ARCH CAPITAL GROUP LTD - 10-Q Quarterly Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2002
Or
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the transition period ______________ to ______________

Commission file number: 0-26456

ARCH CAPITAL GROUP LTD.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

Bermuda Not Applicable
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)

Wessex House, 3rd Floor
45 Reid Street
Hamilton, Bermuda HM 12
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code: (441) 278-9250

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(Former name, former address and former fiscal year, if changed since
last report)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.

Yes /X/ No / /

Indicate the number of shares outstanding of each of the issuer's classes of
common shares.

Class Outstanding At June 30, 2002
------------------------------ ----------------------------
Common Shares, $0.01 par value 23,795,740

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ARCH CAPITAL GROUP LTD.

INDEX

1

REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Shareholders of
Arch Capital Group Ltd.:

We have reviewed the accompanying consolidated balance sheet of Arch Capital
Group Ltd. and its subsidiaries as of June 30, 2002, and the related
consolidated statements of income for each of the three and six month periods
ended June 30, 2002 and 2001, and the consolidated statements of comprehensive
income, changes in shareholders' equity, and cash flows for each of the six
month periods ended June 30, 2002 and 2001. These financial statements are the
responsibility of the Company's management.

We conducted our review in accordance with standards established by the American
Institute of Certified Public Accountants. A review of interim financial
information consists principally of applying analytical procedures to financial
data and making inquiries of persons responsible for financial and accounting
matters. It is substantially less in scope than an audit conducted in accordance
with generally accepted auditing standards, the objective of which is the
expression of an opinion regarding the financial statements taken as a whole.
Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should
be made to the accompanying consolidated interim financial information for it to
be in conformity with accounting principles generally accepted in the United
States of America.

We previously audited in accordance with auditing standards generally accepted
in the United States of America, the consolidated balance sheet as of December
31, 2001, and the related consolidated statements of income, comprehensive
income and changes in shareholders' equity, and of cash flows for the year then
ended (not presented herein), and in our report dated February 28, 2002, except
as to the matters described in Note 18 to the consolidated financial statements
which are as of March 7, 2002, we expressed an unqualified opinion on those
consolidated financial statements. In our opinion, the information set forth in
the accompanying condensed consolidated balance sheet information as of December
31, 2001, is fairly stated in all material respects in relation to the
consolidated balance sheet from which it has been derived.

/s/ PricewaterhouseCoopers LLP
PricewaterhouseCoopers LLP
New York, New York
August 2, 2002

2

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)

See Notes to Consolidated Financial Statements

3

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT SHARE DATA)

See Notes to Consolidated Financial Statements

4

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(IN THOUSANDS)

See Notes to Consolidated Financial Statements

5

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(IN THOUSANDS)

See Notes to Consolidated Financial Statements

6

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

See Notes to Consolidated Financial Statements

7

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. GENERAL

The interim consolidated financial statements have been prepared in
conformity with accounting principles generally accepted in the United States
("GAAP") and include the accounts of Arch Capital Group Ltd. ("ACGL") and its
subsidiaries (together with ACGL, the "Company"), including Arch Reinsurance
Ltd. ("Arch Re Bermuda"), Arch Capital Group (U.S.) Inc. ("Arch-U.S."), Arch
Reinsurance Company ("Arch Re U.S."), Arch Insurance Company ("Arch Insurance"),
formerly known as First American Insurance Company, Arch Excess & Surplus
Insurance Company ("Arch E&S"), formerly known as Cross River Insurance Company,
Arch Specialty Insurance Company ("Arch Specialty"), formerly known as Rock
River Insurance Company, Arch Risk Transfer Services Ltd. ("ART Services"),
American Independent Insurance Holding Company ("AIHC"), and Hales & Company
Inc. ("Hales"). All significant intercompany transactions and balances have been
eliminated in consolidation.

The preparation of financial statements in conformity with GAAP requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates. In the opinion of management, the accompanying unaudited interim
consolidated financial statements reflect all adjustments necessary (consisting
only of normal recurring accruals) for a fair statement of results on an interim
basis. The results of any interim period are not necessarily indicative of the
results for a full year or any future periods. Certain information and footnote
disclosures normally included in financial statements prepared in accordance
with GAAP have been condensed or omitted pursuant to such rules and regulations;
however, management believes that the disclosures are adequate to make the
information presented not misleading. This report should be read in conjunction
with the Company's annual report on Form 10-K for the year ended December 31,
2001, including the Company's audited consolidated financial statements and
related notes and the section entitled "Risk Factors." Many events, such as
natural catastrophes such as earthquakes, hurricanes, tornados and hailstorms,
can have a significant impact on the results of any one or more reporting
periods.

In October 2001, the Company launched an underwriting initiative to meet
current and future demand in the global insurance and reinsurance markets that
included the recruitment of new management teams and an equity capital infusion
of $763.2 million. In April 2002, the Company completed an offering of 7,475,000
of its common shares and received net proceeds of $179.2 million. Due to the
significant changes in the Company's business and operations resulting from the
new underwriting initiative and related capital infusions, comparisons of 2002
to 2001 results are not meaningful.

2. ACCOUNTING PRONOUNCEMENTS

In August 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 144, "Accounting for
the Impairment or Disposal of Long-Lived Assets," which was adopted by the
Company on January 1, 2002. SFAS No. 144 addresses the accounting and reporting
for impairment of long-lived assets to be held and used, as well as long-lived
assets to be disposed of. The standard requires that long-lived assets to be
held and used will be written down to fair value when they are considered
impaired. Long-lived assets to be disposed of are required to be carried at the
lower of carrying amount or fair value less estimated cost to sell. SFAS No. 144
also broadens the presentation of discontinued operations on the income
statement to include a component of an entity (rather than a segment of a
business). The adoption of this standard did not have a material effect on the
Company's results of operations for the three month and six month periods ended
June 30, 2002 or its financial position.

In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." SFAS No. 146 will be applied
prospectively to exit or disposal activities initiated after December 31, 2002
and requires companies to recognize costs associated with exit activities when
they are incurred, rather than at the date of a commitment to an exit or
disposal plan. The Company is currently evaluating this standard.

8

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

3. RECLASSIFICATIONS

To facilitate period to period comparisons, certain amounts in the 2001
consolidated financial statements have been reclassified to conform to the 2002
presentation. Such reclassifications had no effect on the Company's net income,
shareholders' equity or cash flows.

4. GOODWILL

In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets," which became effective for the Company on January 1, 2002. In adopting
SFAS No. 142, the Company discontinued amortizing goodwill and will test
goodwill at least annually for impairment. SFAS No. 142 also requires that, upon
adoption, the Company complete a transitional goodwill impairment test six
months from the date of adoption. The Company tested its goodwill for impairment
at each reporting unit as of January 1, 2002 in accordance with SFAS No. 142
and, based on such evaluation, it was determined that goodwill was not impaired.
Goodwill will be tested for impairment on an annual basis and between annual
tests in certain circumstances.

The carrying amount of goodwill at June 30, 2002 was $28.8 million,
consisting of $23.1 million relating to the Company's insurance subsidiaries
($13.6 million, $6.7 million and $2.8 million relating to the acquisitions of
AIHC, ART Services and Arch Specialty, respectively) and $5.7 million relating
to the acquisition of Hales.

The following table provides the pro forma effect on net income and basic
and diluted earnings per share for the three and six month periods ended June
30, 2002 and 2001, as if the amortization of goodwill had ceased at the
beginning of 2001 (net of taxes):

9

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

5. CONTINGENCIES RELATING TO THE SALE OF PRIOR REINSURANCE OPERATION

On May 5, 2000, the Company sold the prior reinsurance operations of Arch
Re U.S. pursuant to an agreement entered into as of January 10, 2000 with
Folksamerica Reinsurance Company and Folksamerica Holding Company (collectively,
"Folksamerica"). The Folksamerica transaction was structured as a transfer and
assumption agreement (and not reinsurance), and, accordingly, the loss reserves
(and any related reinsurance recoverables) relating to the transferred business
are not included as assets or liabilities on the Company's balance sheet.
Folksamerica assumed Arch Re U.S.'s rights and obligations under the reinsurance
agreements transferred in the asset sale. The reinsureds under such agreements
were notified that Folksamerica had assumed Arch Re U.S.'s obligations and that,
unless the reinsureds object to the assumption, Arch Re U.S. will be released
from its obligations to those reinsured. None of such reinsureds objected to the
assumption. However, Arch Re U.S. will continue to be liable under those
reinsurance agreements if the notice is found not to be an effective release by
the reinsureds. Folksamerica has agreed to indemnify the Company for any losses
arising out of the reinsurance agreements transferred to Folksamerica
Reinsurance Company in the asset sale. However, in the event that Folksamerica
refuses or is unable to perform its obligations to the Company, Arch Re U.S. may
incur losses relating to the reinsurance agreements transferred in the asset
sale. Folksamerica has an A.M. Best rating of "A-" (Excellent).

Under the terms of the agreement, $20 million of the purchase price had
been placed in escrow for a period of five years. Such amounts represented
restricted funds that appeared under a separate caption entitled "Securities
held in escrow" on the Company's consolidated balance sheet at December 31,
2001. These funds were to be used to reimburse Folksamerica if the loss reserves
(which were $32.3 million at the closing of the asset sale) transferred to it in
the asset sale relating to business produced on behalf of Arch Re U.S. by a
certain managing underwriting agency were deficient as measured at the end of
such five-year period or to satisfy certain indemnity claims Folksamerica may
have had during such period. On February 25, 2002, the Company reached a
definitive settlement agreement with Folksamerica pursuant to which the Company
satisfied its obligations under the escrow agreement for consideration of $17.0
million, plus accrued interest income of $1.8 million. Accordingly, during the
2001 fourth quarter, the Company recorded an after-tax benefit of $0.4 million,
which consisted of a charge of $2.5 million, offset by a reversal of a related
reserve in the amount of $2.9 million. The related reserve had been provided for
the purchase of reinsurance, which was no longer required due to the fact that
the escrow arrangements have been terminated under the above settlement
agreement.

Under the terms of the agreement, the Company had also purchased in 2000
reinsurance protection covering the Company's transferred aviation business to
reduce the net financial loss to Folksamerica on any large commercial airline
catastrophe to $5.4 million, net of reinstatement premiums. Although the Company
believes that any such net financial loss will not exceed $5.4 million, the
Company has agreed to reimburse Folksamerica if a loss is incurred that exceeds
$5.4 million for aviation losses under certain circumstances prior to May 5,
2003. The Company also made representations and warranties to Folksamerica about
the Company and the business transferred to Folksamerica for which the Company
retains exposure for certain periods, and made certain other agreements,
including that the Company would not compete with Folksamerica to acquire or
reinsure any treaties included in the assumed business until May 5, 2004.
Although Folksamerica has not asserted that any amount is currently due under
any of the indemnities provided by the Company under the asset purchase
agreement, Folksamerica has indicated a potential indemnity claim under the
agreement in the event of the occurrence of certain future events. Based on all
available information, the Company has denied the validity of any such potential
claim. In addition, the Company retained its tax and employee benefit
liabilities and other liabilities not assumed by Folksamerica, including all
liabilities not arising under reinsurance agreements transferred to Folksamerica
in the asset sale and all liabilities (other than liabilities arising under
reinsurance agreements) arising out of or relating to the managing underwriting
agency referred to above.

10

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

6. SEGMENT INFORMATION

The Company classifies its businesses into two underwriting segments -
reinsurance and insurance - and a corporate segment (non-underwriting). Segment
performance is evaluated based on underwriting income or loss. Other revenue and
expense items are not evaluated by segment. In addition, the Company does not
manage its assets by segment and, accordingly, investment income is not
allocated to each segment. The accounting policies of the segments are the same
as those used for the consolidated financial statements. Inter-segment insurance
business is allocated to the segment accountable for the underwriting results in
accordance with SFAS No. 131.

The reinsurance segment consists of the Company's reinsurance underwriting
subsidiaries, Arch Re Bermuda, based in Bermuda, and Arch Re U.S., based in the
United States. The reinsurance segment's strategy is to write significant
portions of business on a select number of specialty property and casualty
treaties. Classes of business focused on include property catastrophe
reinsurance, other property business (losses on a single risk, both excess of
loss and pro rata), casualty, other specialty business, marine, aviation and
space, casualty clash and non-traditional business.

The insurance segment includes the Company's primary underwriting
subsidiaries, which include Arch Insurance, Arch Specialty, Arch E&S and
American Independent. The insurance segment is comprised of six profit centers
including property, casualty, executive assurance, healthcare, professional
liability insurance and program business, and other (currently identified as the
non-standard auto business of American Independent and the lenders business of
Arch Insurance).

The corporate segment (non-underwriting) includes net investment income and
net realized gains or losses and other corporate expenses incurred by the
Company. The corporate segment also includes the results of Hales, the Company's
merchant banking subsidiary. Due to the significant changes in the Company's
business and operations resulting from the new underwriting initiative and
related capital infusions, comparisons of 2002 and 2001 results are not
meaningful. Accordingly, segment information provided below relates solely to
2002 periods. The following tables set forth an analysis of the Company's
underwriting income or loss by segment, together with a reconciliation of
underwriting income or loss to net income for the three month and six month
periods ended June 30, 2002.

11

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

6. SEGMENT INFORMATION (CONTINUED)

(1) Reflects $18.2 million of net premiums written assumed by the reinsurance
segment from the insurance segment.
(2) Underwriting ratios are calculated based on net premiums earned.
(3) The acquisition expense ratio is adjusted to include certain policy-related
fee income.

12

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

6. SEGMENT INFORMATION (CONTINUED)

(1) Reflects $37.0 million of net premiums written assumed by the reinsurance
segment from the insurance segment.
(2) Underwriting ratios are calculated based on net premiums earned.
(3) The acquisition expense ratio is adjusted to include certain policy-related
fee income.

13

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

6. SEGMENT INFORMATION (CONTINUED)

Set forth below is summary information regarding net premiums written by
client location and by line of business for the reinsurance and insurance
segments for the three and six month periods ended June 30, 2002:

(1) Reflects $18.2 million and $37.0 million of net premiums written,
respectively, for the three month and six month periods ended June 30, 2002
assumed by the reinsurance segment from the insurance segment.

14

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

7. REINSURANCE

In the normal course of business, the Company's insurance subsidiaries cede
a portion of their premium through quota share, surplus, excess of loss and
facultative reinsurance agreements. The Company's reinsurance subsidiaries are
currently retaining substantially all of their assumed reinsurance premiums
written. Reinsurance recoverables are recorded as assets, predicated on the
reinsurers' ability to meet their obligations under the reinsurance agreements.
If the reinsurers are unable to satisfy their obligations under the agreements,
the Company's insurance subsidiaries would be liable for such defaulted amounts.

With respect to 2002 and 2001 results reflected below, the following table
sets forth the effects of reinsurance on the Company's reinsurance and insurance
subsidiaries to unaffiliated reinsurers. With respect to 2001 results, the table
sets forth the effects of reinsurance on American Independent only, which was
acquired by the Company in February 2001.

15

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

8. INVESTMENT INFORMATION

The following tables reconcile estimated fair value and carrying value to
the amortized cost of fixed maturities and equity securities at June 30, 2002
and December 31, 2001:

Privately held securities consisted of the following at June 30, 2002 and
December 31, 2001:

During the six months ended June 30, 2002, the Company received
distributions from The ARC Group, LLC ("ARC") totaling $1.4 million. On April
12, 2002, the Company sold its investment in ARC to Trident II, L.P. and two
limited partnerships associated with Marsh & McLennan Companies, Inc. for
consideration of $14.5 million. The realized gain of $5.8 million on the sale of
the Company's investment in ARC is net of certain

16

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

8. INVESTMENT INFORMATION (CONTINUED)

transaction expenses and was recorded in the 2002 second quarter. During the six
months ended June 30, 2002, the Company also received aggregate distributions of
$2.7 million from Trident II, L.P. including (1) a return of capital of $2.3
million which reduced the Company's carrying value in Trident II, L.P. and (2)
net realized gains of $434,000. In August 2002, the Company received a return of
capital of approximately $392,000 from New Europe Insurance Ventures ("NEIV"),
which reduced the Company's carrying value in NEIV at such date.

At June 30, 2002, the Company had investment commitments relating to its
privately held securities totaling approximately $3.6 million, and the Company
had funded a total of $1.1 million of its $1.5 million capital commitment to
Distribution Investors, LLC.

9. EARNINGS PER SHARE

The following table sets forth the computation of basic and diluted
earnings per share:

On April 8, 2002, ACGL issued 7,475,000 of its common shares and received
net proceeds of approximately $179.2 million. In addition, in April 2002,
446,608 newly issued common shares of ACGL were issued upon the exercise of
1,559,257 Class A warrants on a cashless basis. On June 28, 2002, ACGL issued
875,753 additional Series A convertible preference shares pursuant to a
post-closing purchase price adjustment mechanism under the subscription
agreement entered into in connection with the capital infusion completed in
November 2001.

10. INCOME TAXES

ACGL is incorporated under the laws of Bermuda and, under current Bermuda
law, is not obligated to pay any taxes in Bermuda based upon income or capital
gains. The Company has received a written undertaking from the Minister of
Finance in Bermuda under the Exempted Undertakings Tax Protection Act 1966 that,
in the event that any legislation is enacted in Bermuda imposing any tax
computed on profits, income, gain or

17

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

10. INCOME TAXES (CONTINUED)

appreciation on any capital asset, or any tax in the nature of estate duty or
inheritance tax, such tax will not be applicable to ACGL or any of its
operations until March 28, 2016. This undertaking does not, however, prevent the
imposition of taxes on any person ordinarily resident in Bermuda or any company
in respect of its ownership of real property or leasehold interests in Bermuda.

ACGL will be subject to U.S. federal income tax only to the extent that it
derives U.S. source income that is subject to U.S. withholding tax or income
that is effectively connected with the conduct of a trade or business within the
U.S. and is not exempt from U.S. tax under an applicable income tax treaty with
the U.S. ACGL will be subject to a withholding tax on dividends from U.S.
investments and interest from certain U.S. taxpayers. ACGL does not consider
itself to be engaged in a trade or business within the U.S. and, consequently,
does not expect to be subject to direct U.S. income taxation. However, because
there is uncertainty as to the activities which constitute being engaged in a
trade or business within the United States, there can be no assurances that the
U.S. Internal Revenue Service will not contend successfully that ACGL or its
non-U.S. subsidiaries are engaged in a trade or business in the United States.
If ACGL or any of its non-U.S. subsidiaries were subject to U.S. income tax,
ACGL's shareholders' equity and earnings could be materially adversely affected.
ACGL's U.S. subsidiaries are subject to U.S. income taxes on their worldwide
income.

ACGL changed its legal domicile from the United States to Bermuda in
November 2000. Legislation has been introduced which (if enacted) could
eliminate the tax benefits available to companies that have changed their legal
domiciles to Bermuda, and such legislation may apply to ACGL. In addition, some
U.S. insurance companies have been lobbying Congress to pass legislation
intended to eliminate certain perceived tax advantages of U.S. insurance
companies with Bermuda affiliates resulting principally from reinsurance between
or among U.S. insurance companies and their Bermuda affiliates. This
legislation, if passed, and other changes in U.S. tax laws, regulations and
interpretations thereof to address these issues could materially adversely
affect the Company.

For the six months ended June 30, 2002, the Company's income tax provision
resulted in an effective tax rate of 14.5%, excluding the reversal of a $7.4
million valuation allowance on certain of the Company's deferred tax assets
during the 2002 second quarter. The Company's remaining valuation allowance is
$2.1 million at June 30, 2002. The effective tax rate will fluctuate based on
the relative amounts of the Company's U.S.-sourced income and its worldwide
income. The valuation allowance reversal was based on the Company's recently
completed restructuring of its U.S.-based insurance underwriting operations and
its business plan.

11. RELATED PARTY TRANSACTIONS

In April 2002, pursuant to agreements entered into in November 2001 in
connection with the Company's new underwriting initiative, a subsidiary of ACGL
made a non-recourse loan of $13.5 million to Robert Clements, the Chairman of
ACGL's Board of Directors, which was used to pay income and self employment
taxes, payable in April 2002, on 1,668,157 restricted shares granted to him on
October 23, 2001. The loan is secured by such shares, and bears interest at a
rate of 4.6% per annum and will mature on the October 23, 2006. If the Company
terminates Mr. Clements' service as Chairman for cause, the loan will become
immediately payable. Mr. Clements will receive additional compensation in cash
in an amount sufficient to defray the interest cost. In addition, the Company
has agreed to make gross-up payments to him in the event of certain tax
liabilities.

In connection with the Company's information technology initiative in 2002,
the Company has entered into arrangements with two software companies, which
provide document management systems and information and research tools to
insurance underwriters, in which Mr. Clements and John Pasquesi, the Vice
Chairman of ACGL's Board of Directors, each own minority ownership interests.
The Company will pay fees under such arrangements based on usage. Under one of
these agreements, fees payable are subject to a minimum of approximately
$575,000 for the two-year period ending July 2004.

18

ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

11. RELATED PARTY TRANSACTIONS (CONTINUED)

Since January 2002, the Company has leased temporary office space from
Tri-City Brokerage Inc. (together with its affiliates, "Tri-City"), a company
in which Peter Appel, President and Chief Executive Officer of ACGL, Mr.
Clements and Distribution Investors, LLC hold ownership interests, for
aggregate rental expense of approximately $110,000 through June 30, 2002. In
addition, Tri-City, as broker, has placed business with the Company's
insurance operations and the Company has incurred commission expenses of
approximately $200,000 under such arrangements through June 30, 2002.

19

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
.
GENERAL

THE COMPANY

We are a Bermuda public limited liability company with over $1.2 billion in
equity capital and, through operations in Bermuda and the United States, are
positioned to write insurance and reinsurance on a worldwide basis. While we are
positioned to provide a full range of property and casualty insurance and
reinsurance lines, we are focusing on writing specialty lines of insurance and
reinsurance.

NEW UNDERWRITING INITIATIVE

In October 2001, we launched an underwriting initiative to meet current and
future demand in the global insurance and reinsurance markets that included the
recruitment of new insurance and reinsurance management teams and an equity
capital infusion of $763.2 million. It is our belief that our existing Bermuda
and U.S.-based underwriting platform, our strong management team and our $1.2
billion in capital that is unencumbered by significant exposure to pre-2002
risks have enabled us both to establish an immediate presence in an attractive
insurance and reinsurance marketplace. In April 2002, we completed an offering
of 7,475,000 of our common shares and received net proceeds of $179.2 million,
which were contributed to the surplus of Arch Re Bermuda, our Bermuda-based
reinsurance and insurance subsidiary.

This discussion and analysis contains forward-looking statements which
involve inherent risks and uncertainties. All statements other than statements
of historical fact are forward-looking statements. These statements are based on
our current assessment of risks and uncertainties. Actual results may differ
materially from those expressed or implied in these statements. Important
factors that could cause actual events or results to differ materially from
those indicated in such statements are discussed in this report, including the
section entitled "--Cautionary Note Regarding Forward Looking Statements," and
the section entitled "Risk Factors" included in our Annual Report on Form 10-K
for the year ended December 31, 2001.

CRITICAL ACCOUNTING POLICIES, ESTIMATES AND RECENT ACCOUNTING PRONOUNCEMENTS

The preparation of consolidated financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities
(including reserves), revenues and expenses, and related disclosures of
contingent liabilities. On an ongoing basis, we evaluate our estimates,
including those related to revenue recognition, insurance and other reserves,
reinsurance recoverables, intangible assets, bad debts, income taxes, pensions,
contingencies and litigation. We base our estimates on historical experience,
where possible, and on various other assumptions that we believe to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions and such differences may be
material. As a relatively new insurance and reinsurance company, very limited
historical information has been reported to us as of June 30, 2002. We believe
that the following critical accounting policies require our more significant
judgments and estimates used in the preparation of our consolidated financial
statements.

PREMIUM REVENUES AND RELATED EXPENSES

Insurance premiums written are recorded in accordance with the terms of the
underlying policies. Reinsurance premiums assumed are recognized as income on a
straight line basis over the terms of the related reinsurance contracts. For
business written on a pro rata basis, premiums written are recorded as the
underlying policies are written, generally over a twelve-month period. For
excess of loss treaties, the minimum annual premium is recorded as written as of
the date of the treaty. These amounts are based on reports received from ceding
companies, supplemented by our own estimates of premiums for which ceding
company reports have not been received. Subsequent differences arising on such
estimates are recorded in the period they are determined. Unearned premium
reserves represent the portion of premiums written that relates to the unexpired
terms of contracts in force. Certain of our contracts included provisions that
adjust premiums or acquisition expenses

20

based upon the experience under the contracts. Premiums written and earned as
well as related acquisition expenses under those contracts are recorded based
upon the projected ultimate experience under these contracts.

We also write non-traditional reinsurance business that is intended to
provide insurers with risk management solutions that complement traditional
reinsurance. Under these contracts, we assume a measured amount of insurance
risk in exchange for a specified margin. Coverages may include a combination of
sublimits and caps. Examples of such non-traditional business include aggregate
stop-loss coverages and financial quota share coverages.

Certain contracts included in our non-traditional reinsurance business,
which pursuant to Statement of Financial Accounting Standards ("SFAS") No.
113, "Accounting and Reporting for Reinsurance of Short-Duration and
Long-Duration Contracts," issued by the Financial Accounting Standards Board
("FASB"), are deemed, for financial reporting purposes, not to transfer
insurance risk, are accounted for using the deposit method of accounting as
prescribed in Statement of Position 98-7, "Deposit Accounting: Accounting for
Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk." For
those contracts that contain an element of underwriting risk, non-refundable
fees are deferred and amortized over the contract period. Such fees are
included in our underwriting results. For those contracts that do not
transfer an element of underwriting risk, the expected profit is reflected in
earnings over the estimated settlement period using the interest method. Such
profit is included in investment income.

Under generally accepted accounting principles ("GAAP"), acquisition
expenses and other expenses that vary with and are directly related to the
acquisition of business related to our underwriting operations are deferred and
amortized over the period in which the related premiums are earned. Under
statutory accounting principles, underwriting expenses are recognized
immediately as premiums are written.

Acquisition expenses consist principally of commissions and brokerage
expenses. Other operating expenses also include expenses that vary with and are
directly related to the acquisition of business. Acquisition expenses for the
insurance segment are reflected net of ceding commissions from third party
reinsurers. Deferred acquisition costs are carried at their estimated realizable
value based on the related unearned premiums and take into account anticipated
losses and loss adjustment expenses, based on historical and current experience,
and anticipated investment income.

RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES

Insurance reserves are inherently subject to uncertainty. The reserves for
losses and loss adjustment expenses represent estimates involving actuarial and
statistical projections at a given point in time of our expectations of the
ultimate settlement and administration costs of losses incurred and it is likely
that the ultimate liability may exceed or be less than such estimates. We
utilize actuarial models as well as available historical insurance and
reinsurance industry loss development patterns to assist in the establishment of
appropriate loss reserves. Even actuarially sound methods can lead to subsequent
adjustments to reserves that are both significant and irregular due to the
nature of the risks written, potentially by a material amount. If our reserves
for losses and loss adjustment expenses are determined to be inadequate, we will
be required to increase the reserves with a corresponding reduction in net
income in the period in which the deficiency is determined.

For reinsurance assumed, the reserves are based on reports received from
ceding companies, supplemented by our estimates of reserves for which ceding
company reports have not been received, and our own historical experience. For
our insurance operations, claims personnel determine whether to establish a case
reserve for the estimated amount of the ultimate settlement, if any. The
estimate reflects the judgment of claims personnel based on general corporate
reserving practices, and on the experience and knowledge of such personnel
regarding the nature and value of the specific type of claim and, where
appropriate, advice of counsel. Our insurance operations also contract with a
number of outside third party administrators and managing general agents in the
claims process, and the work of such parties is reviewed by our claims
personnel. Reserves are also established to provide for the estimated expense of
settling claims, including legal and other fees and the general expenses of
administering the claims adjustment process. Periodically, adjustments to the
case reserves may be made as additional information regarding the claims is
reported or payments are made.

In accordance with industry practice, we maintain incurred but not reported
("IBNR") reserves. Such reserves are established to provide for future case
reserves and loss payments on incurred claims which have not

21

yet been reported to an insurer or reinsurer. In calculating its IBNR reserves,
we use generally accepted actuarial reserving techniques that take into account
quantitative loss experience data, together, where appropriate, with qualitative
factors. IBNR reserves are based on loss experience of the company and the
industry, and are grouped both by class of business and by accident year. IBNR
reserves are also adjusted to take into account certain factors such as changes
in the volume of business written, reinsurance contract terms and conditions,
the mix of business, claims processing and inflation that can be expected to
affect our liability for losses over time.

Even though most insurance contracts have policy limits, the nature of
property and casualty insurance and reinsurance is that losses can exceed policy
limits for a variety of reasons and could very significantly exceed the premiums
received on the underlying policies. We will attempt to limit our risk of loss
through reinsurance and may also use retrocessional arrangements. The
availability and cost of reinsurance and retrocessional protection is subject to
market conditions, which are beyond our control.

In establishing the reserves for losses and loss adjustment expenses, we
have made various assumptions relating to the pricing of our reinsurance
contracts and insurance policies, available historical industry experience and
current industry conditions. Our reserving process reflects that there is a
possibility that the assumptions made could prove to be inaccurate due to
several factors primarily relating to our start-up nature, including the fact
that very limited historical information has been reported to us through June
30, 2002, although there can be no assurances that our reserves will prove to be
adequate. It is possible that claims in respect of events that have occurred
could exceed our reserves and have a material adverse effect on our results of
operations in a particular period or our financial condition in general.

COLLECTION OF INSURANCE-RELATED BALANCES

We maintain allowances for doubtful accounts for probable losses resulting
from our inability to collect premiums. We are subject to credit risk with
respect to our reinsurance ceded because the ceding of risk to reinsurers does
not relieve us of our liability to the clients or companies we insure. If the
financial condition of our reinsurers or retrocessionaires were to deteriorate,
resulting in an impairment of their ability to make payments, additional
allowances may be required.

We are also subject to credit risk from our alternative market products,
such as rent-a-captive risk-sharing programs which allow a client to retain a
significant portion of its loss exposure without the administrative costs and
capital commitment required to establish and operate its own captive. In certain
of these programs, we participate in the operating results by providing excess
reinsurance coverage and earn commissions and management fees. We also write
program business on a risk-sharing basis with agents or brokers which is
achieved with a contingent commission structure based upon the program
underwriting results. While we attempt to obtain sufficient collateral from
managing general agents or other clients to guarantee their projected financial
obligations to us, there is no guarantee that such collateral will be sufficient
to secure their actual ultimate obligations.

VALUATION ALLOWANCE

We record a valuation allowance to reduce certain of our deferred tax
assets to the amount that is more likely than not to be realized. While we have
considered future taxable income and feasible tax planning strategies in
assessing the need for a valuation allowance, in the event we were to determine
that we would not be able to realize all or part of our deferred tax assets in
the future, an adjustment to the deferred tax asset would be charged to income
in the period such determination was made. In addition, if we subsequently
assessed that the valuation allowance was no longer needed, then a benefit would
be recorded to income in the period such determination was made.

INVESTMENTS

We currently classify all of our publicly traded fixed maturity, short-term
investments and equity securities as "available for sale" and, accordingly, they
are carried at estimated fair value. The fair value of publicly traded fixed
maturity securities and publicly traded equity securities is estimated using
quoted market prices or dealer quotes. Investments included in our private
portfolio include securities issued by privately held companies that are
generally restricted as to resale or are otherwise illiquid and do not have
readily ascertainable market values. Our investments in privately held equity
securities, other than those carried under the equity method of

22

accounting, are carried at estimated fair value. Fair value is initially
considered to be equal to the cost of such investment until the investments are
revalued based on substantive events or other factors which could indicate a
diminution or appreciation in value. In accordance with Accounting Principles
Board ("APB") Opinion No. 18 for privately held equity investments accounted for
under the equity method, we review the facts and circumstances surrounding our
ownership for each investment to determine the appropriate accounting method for
such investment and we record our percentage share of the investee company's net
income. The risk of investing in such securities is generally greater than the
risk of investing in securities of widely held, publicly traded companies. Lack
of a secondary market and resale restrictions may result in an inability by us
to sell a security at a price that would otherwise be obtainable if such
restrictions did not exist and may substantially delay the sale of a security we
seek to sell.

In accordance with SFAS No. 115, "Accounting for Certain Investments in
Debt and Equity Securities," we review our investments to determine whether a
decline in fair value below the amortized cost basis is other than temporary. If
such decline in fair value is judged to be other than temporary, we would write
down the investment to fair value as a new cost basis and the amount of the
write-down would be charged to income as a realized loss. The new cost basis
would not be changed for subsequent recoveries in fair value.

STOCK ISSUED TO EMPLOYEES

We follow APB Opinion No. 25, "Accounting for Stock Issued to Employees"
and related interpretations in accounting for employee stock options.
Accordingly, under APB No. 25, compensation expense for stock option grants is
recognized only to the extent that the fair value of the underlying stock
exceeds the exercise price of the option at the measurement date. In addition,
under APB No. 25, we do not recognize compensation expense for stock issued to
employees under our stock purchase plan. See "Other Revenue and Expenses--Non
Cash Compensation."

For restricted shares granted, we record deferred compensation equal to the
market value of the shares at the measurement date, which is amortized and
charged to income as non-cash compensation over the vesting period. These
restricted shares are recorded as outstanding upon issuance (regardless of any
vesting period). See "Other Revenue and Expenses--Non-Cash Compensation."

RECENT ACCOUNTING PRONOUNCEMENTS

In August 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets," which we adopted on January 1,
2002. SFAS No. 144 addresses the accounting and reporting for impairment of
long-lived assets to be held and used, as well as long-lived assets to be
disposed of. The standard requires that long-lived assets to be held and used
will be written down to fair value when they are considered impaired. Long-lived
assets to be disposed of are to be carried at the lower of carrying amount or
fair value less estimated cost to sell. SFAS No. 144 also broadens the
presentation of discontinued operations on the income statement to include a
component of an entity (rather than a segment of a business). The adoption of
this standard did not have a material effect on our financial position at June
30, 2002 or results of operations for the six months ended June 30, 2002.

In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities." SFAS No. 146 will be applied prospectively to
exit or disposal activities initiated after December 31, 2002 and requires
companies to recognize costs associated with exit activities when they are
incurred rather than at the date of a commitment to an exit or disposal plan. We
are currently evaluating this standard.

RESULTS OF OPERATIONS

Comparisons of our 2002 and 2001 results of operations to each other and to
prior year periods are not relevant due to the changes in our business during
2001 and 2002, including (1) our 2001 acquisition activity, (2) our new
underwriting initiatives in insurance and reinsurance and (3) the capital
infusions in November 2001 and April 2002. In addition, because of these
factors, as well as the other factors described in this report, including those
noted below under the caption "--Cautionary Note Regarding Forward-Looking
Statements" and in the section entitled "Risk Factors" included in our Annual
Report on Form 10-K for the year ended December 31, 2001, our historical
financial results do not provide you with a meaningful expectation of our future
results.

23

The following table presents the after-tax components of net income for the
three and six month periods ended June 30, 2002 and 2001. Certain prior period
information has been reclassified to conform to the current presentation.

The increase in diluted average shares outstanding from 2001 to 2002 was
primarily due to the issuance of convertible preference shares and Class A
warrants in connection with our capital infusion in November 2001 and the
issuance of 7,475,000 common shares in connection with an offering completed by
us in April 2002. Pursuant to a post-closing purchase price adjustment mechanism
under the subscription agreement entered into in connection with the capital
infusion in November 2001 (the "Subscription Agreement"), we issued 875,753
additional Series A convertible preference shares on June 28, 2002. Such
issuance did not result in a significant increase in our average shares for the
three or six month periods ended June 30, 2002.

Under SFAS No. 128, "Earnings Per Share," upon the satisfaction of all the
conditions necessary for the issuance of contingent shares, such shares are
required to be included in the denominator of the diluted earnings per share
calculation as of the beginning of the interim period in which the conditions
are satisfied. If the contingency provisions with respect to our contingently
issuable common shares described below under the caption "--Potential
Adjustments to Book Value Per Share" had been met as of January 1, 2002, pro
forma diluted weighted average shares outstanding for the three and six month
periods ended June 30, 2002 would have been 62,601,966 shares and 58,715,535
shares, respectively, and pro forma diluted net income per share for the three
and six month periods ended June 30, 2002 would have been $0.31 and $0.39,
respectively. Under SFAS No. 128, once such shares have been issued following
the satisfaction of such conditions, those shares are required to be included in
the computation of basic earnings per share.

After-tax operating income is defined as net income, excluding net realized
investment gains or losses on investment sales, non-cash compensation charges,
foreign exchange gains or losses and equity in net income or loss of investees.
As set forth in the above table, for the three months ended June 30, 2002,
after-tax operating income was $15.5 million, or $0.27 per share, and for the
six months ended June 30, 2002, after-tax operating income was $23.9 million, or
$0.43 per share. Net income for the 2002 second quarter was $19.2 million, or
$0.33 per share, and for the six months ended June 30, 2002, net income was
$23.2 million, or $0.42 per share.

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Operating income for the 2002 second quarter and six months ended June 30, 2002
reflect the underwriting results of our rinsurance and insurance segments, as
disused below.

SEGMENT INFORMATION

We classify our businesses into two underwriting segments, reinsurance and
insurance. For a description of our underwriting segments, please refer to note
6 under the caption "Segment Information" of the notes accompanying our
consolidated financial statements.

REINSURANCE SEGMENT

OPERATING RESULTS. The following table sets forth an analysis of the
underwriting results for the reinsurance segment for the three and six month
periods ended June 30, 2002. Due to the significant changes in our business
and operations resulting from the new underwriting initiative, comparisons of
2002 to 2001 results are not meaningful.

(1) Reflects $18.2 million and $37.0 million of net premiums written,
respectively, for the three month and six month periods ended June 30, 2002
assumed by the reinsurance segment from the insurance segment.
(2) The loss ratios for statutory and GAAP are based on earned premiums. The
statutory expense ratios are based on net premiums written, while the GAAP
expense ratios are based on net premiums earned.

UNDERWRITING INCOME (LOSS). Underwriting income or loss equals net
premiums earned less losses and loss adjustment expenses incurred and
underwriting expenses incurred. The components are discussed below.

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GROSS AND NET PREMIUMS WRITTEN. During the period from January 1 to July
31, 2002, our reinsurance subsidiaries have entered into reinsurance treaties
and other reinsurance arrangements that are expected to provide approximately
$800 million of annualized net reinsurance premiums, a substantial portion of
which will be recorded in calendar year 2002. Approximately 67% of the
annualized premiums written were generated from pro rata contracts and 33%
were derived from excess of loss treaties. The quarterly and year-to-date net
premiums written differs from the annualized net reinsurance premiums due to
the timing of recording premiums for contracts written on a pro rata and
excess of loss basis. A significant portion of amounts included as premiums
receivable, which represent estimated premiums, net of commissions, are not
yet due based on the terms of the underlying contracts.

We are currently retaining substantially all of our reinsurance premiums
written. We may purchase reinsurance on both a facultative and treaty basis
primarily to reduce net liability on individual risks and, if deemed necessary,
to reduce our exposure to catastrophic losses.

Set forth below is summary information regarding net premiums written
produced by geographic location and by line of business for the reinsurance
segment for the three and six month periods ended June 30, 2002:

(1) Reflects $18.2 million and $37.0 million of net premiums written,
respectively, for the three month and six month periods ended June 30, 2002
assumed by the reinsurance segment from the insurance segment.

NET PREMIUMS EARNED. Reinsurance premiums written are recognized as
earned on a pro rata basis over the terms of the related reinsurance
contracts. Unearned premiums represent the portion of premiums written which
is applicable to the unexpired terms of policies in force. When a company is
growing rapidly, there will be a significant difference

26

between written and earned premiums. For the six months ended June 30, 2002,
approximately 34% of the reinsurance segment net premiums written were earned.

LOSSES AND LOSS ADJUSTMENT EXPENSES. Losses and loss adjustment expenses
incurred for the three and six month periods ended June 30, 2002 were 69.7%
and 71.1%, respectively, of net premiums earned. For a discussion of the
reserves for losses and loss adjustment expenses, please refer to the section
above entitled "Critical Accounting Policies, Estimates and Recent Accounting
Pronouncements - Reserves for Losses and Loss Adjustment Expenses."

UNDERWRITING EXPENSES. For the three and six month periods ended June
30, 2002, acquisition expenses were 16.8% and 15.5%, respectively, of net
premiums earned. As a percentage of net premiums earned, acquisition expenses
for the 2002 second quarter are higher compared to the six month period due
primarily to an increase in the percentage of pro rata business earned during
the 2002 second quarter. Typically, pro rata business is written at a higher
expense ratio and lower loss ratio than excess of loss business. For the
three and six month periods ended June 30, 2002, other operating expenses
were 2.7% and 4.0%, respectively, of net premiums earned.

INSURANCE SEGMENT

OPERATING RESULTS. The following table sets forth an analysis of the
underwriting results for the insurance segment for the three and six month
periods ended June 30, 2002. Due to the significant changes in our business
and operations resulting from the new underwriting initiative, comparisons of
2002 to 2001 results are not meaningful.

(1) Reflects $18.2 million and $37.0 million of net premiums written,
respectively, for the three month and six month periods ended June 30, 2002
assumed by the reinsurance segment from the insurance segment.
(2) The loss ratios for statutory and GAAP are based on earned premiums. The
statutory expense ratios are based on net premiums written, while the GAAP
expense ratios are based on net premiums earned.
(3) The acquisition expense ratio is adjusted to include certain policy-related
fee income.

27

Set forth below is summary information regarding net premiums written
produced by geographic location and by line of business for the insurance
segment for the three and six month periods ended June 30, 2002:

(1) Reflects $18.2 million and $37.0 million of net premiums written,
respectively, for the three month and six month periods ended June 30, 2002
assumed by the reinsurance segment from the insurance segment.

GROSS AND NET PREMIUMS WRITTEN. Our insurance segment commenced writing
business in a number of specialty lines in the 2002 second quarter. We expect
that the amount of premiums written will continue to increase in the
remainder of 2002 as this operation continues to build its infrastructure and
increase its participation in the insurance marketplace.

LOSSES AND LOSS ADJUSTMENT EXPENSES. Losses and loss adjustment expenses
incurred for the three and six month periods ended June 30, 2002 were 77.1%
and 78.4%, respectively, of net premiums earned. For a discussion of the
reserves for losses and loss adjustment expenses, please refer to the section
above entitled "Critical Accounting Policies, Estimates and Recent Accounting
Pronouncements - Reserves for Losses and Loss Adjustment Expenses."

UNDERWRITING EXPENSES. The acquisition expense ratios for the three
month and six month periods ended June 30, 2002 were calculated net of
certain policy-related fee income, which is earned primarily by American
Independent, and resulted in expense ratios of (7.2%) and (8.1%),
respectively. Operating expenses included "start-up" expenses of $2.1 million
and $3.7 million, respectively, for the three and six month periods ended
June 30, 2002. In addition, such periods also include a charge of $1.1
million recorded during the second quarter of 2002 as a result of the
establishment of a reserve related to a receivable from a managing general
agent. We expect that we will incur a significant amount of additional costs
in 2002 in connection with the continued expansion of our insurance
operations.

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OTHER REVENUE AND EXPENSES

NET INVESTMENT INCOME

The increase in net investment income was due to the significant increase
in our invested assets resulting from (i) the capital infusion completed in
November 2001, (ii) the proceeds received from the public offering of our common
shares in April 2002 and (iii) cash flow from operations. The pre-tax investment
yields on our fixed income securities for the three and six month periods ended
June 30, 2002 were 4.1% and 3.6%, respectively.

CORPORATE EXPENSES AND OTHER FEE INCOME

Corporate expenses represent certain holding company and infrastructure
costs necessary to support our growing worldwide reinsurance and insurance
operations. Other fee income represents revenues provided by our
non-underwriting operations.

NET REALIZED INVESTMENT GAINS (LOSSES)

For the three and six month periods ended June 30, 2002 and 2001, our
sources of net realized investment gains (losses) were as follows:

The net realized gains of $6.2 million for the three and six month
periods ended June 30, 2002 on our privately held securities resulted
primarily from the disposition of our investment in The ARC Group, LLC in
April 2002 and the sale of certain underlying holdings included in our
Trident II, L.P. interest. The net realized losses of $3.7 million and $4.5
million for the three and six month periods ended June 30, 2002,
respectively, on our fixed maturity portfolio resulted from the sale of
certain securities to reduce credit exposure, and sales related to
rebalancing the portfolio which is managed on a total return basis.

NON-CASH COMPENSATION

During 2001 and 2002, we made certain grants (primarily of restricted
shares) to new employees and the chairman of our board of directors under our
stock incentive plans and other arrangements. These grants were made primarily
in connection with our new underwriting initiative and resulted in a pre-tax
provision for non-cash compensation of $8.6 million and $12.8 million,
respectively, for the three and six month periods ended June 30, 2002. As a
result of the grants referred to above, we expect to record a significant
increase in non-cash compensation in the remainder of 2002 as compared to 2001.

As provided under SFAS No. 123, "Accounting for Stock-Based Compensation,"
we have elected to continue to account for stock-based compensation in
accordance with APB No. 25. If we had elected to expense employee stock options
under the fair value method of SFAS No. 123, our basic net income per share for
the three and six months ended June 30, 2002 would have been reduced by $0.20
and $0.53, respectively, and our diluted net income per share would have been
reduced by $0.07 and $0.16, respectively.

NET FOREIGN EXCHANGE GAINS

In the 2002 second quarter, net foreign exchange gains of $3,352,000
consisted of an unrealized gain of $3,263,000 and a realized gain of $89,000.
Net foreign exchange gains for the six months ended June 30, 2002 of $3,244,000
consisted of an unrealized gain of $3,263,000 and a realized loss of $19,000.
The net unrealized gain resulted from the translation of foreign denominated
monetary assets and liabilities at June 30, 2002 as required by GAAP. Under
GAAP, accounts that are classified as monetary assets and liabilities, such as
premiums receivable and the reserve for losses and loss adjustment expenses, are
revalued at each balance sheet

29

date. Accounts that are classified as non-monetary are not revalued. Pursuant to
GAAP, the unearned premium reserve is classified as non-monetary and,
accordingly, was not revalued at June 30, 2002. If the unearned premium reserve
was considered a monetary asset under GAAP, the unrealized foreign exchange gain
would have been reduced by $3.3 million for the three and six month periods
ended June 30, 2002.

Foreign exchange gains and losses vary with fluctuations in currency rates.
As such, these gains and losses could add significant volatility to our net
income in future periods.

EQUITY IN NET INCOME OF INVESTEES

At June 30, 2002, we held seven investments in privately held securities,
including four investments held under the equity method of accounting. Under the
equity method, we record a proportionate share of the net income or loss based
on our ownership percentage. Of the $1.6 million of pre-tax equity in net income
of investees for the six months ended June 30, 2002, approximately $557,000 was
generated from our investment in ARC, which was sold in April 2002.

INCOME TAXES

During the 2002 second quarter, we reversed a $7.4 million valuation
allowance on certain of our deferred tax assets. The valuation allowance
reversal was based on our recently completed restructuring of our U.S.-based
insurance underwriting operations and our business plan.

For the six months ended June 30, 2002, our income tax provision resulted
in an effective tax rate of 14.5%, excluding the reversal of a $7.4 million
valuation allowance. Our remaining valuation allowance at June 30, 2002 is $2.1
million. Our effective tax rate will fluctuate based on the relative amounts of
our U.S.-sourced income and our worldwide income. The effective tax rate on our
net operating income for the six months ended June 30, 2002 was 5.9%, which was
lower than our overall effective tax rate due to the relative amounts of our
U.S.-sourced income and our worldwide income. See note 10 under the caption
"Income Taxes" of the notes accompanying our consolidated financial statements.

ACGL will be subject to U.S. federal income tax only to the extent that it
derives U.S. source income that is subject to U.S. withholding tax or income
that is effectively connected with the conduct of a trade or business within the
U.S. and is not exempt from U.S. tax under an applicable income tax treaty with
the U.S. ACGL will be subject to a withholding tax on dividends from U.S.
investments and interest from certain U.S. taxpayers. ACGL does not consider
itself to be engaged in a trade or business within the U.S. and, consequently,
does not expect to be subject to direct U.S. income taxation. However, because
there is uncertainty as to the activities which constitute being engaged in a
trade or business within the United States, there can be no assurances that the
U.S. Internal Revenue Service will not contend successfully that ACGL or its
non-U.S. subsidiaries are engaged in a trade or business in the United States.
If ACGL or any of its non-U.S. subsidiaries were subject to U.S. income tax,
ACGL's shareholders' equity and earnings could be materially adversely affected.
ACGL's U.S. subsidiaries are subject to U.S. income taxes on their worldwide
income.

ACGL changed its legal domicile from the United States to Bermuda in
November 2000. Legislation has been introduced which (if enacted) could
eliminate the tax benefits available to companies that have changed their legal
domiciles to Bermuda, and such legislation may apply to ACGL. In addition, some
U.S. insurance companies have been lobbying Congress to pass legislation
intended to eliminate certain perceived tax advantages of U.S. insurance
companies with Bermuda affiliates resulting principally from reinsurance between
or among U.S. insurance companies and their Bermuda affiliates. This
legislation, if passed, and other changes in U.S. tax laws, regulations and
interpretations thereof to address these issues could materially adversely
affect us.

LIQUIDITY AND CAPITAL RESOURCES

ACGL is a holding company whose assets primarily consist of the shares in
its subsidiaries. Generally, we depend on our available cash resources, liquid
investments and dividends or other distributions from our subsidiaries to make
payments, including the payment of operating expenses we may incur and for any
dividends our board of directors may determine. ACGL does not currently intend
to declare any dividends.

30

Pursuant to a shareholders agreement that we entered into in connection
with the November 2001 capital infusion, we have agreed not to declare any
dividend or make any other distribution on our common shares, and not to
repurchase any common shares, until we have repurchased from the Warburg Pincus
funds, the Hellman & Friedman funds and the other holders of our preference
shares, pro rata, on the basis of the amount of each of these shareholders'
investment in us at the time of such repurchase, preference shares having an
aggregate value of $250.0 million, at a per share price acceptable to these
shareholders.

The ability of our regulated insurance and reinsurance subsidiaries to
pay dividends or make distributions is dependent on their ability to meet
applicable regulatory standards. Arch Re Bermuda is prohibited from declaring
or paying in any financial year dividends of more than 25% of its total
statutory capital and surplus (as shown on its previous financial year's
statutory balance sheet) unless it files, at least seven days before payment
of such dividends, with the Bermuda Monetary Authority an affidavit stating
that it will continue to meet the required margins. In addition, Arch Re
Bermuda is prohibited, without prior approval of the Bermuda Monetary
Authority, from reducing by 15% or more its total statutory capital, as set
out in its previous year's financial statements. At December 31, 2001 and
June 30, 2002, Arch Re Bermuda had statutory capital and surplus (as
determined under Bermuda law) of $508 million and $667 million, respectively.
As of December 31, 2001, our U.S. insurance and reinsurance subsidiaries may
not pay any significant dividends or distributions during 2002 without prior
regulatory approval. In addition, the ability of our insurance and
reinsurance subsidiaries to pay dividends could be constrained by our
dependence on financial strength ratings from independent rating agencies.
Our ratings from these agencies depend to a large extent on the
capitalization levels of our insurance and reinsurance subsidiaries.

Our aggregate invested assets, including cash and short-term investments,
totaled $1.3 billion and $1.0 billion at June 30, 2002 and December 31, 2001,
respectively. As of June 30, 2002, our readily available cash, short-term
investments and marketable securities, excluding amounts held by our regulated
insurance and reinsurance subsidiaries, totaled $41.2 million. Such amount
consisted of $16.5 million of cash and short-term investments and $24.7 million
of fixed maturity investments. As of that date, investments that are restricted
or generally unavailable for liquidity purposes (other than our ownership
interests in our subsidiaries and the invested assets of our regulated insurance
and reinsurance subsidiaries) included $24.9 million of privately held
securities. In addition, at June 30, 2002, we had investment commitments
relating to our privately held investments of approximately $3.6 million.

Cash flows on a consolidated basis are provided by premiums collected, fee
income, investment income and collected reinsurance recoverables, offset by
losses and loss adjustment expense payments, reinsurance premiums payable and
operating costs. Consolidated cash flows provided by (used for) operating
activities for the six months ended June 30, 2002 and 2001 were approximately
$113.7 million and ($292,000), respectively.

Our expanded underwriting activities will initially be supported by our
capital, and we expect that our other operational needs for the foreseeable
future will be met by our balance of cash and short-term investments, as well as
by funds generated from premiums and investment income and proceeds on the sale
or maturity of our investments.

We have an effective shelf registration statement with the Securities
and Exchange Commission. It permits us to issue various types of securities,
including unsecured debt securities, preference shares and common shares,
from time to time, up to an aggregate of $500 million. During April, we
issued 7,475,000 of our common shares and received net proceeds of
approximately $179 million, net of transaction costs. The net proceeds of the
offering were principally used to increase the surplus of our insurance and
reinsurance subsidiaries. The unused portion of our shelf registration is
approximately $309 million following the offering in April. Any additional
issuance of common shares by us could have the effect of diluting our
earnings and our book value per share.

In addition, the Warburg Pincus funds and the Hellman & Friedman funds
together control a majority of our voting power on a fully-diluted basis and
have the right to nominate a majority of directors to our board under the
shareholders agreement entered into in connection with the November 2001 capital
infusion. The shareholders agreement also provides that we cannot engage in
transactions including mergers and acquisitions and transactions in excess of
certain amounts, without the consent of a designee of the Warburg Pincus funds
and a designee of the Hellman & Friedman funds. These provisions could have an
effect on the operation of our business and, to the extent these provisions
discourage takeover attempts, they could deprive our shareholders of
opportunities to realize takeover premiums for their shares or could depress the
market price of our common shares. By reason of their ownership and the
shareholders agreement, the Warburg Pincus funds and the Hellman & Friedman
funds are able to strongly influence or effectively control actions to be taken
by us. The

31

interests of these shareholders may differ materially from the interests of
the holders of our common shares, and these shareholders could take actions
that are not in the interests of the holders of our common shares.

CERTAIN MATTERS WHICH MAY MATERIALLY AFFECT OUR RESULTS OF OPERATIONS AND/OR
FINANCIAL CONDITION

RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES

We establish reserves for losses and loss adjustment expenses which
represent estimates involving actuarial and statistical projections, at a
given point in time, of our expectations of the ultimate settlement and
administration costs of losses incurred. We utilize actuarial models as well
as available historical insurance industry loss development patterns to
assist in the establishment of appropriate loss reserves. Actual losses and
loss adjustment expenses paid may deviate, perhaps substantially, from the
reserve estimates reflected in our financial statements. See "--Critical
Accounting Polices, Estimates and Recent Accounting Pronouncements - Reserves
for Losses and Loss Adjustment Expenses."

REINSURANCE PROTECTION AND RECOVERABLES

For purposes of limiting our risk of loss, we reinsure a portion of our
exposures, paying to reinsurers a part of the premiums received on the policies
we write, and we may also use retrocessional protection. For the three and six
month periods ended June 30, 2002, ceded premiums written represented
approximately 12% and 10%, respectively, of gross written premium. In 2002, we
are retaining a greater amount of our insurance premiums written as compared to
2001 as a result of the new underwriting initiative and our improved financial
position.

The availability and cost of reinsurance and retrocessional protection
is subject to market conditions, which are beyond our control. Currently, the
market for these arrangements is experiencing high demand for various
products and it is not certain that we will be able to obtain adequate
protection at cost effective levels. As a result of such market conditions
and other factors, we may not be able successfully to alleviate risk through
reinsurance and retrocessional arrangements. Further, we are subject to
credit risk with respect to our reinsurance and retrocessions because the
ceding of risk to reinsurers and retrocessionaires does not relieve us of our
liability to the clients or companies we insure or reinsure. Our failure to
establish adequate reinsurance or retrocessional arrangements or the failure
of our existing reinsurance or retrocessional arrangements to protect us from
overly concentrated risk exposure could adversely affect our financial
condition and results of operations. We monitor the financial condition of
our reinsurers and attempt to place coverages only with substantial,
financially sound carriers. At June 30, 2002, approximately 91% of our
reinsurance recoverables were due from carriers which had an A.M. Best rating
of "A-" or better. We had no amounts recoverable from a single entity or
group of entities that exceeded 5% of our total shareholders' equity. At June
30, 2002, amounts due from the following reinsurers represented approximately
47% of our reinsurance recoverables (with A.M. Best ratings in parentheses):
Hartford Fire Insurance Company ("A+"); Folksamerica Reinsurance Company
("A-"); GMAC Insurance Group ("A+"); Swiss Re America Group ("A++"); Odyssey
Reinsurance Corporation ("A"); GE Reinsurance Corporation ("A++"); PMA
Capital Insurance Company ("A u"; under review by A.M. Best with negative
implications); and St. Paul Fire and Marine Insurance Company ("A"). We also
have reinsurance recoverables from Lloyd's of London syndicates (group rating
of "A-") aggregating approximately 10% of our total. In addition, in
connection with our acquisition of Arch Specialty in February 2002, the
seller, Sentry Insurance a Mutual Company, which has an A.M. Best rating of
"A+" (Superior), agreed to reinsure or otherwise assume all liabilities
arising out of Arch Specialty's business prior to the closing of the
acquisition. The amount of recoverables from Sentry under such arrangements
represents approximately 25% of our total recoverables.

NATURAL AND MAN-MADE CATASTROPHIC EVENTS

We have large aggregate exposures to natural and man-made catastrophic
events. Catastrophes can be caused by various events, including but not limited
to hurricanes, floods, windstorms, earthquakes, hailstorms, explosions, severe
winter weather and fires, and we may have losses which may result from acts of
war or acts of terrorism and political instability. Catastrophes can also cause
losses in non-property lines of business such as workers' compensation or
general liability. In addition to the nature of property business, we believe
that economic and geographic trends affecting insured property, including
inflation, property value appreciation and geographic concentration tend to
generally increase the size of losses from catastrophic events over time.
Therefore, claims for natural and man-made catastrophic events could expose us
to large losses and cause

32

substantial volatility in our results of operations, which could cause the value
of our common shares to fluctuate widely.

We have substantial exposure to unexpected, large losses resulting from
future man-made catastrophic events, such as acts of war, acts of terrorism and
political instability. These risks are inherently unpredictable and recent
events may lead to increased frequency and severity of losses. It is difficult
to predict the timing of such events with statistical certainty or estimate the
amount of loss any given occurrence will generate. It is not possible to
eliminate completely our exposure to unforecasted or unpredictable events, and
to the extent that losses from such risks occur, our financial condition and
results of operations could be materially adversely affected.

We specifically insure and reinsure risks resulting from terrorism.
Although we may attempt to exclude losses from terrorism and certain other
similar risks from some coverages written by us, we may not be successful in
doing so. Moreover, irrespective of the clarity and inclusiveness of policy
language, there can be no assurance that a result-oriented court or arbitration
panel favoring the insured or ceding company will enforce the language as
written; such a tribunal may adopt a strained interpretation of the policy
language, invoke public policy to limit enforceability of policy language,
ignore policy language, make factual findings unwarranted by the evidence or
otherwise seek to justify a ruling adverse to us.

For our catastrophe exposed reinsurance business, we seek to limit the
amount of exposure we will assume from any one reinsured and the amount of
the exposure to catastrophe losses in any geographic zone. In our reinsurance
business, we monitor our exposure to catastrophic events, including
earthquake, wind and specific terrorism exposures, and continuously
reevaluate the estimated probable maximum pre-tax loss for such exposures.
With respect to our reinsurance business, our estimated probable maximum
pre-tax loss is determined through the use of modeling techniques, but such
estimate does not represent our total potential loss for such exposures. In
our reinsurance business, we seek to limit the probable maximum pre-tax loss
to a percentage of our total shareholders' equity for severe catastrophic
events. Currently, for our reinsurance business, we generally seek to limit
the probable maximum pre-tax loss to approximately 25% of total shareholders'
equity for severe catastrophic events that could be expected to occur once in
every 250 years, which 25% does not include, for such purposes, business
assumed directly from our insurance subsidiaries. There can be no assurances
that we will not suffer pre-tax losses greater than 25% of our total
shareholders' equity from a catastrophic event due to several factors,
including the inherent uncertainties in estimating the frequency and severity
of such events and the margin of error in making such determinations
resulting from potential inaccuracies in the data provided by clients and
brokers, the modeling techniques and the application of such techniques. In
addition, depending on business opportunities and the mix of business that
may comprise our reinsurance portfolio, we may seek to limit the probable
maximum pre-tax loss to a higher percentage of our total shareholders' equity
for our catastrophe exposed reinsurance business.

Further, for our insurance business, which began operating in its new
specialty areas of focus in the 2002 second quarter, we also intend to
monitor and limit the amount of our exposure to catastrophic losses and, in
that connection, may seek to purchase catastrophe reinsurance protection. The
availability and cost of such reinsurance protection is subject to market
conditions, which are beyond our control. As a result of market conditions
and other factors, we may not be successful in obtaining such protection. See
"--Reinsurance Protection and Recoverables" above.

FOREIGN CURRENCY EXCHANGE RATE FLUCTUATION

We write business on a worldwide basis, and our results of operations may
be affected by fluctuations in the value of currencies other than the U.S.
dollar. Changes in foreign currency exchange rates can reduce our revenues and
increase our liabilities and costs, as measured in the dollar as our functional
currency. We have not attempted and currently do not expect to attempt to reduce
our exposure to these exchange rate risks by using hedging transactions. We may
therefore suffer losses solely as a result of exchange rate fluctuations.

MANAGEMENT AND OPERATIONS

As a relatively new insurance and reinsurance company, our success will
depend on our ability to integrate new management and operating personnel and to
establish and maintain operating procedures and internal controls to effectively
support our business and our regulatory and reporting requirements, and no
assurances can be given as to the success of these endeavors.

33

CONTINGENCIES RELATING TO THE SALE OF PRIOR REINSURANCE OPERATIONS

See note 5 under the caption "Contingencies Relating to the Sale of Prior
Reinsurance Operations" of the notes accompanying our consolidated financial
statements.

RESTRUCTURING OF U.S.-BASED INSURANCE OPERATIONS

In April 2002, we completed a restructuring of our U.S. insurance
subsidiaries after receiving all applicable regulatory approvals. As a result
of the restructuring, the statutory capital of Arch Re U.S. was increased to
approximately $350 million (as determined under U.S. statutory accounting
policies) and Arch Re U.S. has become the parent of our U.S.-based insurance
group. The names of our U.S.-based insurers were changed as follows: First
American Insurance Company was renamed Arch Insurance Company; Rock River
Insurance Company was renamed Arch Specialty Insurance Company; and Cross
River Insurance Company was renamed Arch Excess & Surplus Insurance Company.
The name changes have been approved by the companies' respective states of
domicile; however, the name change approvals have not yet been obtained from
all the other states.

INDUSTRY; RATINGS

We operate in a highly competitive environment, and since the September 11,
2001 events, new capital has entered the market. These factors may mitigate the
benefits that the financial markets may perceive for the property and casualty
insurance industry, and we cannot offer any assurances that we will be able to
compete successfully in our industry or that the intensity of competition in our
industry will not erode profitability for insurance and reinsurance companies
generally, including us. In addition, we can offer no assurances that we will
participate at all or to the same extent as more established or other companies
in any price increases or increased profitability in our industry. If we do not
share in such price increases or increased profitability, our financial
condition and results of operations could be materially adversely affected.

Financial strength and claims paying ratings from third party rating
agencies are instrumental in establishing the competitive positions of companies
in our industry. Periodically, rating agencies evaluate us to confirm that we
continue to meet their criteria for the ratings assigned to us by them. Our
reinsurance subsidiaries, Arch Re U.S. and Arch Re Bermuda, and our insurance
subsidiaries, Arch Insurance and Arch Specialty, each currently have financial
strength ratings of "A-" (Excellent) from A.M. Best. Arch E&S currently is rated
"NR-2" (Insufficient Size and/or Operating Experience) from A.M. Best and
American Independent has a financial strength rating of "C++" (Marginal) from
A.M. Best. We do not believe that American Independent's non-standard automobile
business is particularly ratings sensitive because its insureds purchase
insurance primarily to satisfy state and local insurance and financial reporting
requirements.

Recently, rating agencies have been coming under increasing pressure as a
result of high-profile corporate bankruptcies and may, as a result, increase
their scrutiny of rated companies, revise their rating policies or take other
action. We can offer no assurances that our ratings will remain at their current
levels. A ratings downgrade, or the potential for such a downgrade, 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.

CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS

In April 2002, we established a letter of credit facility for up to $200
million with Fleet National Bank. This facility expires April 16, 2003. The
principal purpose of this facility is to issue, as required, evergreen
standby letters of credit in favor of primary insurance or reinsurance
counterparties with which we have entered into reinsurance arrangements. Such
letters of credit when issued will be secured by a portion of our investment
portfolio. In addition, the letter of credit facility also requires that the
net worth of ACGL be at least $750 million and that we maintain certain
levels of collateral in order for letters of credit to be issued. At June 30,
2002, we had approximately $31.9 million in outstanding letters of credit. In
addition to letters of credit, we have and may establish insurance trusts in
the U.S. and Canada to secure our reinsurance amounts payable as required.

It is anticipated that the letter of credit facility will be renewed on
expiry, but such renewals are subject to the availability of credit from banks
which we utilize. In the event such support is insufficient, we could be
required to provide alternative security to cedents. This could take the form of
additional insurance trusts supported by our investment portfolio or funds
withheld using our cash resources. The value of letters of credit is driven by,

34

among other things, loss development of existing reserves, the payment pattern
of such reserves, the further expansion of our business and the loss experience
of such business. If we are unable to post security in the form of letters of
credit or trust funds when required, our operations could be significantly and
negatively affected.

INVESTMENTS

At June 30, 2002, consolidated cash and invested assets totaled
approximately $1.3 billion, consisting of $213.4 million of cash and short-term
investments, $1.1 billion of publicly traded fixed maturity investments and
$31.6 million of privately held securities. Our fixed income portfolio had an
average Standard & Poor's Corporation quality rating of "AA-" and an average
duration of 2.8 years at June 30, 2002.

The following table provides information on the composition of our fixed
maturity investments at June 30, 2002:

The following table presents the credit quality (using Standard & Poor's
ratings) distribution of our fixed maturity securities at June 30, 2002:

As part of our investment strategy, we seek to establish a level of cash
and highly liquid short-term and intermediate-term securities which, combined
with expected cash flow, is believed by us to be adequate to meet our
foreseeable payment obligations. Our investment portfolio is managed on a total
return basis. The total return approach may result in realized gains or losses
in any given period as the portfolio is adjusted to reflect perceived changes in
relative value.

Our current investment guidelines stress preservation of capital, market
liquidity and diversification of risk. To achieve this objective, our current
fixed income investment guidelines provide for an average credit quality of
"Aa3" and "AA-" as measured by Moody's Investors Services and Standard & Poor's,
respectively. Notwithstanding the foregoing, our investments are subject to
market-wide risks and fluctuations, as well as to risks inherent in particular
securities.

35

At June 30, 2002, our private equity portfolio consisted of seven
investments, with additional investment portfolio commitments in an aggregate
amount of approximately $3.6 million. We do not currently intend to make any
significant investments in privately held securities over and above our current
commitments. See note 8, "Investment Information," of the notes accompanying our
consolidated financial statements.

BOOK VALUE PER SHARE

On a diluted basis, the per share book value at June 30, 2002 was $20.27,
compared with $19.59 at December 31, 2001. The increase in diluted book value
per share was primarily attributable to the net effects of issuing 7,475,000
common shares at $25.50 per share in the stock offering which was completed in
April 2002, and an increase in unrealized appreciation of investments of $10.9
million. These increases were partially offset by the effects of the issuance on
June 28, 2002 of 875,753 additional Series A convertible preference shares
pursuant to a post-closing purchase price adjustment mechanism under the
Subscription Agreement. The diluted per share book value reflects our
outstanding convertible preference shares and Class A warrants, but does not
take into account certain potential adjustments. If such potential adjustments
were triggered, the diluted pro forma book value at June 30, 2002 would have
been reduced by $0.91 per share. The calculation of our book value per share
amounts and the potential adjustments to book value per share are described
below.

CALCULATION OF BOOK VALUE PER SHARE

The following actual book value per share calculations are based on
shareholders' equity of $1,246,047 at June 30, 2002 (unaudited) and $1,020,369
at December 31, 2001 (audited).

(1) Book value per common share at June 30, 2002 and December 31, 2001 was
determined by dividing (i) the difference between total shareholders' equity and
the aggregate liquidation preference of the Series A convertible preference
shares of $767.8 million and $749.4 million, respectively, by (ii) the number of
common shares outstanding.

(2) Includes preference shares that were issued on November 20, 2001 in exchange
for $763.1 million of cash. The number of preference shares issued was based on
the estimated per share price of $21.38. The estimated per share price was based
on (i) total shareholders' equity as of June 30, 2001 (adjusted for certain
amounts as described in the Subscription Agreement entered into in connection
with the November 2001 capital infusion), divided by (ii) the total number of
common shares outstanding as of June 30, 2001, which was 12,863,079. In
addition, the amount of preference shares at June 30, 2002 includes 875,753
preference shares that were issued by us on June 28, 2002 pursuant to a
post-closing purchase price adjustment mechanism under the Subscription
Agreement. Each preference share is convertible at any time and from time to
time at the option of the holder thereof into one fully paid and nonassessable
common share, subject to possible adjustment.

(3) Includes the net number of common shares that would be issued under the
Class A warrants, primarily issued in connection with the capital infusion
transaction, calculated using the treasury stock method. Class A warrants to
purchase an aggregate of 3,842,450 and 5,401,707 common shares were outstanding
as of June 30, 2002 and

36

December 31, 2001, respectively. Class A warrants are immediately exercisable at
$20 per share and expire September 19, 2002. In April 2002, 446,608 common
shares were issued upon the exercise of 1,559,257 Class A warrants on a cashless
basis.

(4) Represents restricted common shares issued in connection with the November
2001 capital infusion transaction. These restricted common shares are included
in common shares at June 30, 2002.

POTENTIAL ADJUSTMENTS TO BOOK VALUE PER SHARE

The following are potential adjustments to book value per share at June 30,
2002 and December 31, 2001, excluding the effects of stock options, that could
be made if certain future events described below occur.

(1) Amount at December 31, 2001 represents an estimate of the amount of
additional Series A convertible preference shares that will be issued to the new
investors during the second quarter of 2002 pursuant to a post-closing purchase
price adjustment mechanism under the Subscription Agreement. The per share price
was based on (i) total shareholders' equity as of June 30, 2001 as set forth on
the audited balance sheet, adjusted for certain items as described in the
Subscription Agreement, divided by (ii) the total number of common shares
outstanding as of June 30, 2001. Consistent with such estimate, 875,753
preference shares were issued to the new investors on June 28, 2002 and are
reflected in the amount of preference shares at June 30, 2002.

(2) Represents an estimate of the amount of additional Series A preference
shares that would be issued under the Subscription Agreement in the event that
on or prior to September 19, 2005 (1) the closing price of our common shares is
at least $30 per share for at least 20 out of 30 consecutive trading days or (2)
a change in control occurs (either case, a "Triggering Event"). Pursuant to the
Subscription Agreement, we have agreed to issue to the new investors additional
Series A preference shares such that the audited per share price is adjusted
downward by $1.50 per preference share.

(3) Includes the number of common shares that would be issued under the Class B
warrants for purposes of calculating diluted book value per share under the
treasury stock method. Class B warrants to purchase an aggregate of 150,000
common shares were outstanding as of June 30, 2002 and December 31, 2001 and
expire September 19, 2005. Class B warrants are exercisable at $20 per share
when (1) the closing price of our common shares is at least $30 per share for at
least 20 out of 30 consecutive trading days or (2) a change in control occurs.

Pursuant to the Subscription Agreement, a post-closing purchase price
adjustment will be calculated in November 2003 (or such earlier date as agreed
upon by us and the investors) based on an adjustment basket. The adjustment
basket will be equal to (1) the difference between value realized upon sale and
the GAAP book value at the closing of the capital infusion (November 2001) (as
adjusted based on a pre-determined growth rate) of agreed upon non-core
businesses; plus (2) the difference between GAAP net book value of the insurance
balances attributable to our core insurance operations with respect to any
policy or contract written or having an effective date prior to November 20,
2001 at the time of the final adjustment and those balances at the closing;
minus (3) reductions in book value arising from costs and expenses relating to
the transaction provided under

37

the Subscription Agreement, actual losses arising out of breach of
representations under the Subscription Agreement and certain other costs and
expenses. If the adjustment basket, which will be calculated by our independent
auditors, is less than zero, we will issue additional preference shares to the
investors based on the decrease in value of the components of the adjustment
basket. If the adjustment basket is greater than zero, we are allowed to use
cash in an amount based on the increase in value of the components of the
adjustment basket to repurchase common shares (other than any common shares
issued upon conversion of the preference shares or exercise of the Class A
warrants). If the adjustment basket is less than zero and in the event that a
Triggering Event occurs, we agreed to issue additional preference shares to the
investors as a further adjustment. In addition, on the fourth anniversary of the
closing, there will be a calculation of a further adjustment basket based on (1)
liabilities owed to Folksamerica (if any) under the Asset Purchase Agreement,
dated as of January 10, 2000, between us and Folksamerica, and (2) specified tax
and ERISA matters under the Subscription Agreement.

MARKET SENSITIVE INSTRUMENTS AND RISK MANAGEMENT

In accordance with the SEC's Financial Reporting Release No. 48, we
performed a sensitivity analysis to determine the effects that market risk
exposures could have on the future earnings, fair values or cash flows of our
financial instruments as of December 31, 2001. (See section captioned
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Market Sensitive Instruments and Risk Management" included in
our 2001 Annual Report on Form 10-K.) Market risk represents the risk of
changes in the fair value of a financial instrument and is comprised of
several components, including liquidity, basis and price risks. At June 30,
2002, there have been no material changes in market risk exposures that
affect the quantitative and qualitative disclosures presented as of December
31, 2001.

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

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

Forward-looking statements involve our current assessment of risks and
uncertainties. Actual events and results may differ materially from those
expressed or implied in these statements. Important factors that could cause
actual events or results to differ materially from those indicated in such
statements are discussed below, elsewhere in this report and in the section
entitled "Risk Factors" included in our Annual Report on Form 10-K for the year
ended December 31, 2001, and include:

- our management's ability to successfully implement its business
strategy, including implementing procedures and internal controls to
support the value of our business and our regulatory and reporting
requirements;

- acceptance of our products and services and security by brokers and
insureds;

- acceptance of our business strategy, security and financial condition
by rating agencies and regulators;

- general economic and market conditions (including as to inflation and
foreign currency exchange rates) and conditions specific to the
reinsurance and insurance markets in which we operate;

- competition, including increased competition, on the basis of pricing,
capacity, coverage terms or other factors;

- our ability to successfully integrate new management and operating
personnel and to establish and maintain operating procedures to
effectively support our new underwriting initiatives and to develop
accurate actuarial data and develop and implement actuarial models
and procedures;

38

- the loss of key personnel;

- the integration of businesses we have acquired or may acquire into our
existing operations;

- greater than expected loss ratios on business written by us and
adverse development on losses and/or loss adjustment expense
liabilities related to business written by us;

- severity and/or frequency of losses;

- claims for natural or man-made catastrophic events in our insurance or
reinsurance business could cause large losses and substantial
volatility in our results of operations;

- acts of terrorism, other hostilities or other unforecasted and
unpredictable events;

- losses relating to aviation business and business produced by a
certain managing underwriting agency for which we may be liable to the
purchaser of our prior reinsurance business or to others in connection
with the May 5, 2000 asset sale;

- availability to us of reinsurance to manage our gross and net
exposures;

- the failure of reinsurers, managing general agents or others to meet
their obligations to us;

- the timing of loss payments being faster or the receipt of reinsurance
recoverables being slower than anticipated by us;

- changes in the financial environment, including interest rates;

- changes in accounting principles or the application of such principles
by accounting firms or regulators;

- statutory or regulatory developments, including as to tax policy and
matters and insurance and other regulatory matters (such as the
adoption of proposed legislation that would affect
Bermuda-headquartered companies and/or Bermuda-based insurers or
reinsurers) and government provision or back-stopping of insurance
(including for acts of terrorism); and

- rating agency policies and practices.

In addition to the risks discussed in the section entitled "Risk Factors"
included in our Annual Report on Form 10-K for the year ended December 31, 2001,
other general factors could affect our results, including: (a) developments in
the world's financial and capital markets and our access to such markets; (b)
changes in regulation or tax laws applicable to us, our subsidiaries, brokers or
customers; and (c) the effects of business disruption or economic contraction
due to terrorism or other hostilities.

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

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Reference is made to the information appearing above under the subheading
"Market Sensitive Instruments and Risk Management" under the caption
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," which information is hereby incorporated by reference.

39

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

We, in common with the insurance industry in general, are subject to
litigation and arbitration in the normal course of our business. As of June 30,
2002, we were not a party to any material litigation or arbitration other than
as a part of the ordinary course of business in relation to claims activity,
none of which is expected by management to have a significant adverse effect on
our results of operation and financial condition and liquidity.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

On March 7, 2002, at a special meeting of shareholders, our shareholders
approved amendments to bye-laws 45 and 75, and on June 27, 2002, at our annual
shareholders meeting, our shareholders approved an amendment to bye-law 20.
These amendments were made in connection with the November 2001 capital infusion
by investors led by Warburg Pincus investment funds, Hellman & Friedman
investment funds and certain members of management. These amendments are
described in more detail in our proxy statements for those meetings filed with
the Securities and Exchange Commission on January 23, 2002 and June 3, 2002.

BYE-LAW 45

Before the amendment, bye-law 45 limited the voting rights of any person
that owned (directly, indirectly or constructively under the Internal Revenue
Code (the "Code")) ACGL shares with more than 9.9% of the total voting power of
all ACGL shares entitled to vote generally at an election of directors to 9.9%
of such voting power. This provision was intended to prevent ACGL from being
characterized as a controlled foreign corporation under the Code. Bye-law 45
also limited the rights of any group within the meaning of the Exchange Act of
1934, as amended (the "Exchange Act"), that owned ACGL shares with more than
9.9% of the total voting power of all ACGL shares entitled to vote generally at
an election of directors to 9.9% of such voting power.

The amendment to bye-law 45 changed these voting limitations so that the
limitation now applies only to votes conferred (directly or indirectly or by
attribution) by ACGL shares directly, indirectly or constructively owned (within
the meaning of section 958 of the Code) by any U.S. person, as defined in
section 7701(a)(30) of the Code. If the votes so conferred on such U.S. person
would represent more than 9.9% of the voting power of all ACGL shares entitled
to vote generally at an election of directors, the votes so conferred would, in
general, be reduced by whatever amount is necessary so that after the reduction
the votes so conferred on such U.S. person constitutes 9.9% of the total voting
power of all ACGL shares entitled to vote generally at any election of
directors.

The amendment allows non-U.S. persons, including the Warburg Pincus
investment funds and the Hellman & Friedman investment funds, to have more than
9.9% of the total voting power of ACGL shares. This change resulted in ACGL
being characterized as a controlled foreign corporation.

There may be circumstances in which the votes conferred on a U.S. person
are reduced to less than 9.9% as a result of the operation of bye-law 45 as
amended, because of shares, including shares of the Warburg Pincus investment
funds and the Hellman & Friedman investment funds, that may be attributed to
that person under the Code.

BYE-LAW 75

Before the amendment, the boards of directors of any of our subsidiaries
that are incorporated in Bermuda, and any other subsidiary designated by our
board of directors, was required to consist of persons who have been elected by
our shareholders either as (1) alternate directors of our board of directors or
(2) designated company directors.

The amendment to bye-law 75 made the provisions of bye-law 75 expressly
applicable to subsidiaries incorporated under the laws of the Cayman Islands and
Barbados, as well as Bermuda. In addition, the

40

references to alternate directors were deleted, since our shareholders have
elected specified individuals to serve as directors of our existing and future
Bermuda, Barbados and other non-U.S. subsidiaries, making the concept of
alternate directors unnecessary.

BYE-LAW 20

Before the amendment, bye-law 20 provided that special meetings of ACGL's
board of directors may be called by the chairman of the board or by the
president, or by a majority of the total number of directors of ACGL.

As amended, bye-law 20 provides that a special meeting of the ACGL board of
directors may be called by three directors or a majority of the total number of
directors (whichever is fewer), in addition to the chairman of the board and the
president of ACGL. We were required to submit this amendment for approval by the
shareholders under the shareholders agreement with the investors in the capital
infusion. Although the Warburg Pincus investment funds and the Hellman &
Friedman investment funds are entitled to designate nominees that, in the
aggregate, constitute a majority of the ACGL board, they have elected not to do
so. Bye-law 20, as amended, provides protection to these investors by allowing
three of their designees on the board, or any group of three directors, to call
a special meeting of the board of directors

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

(a) The annual meeting of shareholders (the "Annual Meeting") of ACGL was held
on June 27, 2002.

(b) Proxies for the Annual Meeting were solicited pursuant to Regulation 14
under the Exchange Act. There was no solicitation in opposition to
management's nominees as listed in ACGL's proxy statement, dated June 4,
2002 (the "Proxy Statement").

(c) The shareholders of ACGL (1) elected the following Class I Directors to
hold office until the 2005 annual meeting of shareholders or until their
successors are elected and qualified: Paul B. Ingrey, Kewsong Lee, David R.
Tunnell and Robert F. Works, (2) adopted an amendment to ACGL's bye-law 20
as set forth and described in the Proxy Statement, (3) approved the
share-based awards to the Chairman and the Vice-Chairman of the Board of
Directors of ACGL in connection with the capital fusion in November 2001,
(4) approved the ACGL 2002 Long Term Incentive and Share Award Plan, (5)
elected certain individuals as Designated Company Directors of certain of
ACGL's non-U.S. subsidiaries, and (6) ratified the selection of
PricewaterhouseCoopers LLP as independent auditors for the fiscal year
ending December 31, 2002. Set forth below are the voting results for these
proposals:

ELECTION OF CLASS I DIRECTORS OF ACGL

ADOPTION OF AMENDMENT TO BYE-LAW 20

APPROVAL OF SHARE-BASED AWARDS MADE TO THE CHAIRMAN AND THE VICE CHAIRMAN
OF THE BOARD OF DIRECTORS OF ACGL

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APPROVAL OF THE ACGL 2002 LONG TERM INCENTIVE AND SHARE AWARD PLAN

ELECTION OF DESIGNATED COMPANY DIRECTORS OF NON-U.S. SUBSIDIARIES

RATIFICATION OF SELECTION OF PRICEWATERHOUSECOOPERS LLP AS INDEPENDENT
AUDITORS

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) EXHIBITS.

(b) REPORTS ON FORM 8-K.

ACGL filed a report on Form 8-K during the three-month period ended June
30, 2002 on April 3, 2002 to report that it had entered into a purchase
agreement covering the issue and sale by ACGL of 6,500,000 common shares (plus
an additional 975,000 common shares to cover over-allotments) of ACGL under
ACGL's registration statement on Form S-3.

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SIGNATURES

================================================================================

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

ARCH CAPITAL GROUP LTD.
-----------------------------------------------------
(REGISTRANT)

/s/ Peter A. Appel
-----------------------------------------------------
Date: August 14, 2002 Peter A. Appel
President and Chief Executive Officer
(Principal Executive Officer) and Director

/s/ John D. Vollaro
-----------------------------------------------------
Date: August 14, 2002 John D. Vollaro
Executive Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)

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EXHIBIT INDEX