they will be subject to
similar rules in relation to licensing and financial supervision.
Arch
Insurance Company Europe, AUAL and Arch Risk Partners, being established in the U.K. and authorized by the FSA, are able, subject to regulatory notifications and there being no
objection from the FSA and the Member States concerned, to establish branches and provide insurance and reinsurance services in all EEA Member States. Arch Re Europe, being established in Ireland and
authorized by the CBOI to write reinsurance, is able, subject to similar regulatory notifications and there being no objection from the CBOI and the Member States concerned, to establish branches and
provide reinsurance services in those EEA states which have implemented the Directive. The Directive itself does not prohibit EEA insurers from obtaining reinsurance from reinsurers licensed outside
the EEA, such as Arch Re Bermuda. As such, and subject to the specific rules in particular Member States, Arch Re Bermuda may do business from Bermuda with insurers in EEA Member States, but it may
not directly operate its reinsurance business within the EEA. Unless agreement is reached between the European Commission and Bermuda to accord Bermuda based reinsurers with market access on the
43
Table of Contents
basis
of the equivalent nature of Bermuda regulation, each individual EEA Member State may impose conditions on reinsurance provided by Bermuda based reinsurers which could restrict their future
provision of reinsurance to the EEA Member State concerned. A number of EEA Member States currently restrict the extent to which Bermudian reinsurers may promote their services in those Member States,
and a few have certain prohibitions on the purchase of insurance from reinsurers not authorized in the EEA. The Directive is scheduled to be repealed and replaced by new provisions under Solvency II
on January 1, 2014. However, this may change depending on whether the implementation date for Solvency II is extended again from January 1, 2014.
Article 172
of Solvency II will, when it comes into force, provide that reinsurance contracts concluded by insurance undertakings in the EEA with reinsurers having their head
office in a country whose solvency regime has been determined to be equivalent to Solvency II shall be treated in the same manner as reinsurance contracts with undertakings in the EEA authorized under
Solvency II. The European Commission is considering whether the solvency regime in Bermuda is equivalent to that laid down in Solvency II. In October 2011, the European Insurance and Occupational
Pensions Authority ("EIOPA"), which is established under European Law as an independent advisory body to the European Parliament, the European Council and the European Commission and specifically to
assist in preparing equivalence decisions, advised that Bermuda meets the criteria set out in EIOPA's methodology for equivalence assessments under Solvency II subject to certain caveats set out in
EIOPA's report. EIOPA will revisit its assessment of the equivalence of the solvency regime in Bermuda when implementation measures for Solvency II have been agreed.
TAX MATTERS
The following summary of the taxation of ACGL and the taxation of our shareholders is based upon current law and is for general
information only. Legislative, judicial or administrative changes may be forthcoming that could affect this summary.
The
following legal discussion (including and subject to the matters and qualifications set forth in such summary) of certain tax considerations (a) under "Taxation
of ACGLBermuda" and "Taxation of ShareholdersBermuda Taxation" is based upon the advice of Conyers Dill & Pearman Limited, Hamilton, Bermuda and
(b) under "Taxation of ACGLUnited States," "Taxation of ShareholdersUnited States Taxation," "Taxation of Our U.S. Shareholders"
and "United States Taxation of Non-U.S. Shareholders" is based upon the advice of Cahill Gordon & Reindel
LLP
, New York,
New York (the advice of such firms does not include accounting matters, determinations or conclusions relating to the business or activities of ACGL). The summary is based upon current law and is for
general information only. The tax treatment of a holder of our shares (common shares or series C non-cumulative preferred shares), or of a person treated as a holder of our shares
for U.S. federal income, state, local or non-U.S. tax purposes, may vary depending on the holder's particular tax situation. Legislative, judicial or administrative changes or
interpretations may be forthcoming that could be retroactive and could affect the tax consequences to us or to holders of our shares.
Taxation of ACGL
Under current Bermuda law, ACGL is not subject to tax on income or profits, withholding, capital gains or capital transfers. ACGL has
obtained from the Minister of Finance under the Exempted Undertakings Tax Protection Act 1966 an assurance that, in the event that Bermuda enacts legislation imposing tax computed on profits, income,
any capital asset, gain or appreciation, or any tax in the nature of estate duty or inheritance, the imposition of any such tax shall not be applicable to ACGL or to any of our operations or our
shares, debentures or other obligations
until March 31, 2035. We could be subject to taxes in Bermuda after that date. This assurance will be subject to the proviso that it is
44
Table of Contents
not
to be construed so as to prevent the application of any tax or duty to such persons as are ordinarily resident in Bermuda (we are not so currently affected) or to prevent the application of any
tax payable in accordance with the provisions of the Land Tax Act 1967 or otherwise payable in relation to any property leased to us or our insurance subsidiary. We pay annual Bermuda government fees,
and our Bermuda insurance and reinsurance subsidiary pays annual insurance license fees. In addition, all entities employing individuals in Bermuda are required to pay a payroll tax and other sundry
taxes payable, directly or indirectly, to the Bermuda government.
ACGL and its non-U.S. subsidiaries intend to conduct their operations in a manner that will not cause them to be treated as
engaged in a trade or business in the United States and, therefore, will not be required to pay U.S. federal income taxes (other than U.S. excise taxes on insurance and reinsurance premium and
withholding taxes on dividends and certain other U.S. source investment income). However, because definitive identification of activities which constitute being engaged in a trade or business in the
U.S. is not provided by the Internal Revenue Code of 1986, as amended (the "Code"), or regulations or court decisions, there can be no assurance that the U.S. Internal Revenue Service will not contend
successfully that ACGL or its non-U.S. subsidiaries are or have been engaged in a trade or business in the United States. A foreign corporation deemed to be so engaged would be subject to
U.S. income tax, as well as the branch profits tax, on its income, which is treated as effectively connected with the conduct of that trade or business unless the corporation is entitled to relief
under the permanent establishment provisions of a tax treaty. Such income tax, if imposed, would be based on effectively connected income computed in a manner generally analogous to that applied to
the income of a domestic corporation, except that deductions and credits generally are not permitted unless the foreign corporation has timely filed a U.S. federal income tax return in accordance with
applicable regulations. Penalties may be assessed for failure to file tax returns. The 30% branch profits tax is imposed on net income after subtracting the regular corporate tax and making certain
other adjustments.
Under
the income tax treaty between Bermuda and the United States (the "Treaty"), ACGL's Bermuda insurance subsidiaries will be subject to U.S. income tax on any insurance
premium income found to be effectively connected with a U.S. trade or business only if that trade or business is conducted through a permanent establishment in the United States. No regulations
interpreting the Treaty have been issued. While there can be no assurances, ACGL does not believe that any of its Bermuda insurance subsidiaries has a permanent establishment in the United States.
Such subsidiaries would not be
entitled to the benefits of the Treaty if (i) less than 50% of ACGL's shares were beneficially owned, directly or indirectly, by Bermuda residents or U.S. citizens or residents,
or (ii) any such subsidiary's income were used in substantial part to make disproportionate distributions to, or to meet certain liabilities to, persons who are not Bermuda residents or U.S.
citizens or residents. While there can be no assurances, ACGL believes that its Bermuda insurance subsidiaries are eligible for Treaty benefits.
The
Treaty clearly applies to premium income, but may be construed as not protecting investment income. If ACGL's Bermuda insurance subsidiaries were considered to be
engaged in a U.S. trade or business and were entitled to the benefits of the Treaty in general, but the Treaty were not found to protect investment income, a portion of such subsidiaries' investment
income could be subject to U.S. federal income tax.
Non-U.S.
insurance companies carrying on an insurance business within the United States have a certain minimum amount of effectively connected net investment income,
determined in accordance with a formula that depends, in part, on the amount of U.S. risk insured or reinsured by such companies. If any of ACGL's non-U.S. insurance
subsidiaries is considered to be engaged in the
45
Table of Contents
conduct
of an insurance business in the United States, a significant portion of such company's investment income could be subject to U.S. income tax.
Non-U.S.
corporations not engaged in a trade or business in the United States are nonetheless subject to U.S. income tax on certain "fixed or determinable annual or periodic
gains, profits and income" derived from sources within the United States as enumerated in Section 881(a) of the Code (such as dividends and certain interest on investments), subject to
exemption under the Code or reduction by applicable treaties.
The
United States also imposes an excise tax on insurance and reinsurance premiums paid to non-U.S. insurers or reinsurers with respect to risks located in the United States.
The rates of tax, unless reduced by an applicable U.S. tax treaty, are 4% for non-life insurance premiums and 1% for life insurance and all reinsurance premiums.
Our U.K. subsidiaries are companies incorporated and have their central management and control in the U.K., and are therefore resident
in the U.K. for corporation tax purposes. As a result, they will be subject to U.K. corporate tax on their respective worldwide profits. The main rate of U.K. corporation tax for the financial year
starting April 1, 2012 is 24% on profits, but progressive decreases in the rate have been announced to take effect on April 1, 2013 through 2014 from 23% to 21%.
In January 2005, Arch Insurance received its federal license to commence underwriting in Canada and began writing business in the first
quarter of 2005 through its branch operation. Effective January 1, 2013, the branch operation was domesticated into Arch Insurance Canada, a new Canadian federal insurance company subsidiary of
Arch Insurance. The branch operation will be taxed on net business income earned in Canada in 2012. Canadian income taxes for the branch operation in 2012 will also be creditable to our U.S.
operations. Arch Insurance Canada is taxed on its worldwide income. The general federal corporate income tax rate in Canada is currently 15%. Provincial and territorial corporate income tax rates are
added to the general federal corporate income tax rate and generally vary between 10% and 16%.
Arch Re Europe was licensed and authorized by the CBOI as a non-life reinsurer in October 2008 and as a life reinsurer in
November 2009. Arch Mortgage was licensed and authorized by the CBOI as a non-life insurer in 2011. Each of Arch Re Europe and Arch Mortgage is incorporated and resident in Ireland for
corporation tax purposes and will be subject to Irish corporate tax on its worldwide profits, including the profits of Arch Re Europe Swiss Branch and its newly authorized U.K. branch. Any creditable
foreign tax (i.e., Swiss or U.K.) payable will be creditable against Arch Re Europe's Irish corporate tax liability on the results of Arch Re Europe's Swiss and U.K. branches. The current rate
of Irish corporation tax applicable to such profits is 12.5%.
Arch Re Europe Swiss Branch is subject to Swiss corporation tax on the profit which is allocated to the branch. The effective tax rate
is approximately 21.17% for Swiss federal, cantonal and communal corporation taxes on the profit. The effective tax rate of the annual cantonal and communal capital taxes on the equity which is
allocated to Arch Re Europe Swiss Branch is approximately 0.172%.
46
Table of Contents
Arch Re Denmark, established as a subsidiary of Arch Re Bermuda, is subject to Danish corporation taxes on its profits at a rate of
25%.
Taxation of Shareholders
The following summary sets forth certain United States federal income tax considerations related to the purchase, ownership and
disposition of our common shares and our series C non-cumulative preferred shares ("preferred shares"). Unless otherwise stated, this summary deals only with shareholders ("U.S.
Holders") that are United States Persons (as defined below) who hold their common shares and preferred shares as capital assets and as beneficial owners. The following discussion is only a general
summary of the United States federal income tax matters described herein and does not purport to address all of the United States federal income tax consequences that may be relevant to a particular
shareholder in light of such shareholder's specific circumstances. In addition, the following summary does not describe the United States federal income tax consequences that may be relevant to
certain types of shareholders, such as banks, insurance companies, regulated investment companies, real estate investment trusts, financial asset securitization investment trusts, dealers in
securities or traders that adopt a mark-to-market method of tax accounting, tax exempt organizations, expatriates or persons who hold the common shares or preferred shares as
part of a hedging or conversion transaction or as part of a straddle, who may be subject to special rules or treatment under the Code. This discussion is based upon the Code, the Treasury regulations
promulgated there under
and any relevant administrative rulings or pronouncements or judicial decisions, all as in effect on the date of this annual report and as currently interpreted, and does not take into account
possible changes in such tax laws or interpretations thereof, which may apply retroactively. This discussion does not include any description of the tax laws of any state or local governments within
the United States, or of any foreign government, that may be applicable to our common shares or preferred shares or the shareholders. Persons considering making an investment in the common shares or
preferred shares should consult their own tax advisors concerning the application of the United States federal tax laws to their particular situations as well as any tax consequences arising under the
laws of any state, local or foreign taxing jurisdiction prior to making such investment.
If
a partnership holds our common shares or preferred shares, the tax treatment of a partner will generally depend upon the status of the partner and the activities of the partnership.
If you are a partner of a partnership holding our common shares or preferred shares, you should consult your tax advisor.
For
purposes of this discussion, the term "United States Person" means:
-
-
a citizen or resident of the United States,
-
-
a corporation or entity treated as a corporation created or organized in or under the laws of the United States, or any
political subdivision thereof,
-
-
an estate the income of which is subject to United States federal income taxation regardless of its source,
-
-
a trust if either (x) a court within the United States is able to exercise primary supervision over the
administration of such trust and one or more United States persons have the authority to control all substantial decisions of such trust or (y) the trust has a valid election in effect to be
treated as a United States person for U.S. federal income tax purposes or
-
-
any other person or entity that is treated for U.S. federal income tax purposes as if it were one of the foregoing.
47
Table of Contents
Currently, there is no Bermuda withholding tax on dividends paid by us.
Taxation of Dividends.
The preferred shares should be properly classified as equity rather than debt for U.S. federal income tax
purposes. Subject to
the discussions below relating to the potential application of the CFC, "related person insurance income" ("RPII") and PFIC rules, as defined below, cash distributions, if any, made with respect to
our common shares or preferred shares will constitute dividends for U.S. federal income tax purposes to the extent paid out of our current or accumulated earnings and profits (as computed using U.S.
tax principles). If a U.S. Holder of our common shares or our preferred shares is an individual or other non-corporate holder, dividends paid, if any, to that holder that constitute
qualified dividend income will be taxable at the rate applicable for long-term capital gains (generally up to 20%), provided that such person meets a holding period requirement. Generally
in order to meet the holding period requirement, the United States Person must hold the common shares for more than 60 days during the 121-day period beginning 60 days before
the ex-dividend date and must hold preferred shares for more than 90 days during the 181-day period beginning 90 days before the ex-dividend date.
Dividends paid, if any, with respect to common shares or preferred shares generally will be qualified dividend income, provided the common shares or preferred shares are readily tradable on an
established securities market in the U.S. in the year in which the shareholder receives the dividend (which should be the case for shares that are listed on the NASDAQ Stock Market or the New York
Stock Exchange) and ACGL is not considered to be a passive foreign investment company in either the year of the distribution or the preceding taxable year. No assurance can be given that the preferred
shares will be considered readily tradable on an established securities market in the United States. See "Taxation of Our U.S. Shareholders" below.
For
taxable years beginning after December 31, 2012, a U.S. Holder that is an individual, estate or a trust that does not fall into a special class of trusts that is exempt from
such tax, will be subject to a 3.8% tax on the lesser of (1) the U.S. Holder's "net investment income" for the relevant taxable year and (2) the excess of the U.S. Holder's modified
adjusted gross income for the taxable year over a certain threshold (which in the case of individual will be between $125,000 and $250,000, depending on the individual's circumstances). A U.S.
Holder's net investment income will generally include its dividend income and its net gains from the disposition of our common shares and preferred shares, unless such dividend income or net gains are
derived in the ordinary course of the conduct of a trade or business (other than a trade or business that consists of certain passive or trading activities).
Distributions
with respect to the common shares and the preferred shares will not be eligible for the dividends received deduction allowed to U.S. corporations under the Code. To the
extent distributions on our common shares and preferred shares exceed our earnings and profits, they will be treated first as a return of the U.S. Holder's basis in our common shares and our preferred
shares to the extent thereof, and then as gain from the sale of a capital asset.
Sale, Exchange or Other Disposition.
Subject to the discussions below relating to the potential application of the CFC, RPII and PFIC
rules, holders
of common shares and preferred shares generally will recognize capital gain or loss for U.S. federal income tax purposes on the sale, exchange or disposition of common shares or preferred shares, as
applicable.
Redemption of Preferred Shares.
A redemption of the preferred shares will be treated under section 302 of the Code as a dividend
if we have
sufficient earnings and profits, unless the redemption satisfies one of the tests set forth in section 302(b) of the Code enabling the redemption to be treated as a sale or exchange, subject to
the discussion herein relating to the potential application of the CFC, RPII and PFIC rules. Under the relevant Code section 302(b) tests, the redemption should be treated as a sale or exchange
only if it (1) is substantially disproportionate, (2) constitutes a complete
48
Table of Contents
termination
of the holder's stock interest in us or (3) is "not essentially equivalent to a dividend." In determining whether any of these tests are met, shares considered to be owned by the
holder by reason of certain constructive ownership rules set forth in the Code, as well as shares actually owned, must generally be taken into account. It may be more difficult for a United States
Person who owns, actually or constructively by operation of the attribution rules, any of our other shares to satisfy any of the above requirements. The determination as to whether any of the
alternative tests of section 302(b) of the Code is satisfied with respect to a particular holder of the preference shares depends on the facts and circumstances as of the time the determination
is made.
Taxation of Our U.S. Shareholders
Under our bye-laws, the 9.9% voting restriction applicable to the Controlled Shares of a U.S. Person (as defined in our
bye-laws) generally does not apply to certain of our investors. Depending upon the ownership of these investors and as a result of certain attribution rules, we and our foreign
subsidiaries could be controlled foreign corporations ("CFCs"). That status as a CFC would not cause us or any of our subsidiaries to be subject to U.S. federal income tax. Such status also would have
no adverse U.S. federal income tax consequences for any U.S. Holder that is considered to own less than 10% of the total combined voting power of our shares or those of our foreign subsidiaries. Only
U.S. Holders that are considered to own 10% or more of the total combined voting power of our shares or those of our foreign subsidiaries (taking into account shares actually owned by such U.S. Holder
as well as shares attributed to such U.S. Holder under the Code or the regulations there under) (a "10% U.S. Voting Shareholder") would be affected by our status as a CFC. The preferred shares
generally should not be considered voting stock for purposes of determining whether a United States Person would be a "10% U.S. Voting Shareholder." The shares may, however, become entitled to vote
(as a class along with any other class of preferred shares of ACGL then outstanding) for the election of two additional members of the board of directors of ACGL if ACGL does not declare and pay
dividends for the equivalent of six or more dividend periods. In such case, the preferred shares should be treated as voting stock for as long as such voting rights continue. Our bye-laws
are intended to prevent any U.S. Holder from being considered a 10% U.S. Voting Shareholder by limiting the votes conferred by the Controlled Shares (as defined in our bye-laws) of any
U.S. Person to 9.9% of the total voting power of all our shares entitled to vote. However, because under our bye-laws certain funds associated with Warburg Pincus and Hellman &
Friedman generally are entitled to vote their directly owned common shares in full, a U.S. Holder that is attributed (under the Code or the regulations there under) common shares owned by such funds
may be considered a 10% U.S. Voting Shareholder. If we are a CFC, a U.S. Holder that is considered a 10% U.S. Voting Shareholder would be subject to current U.S. federal income taxation (at ordinary
income tax rates) to the extent of all or a portion of the undistributed earnings and profits of ACGL and our subsidiaries attributable to "subpart F income" (including certain insurance
premium income and investment income) and may be taxable at ordinary income tax rates on any gain realized on a sale or other disposition (including by way of repurchase or liquidation) of our shares
to the extent of the current and accumulated earnings and profits attributable to such shares.
While
our bye-laws are intended to prevent any member from being considered a 10% U.S. Voting Shareholder (except as described above), there can be no assurance that a U.S.
Holder will
not be treated as a 10% U.S. Voting Shareholder, by attribution or otherwise, under the Code or any applicable regulations there under.
49
Table of Contents
Generally, we do not expect the gross RPII (related person insurance income) of any of our non-U.S. subsidiaries to equal
or exceed 20% of its gross insurance income in any taxable year for the foreseeable future and do not expect the direct or indirect insureds (and related persons) of any such subsidiary to directly or
indirectly own 20% or more of either the voting power or value of our stock. Consequently, we do not expect any U.S. person owning common shares or preferred shares to be required to include in gross
income for U.S. federal income tax purposes RPII income, but there can be no assurance that this will be the case.
Section 953(c)(7)
of the Code generally provides that Section 1248 of the Code (which generally would require a U.S. Holder to treat certain gains attributable to the sale,
exchange or disposition of common shares or preferred shares as a dividend) will apply to the sale or exchange by a U.S. shareholder of shares in a foreign corporation that is characterized as a CFC
under the RPII rules if the foreign corporation would be taxed as an insurance company if it were a domestic corporation, regardless of whether the U.S. shareholder is a 10% U.S. Voting Shareholder or
whether the corporation qualifies for either the RPII 20% ownership exception or the RPII 20% gross income exception. Although existing Treasury Department regulations do not address the question,
proposed Treasury regulations issued in April 1991 create some ambiguity as to whether Section 1248 and the requirement to file
Form 5471 would apply when the foreign corporation has a foreign insurance subsidiary that is a CFC for RPII purposes and that would be taxed as an insurance company if it were a domestic
corporation. We believe that Section 1248 and the requirement to file Form 5471 will not apply to a less than 10% U.S. Shareholder because ACGL is not directly engaged in the insurance
business. There can be no assurance, however, that the U.S. Internal Revenue Service will interpret the proposed regulations in this manner or that the Treasury Department will not take the position
that Section 1248 and the requirement to file Form 5471 will apply to dispositions of our common shares or our preferred shares.
If
the U.S. Internal Revenue Service or U.S. Treasury Department were to make Section 1248 and the Form 5471 filing requirement applicable to the sale of our shares, we
would notify shareholders that Section 1248 of the Code and the requirement to file Form 5471 will apply to dispositions of our shares. Thereafter, we would send a notice after the end
of each calendar year to all persons who were shareholders during the year notifying them that Section 1248 and the requirement to file Form 5471 apply to dispositions of our shares by
U.S. Holders. We would attach to this notice a copy of Form 5471 completed with all our information and instructions for completing the shareholder information.
Tax-exempt entities may be required to treat certain Subpart F insurance income, including RPII, that is includible
in income by the tax-exempt entity as unrelated business taxable income. Prospective investors that are tax exempt entities are urged to consult their tax advisors as to the potential
impact of the unrelated business taxable income provisions of the Code.
Sections 1291 through 1298 of the Code contain special rules applicable with respect to foreign corporations that are "passive
foreign investment companies" ("PFICs"). In general, a foreign corporation will be a PFIC if 75% or more of its income constitutes "passive income" or 50% or more of its assets produce passive income.
If we were to be characterized as a PFIC, U.S. Holders would be subject to a penalty tax at the time of their sale of (or receipt of an "excess distribution" with respect to) their common shares or
preferred shares. In general, a shareholder receives an "excess distribution" if the amount of the distribution is more than 125% of the average distribution with respect to the
50
Table of Contents
shares
during the three preceding taxable years (or shorter period during which the taxpayer held the stock). In general, the penalty tax is equivalent to an interest charge on taxes that are deemed
due during the period the shareholder owned the shares, computed by assuming that the excess distribution or gain (in the case of a sale) with respect to the shares was taxable in equal portions
throughout the holder's period of ownership. The interest charge is equal to the applicable rate imposed on underpayments of U.S. federal income tax for such period. A U.S. shareholder may avoid some
of the adverse tax consequences of owning shares in a PFIC by making a qualified electing fund ("QEF") election. A QEF election is revocable only with the consent of the IRS and has the following
consequences to a shareholder:
-
-
For any year in which ACGL is not a PFIC, no income tax consequences would result.
-
-
For any year in which ACGL is a PFIC, the shareholder would include in its taxable income a proportionate share of the net
ordinary income and net capital gains of ACGL and certain of its non-U.S. subsidiaries.
The
PFIC statutory provisions contain an express exception for income "derived in the active conduct of an insurance business by a corporation which is predominantly engaged in an
insurance business..." This exception is intended to ensure that income derived by a bona fide insurance company is not treated as passive income, except to the extent such income is attributable to
financial reserves in excess of the reasonable needs of the insurance business. The PFIC statutory provisions contain a look-through rule that states that, for purposes of determining
whether a foreign corporation is a PFIC, such foreign corporation shall be treated as if it "received directly its proportionate share of the income" and as if it "held its proportionate share of the
assets" of any other corporation in which it owns at least 25% of the stock. We believe that we are not a PFIC, and we will use reasonable best efforts to cause us and each of our non-U.S.
insurance subsidiaries not to constitute a PFIC.
No
regulations interpreting the substantive PFIC provisions have yet been issued. Each U.S. Holder should consult his tax advisor as to the effects of these rules.
United States Taxation of Non-U.S. Shareholders
Cash distributions, if any, made with respect to common shares or preferred shares held by shareholders who are not United States
Persons ("Non-U.S. holders") generally will not be subject to United States withholding tax.
Sale, Exchange or Other Disposition
Non-U.S. holders of common shares or preferred shares generally will not be subject to U.S. federal income tax with respect
to gain realized upon the sale, exchange or other disposition of such shares unless such gain is effectively connected with a U.S. trade or business of the Non-U.S. holder in the United
States or such person is present in the United States for 183 days or more in the taxable year the gain is realized and certain other requirements are satisfied.
If a trust or estate that is otherwise treated as a Non-U.S. Holder has any beneficiaries that are U.S. taxpayers, such
trust or beneficiaries may be subject to the medicare tax described under "Taxation of ShareholdersUnited States Taxation". If you are a non-U.S. trust or estate
that has any U.S. beneficiaries, you should consult your own tax advisors regarding the potential application of this medicare tax.
51
Table of Contents
Non-U.S. holders of common shares or preferred shares will not be subject to U.S. information reporting or backup
withholding with respect to dispositions of common shares effected through a non-U.S. office of a broker, unless the broker has certain connections to the United States or is a United
States person. No U.S. backup withholding will apply to payments of dividends, if any, on our common shares or our preferred shares.
Shareholders should consult their own tax advisors with respect to the applicability to them of the tax laws of other jurisdictions.