Watford Holdings Ltd. - Quarter Report: 2019 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2019

☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number: 001-38788

Watford Holdings Ltd.

(Exact Name of Registrant as Specified in its Charter)



Bermuda (State or other jurisdiction of incorporation or organization)	98-1155442 (I.R.S. Employer Identification Number)
Waterloo House, 1^stFloor 100 Pitts Bay Road, Pembroke HM 08, Bermuda (Address of principal executive offices)	(441) 278-3455 (Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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 ☒ No ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.



Large accelerated filer ☐	Accelerated filer ☐	Non-accelerated filer ☒	Smaller reporting company ☐	Emerging growth company ☒

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☒

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒

Securities registered pursuant to Section 12(b) of the Act:



Title of each class	Trading Symbol(s)	Name of each exchange on which registered
Common Shares	WTRE	Nasdaq Global Select Market
8½% Cumulative Redeemable Preference Shares	WTREP	Nasdaq Global Select Market

As of November 8, 2019, there were 21,421,977 common shares, $0.01 par value per share, of the registrant outstanding.



	Watford Holdings Ltd.
	Index to Form 10-Q
		Page
Part I.	Financial information	3
Item 1.	Consolidated financial statements	5
Item 2.	Management’s discussion and analysis of financial condition and results of operations	50
Item 3.	Quantitative and qualitative disclosures about market risk	92
Item 4.	Controls and procedures	96

Part II.	Other information	97
Item 1.	Legal proceedings	97
Item 1A.	Risk factors	97
Item 2.	Unregistered sales of equity securities and use of proceeds	98
Item 3.	Defaults upon senior securities	98
Item 4.	Mine safety disclosures	98
Item 5.	Other information	98
Item 6.	Exhibits	99
	Signatures	100

Explanatory note - Certain defined terms

Unless the context suggests otherwise, any reference in this report to:


•	“ACGL” refers to Arch Capital Group Ltd. and its controlled subsidiaries;


•	“Arch” refers to any one or more of the following direct or indirect subsidiaries of ACGL, as applicable in the context in which such term appears:


•	Arch Investment Management Ltd., or AIM, which manages the majority of our investment grade portfolio;


•	Arch Reinsurance Company, or ARC, which is a party to certain quota share agreements with one or more of our operating subsidiaries and a services agreement with Watford Holdings (U.S.) Inc.;


•	Arch Reinsurance Ltd., or ARL, which is a party to certain quota share agreements with one or more of our operating subsidiaries and owned approximately 11% of our outstanding common shares as of September 30, 2019;


•	Arch Underwriters Inc., or AUI, which manages the underwriting business of our U.S. operating subsidiaries;


•	Arch Underwriters Ltd., or AUL, which manages the underwriting business of our non-U.S. operating subsidiaries, including Watford Re;


•	“HPS” refers to HPS Investment Partners, LLC (formerly known as Highbridge Principal Strategies, LLC), which manages our non-investment grade portfolio, as well as accounts in our investment grade portfolio;


•	our “Investment Managers” refers to AIM, HPS or any other investment managers that manage our investment grade portfolio or our non-investment grade portfolio from time to time;


•	“Watford,” “we,” “us” and “our” refers to Watford Holdings Ltd. and its subsidiaries;


•	“Watford Holdings” refers to our company, Watford Holdings Ltd., a Bermuda exempted company;


•	“Watford Re” refers to Watford Re Ltd., a Bermuda domiciled insurance company and a wholly-owned subsidiary of our company;


•	“Watford Trust” refers to Watford Asset Trust I, a statutory trust organized under the laws of the State of Delaware;


•	“WIC” refers to Watford Insurance Company, a New Jersey domiciled insurance company and a wholly-owned subsidiary of our company;


•	“WICE” refers to Watford Insurance Company Europe Limited, a Gibraltar domiciled insurance company and a wholly-owned subsidiary of our company; and


•	“WSIC” refers to Watford Specialty Insurance Company, a New Jersey domiciled insurance company and a wholly-owned subsidiary of our company.

Part I. Financial information

Cautionary note regarding forward-looking statements

The Private Securities Litigation Reform Act of 1995 (or the PSLRA) provides a “safe harbor” for forward-looking statements. This report contains forward-looking statements that are intended to enhance the reader’s ability to assess our future financial and business performance. These statements are based on the beliefs and assumptions of our management, and are subject to risks and uncertainties. Generally, statements that are not about historical facts, including statements concerning our possible or assumed future actions or results of operations are forward-looking statements. Forward-looking statements include, but are not limited to, statements that represent our beliefs, expectations or estimates concerning future operations, strategies, financial results or performance, financings, investments, acquisitions, expenditures or other developments and anticipated trends and competition in the markets in which we operate. Forward-looking statements, for purposes of the PSLRA or otherwise, can also be identified by the use of forward-looking terminology such as “may,” “believes,” “intends,” “anticipates,” “plans,” “estimates,” “expects,” “should” or similar expressions.

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 and elsewhere in this report and in our other reports and other documents filed with the Securities and Exchange Commission, or the SEC, and include:


•	our limited operating history;


•	fluctuations in the results of our operations;


•	our ability to compete successfully with more established competitors;


•	our losses exceeding our reserves;


•	downgrades, potential downgrades or other negative actions by rating agencies;


•	our dependence on key executives and inability to attract qualified personnel, or the potential loss of Bermudian personnel as a result of Bermuda employment restrictions;


•	our dependence on letter of credit facilities that may not be available on commercially acceptable terms;


•	our potential inability to pay dividends or distributions;


•	our potential need for additional capital in the future and the potential unavailability of such capital to us on favorable terms or at all;


•	our dependence on clients’ evaluations of risks associated with such clients’ insurance underwriting;


•	the suspension or revocation of our subsidiaries’ insurance licenses;


•	Watford Holdings potentially being deemed an investment company under U.S. federal securities law;


•	the potential characterization of us and/or any of our subsidiaries as a passive foreign investment company, or PFIC;


•	our dependence on Arch for services critical to our underwriting operations;


•	changes to our strategic relationship with Arch or the termination by Arch of any of our services agreements or quota share agreements;


•	our dependence on HPS and AIM to implement our investment strategy;


•	the termination by HPS or AIM of any of our investment management agreements;


•	risks associated with our investment strategy being greater than those faced by competitors;


•	changes in the regulatory environment;


•	our potentially becoming subject to U.S. federal income taxation;


•	our potentially becoming subject to U.S. withholding and information reporting requirements under the U.S. Foreign Account Tax Compliance Act, or FATCA, provisions; and


•	the other risks identified in this report, including, without limitation, those under the sections titled Part II Item 1A “Risk factors” and Part I Item 2 “Management’s discussion and analysis of financial condition and results of operations.”

Consequently, such forward-looking statements should be regarded solely as our current plans, estimates or belief as of the date of this report. All subsequent 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 do not intend, and do not undertake, any obligation to update any forward-looking statements to reflect future events or circumstances after the date of this report.

Item 1. Consolidated financial statements



	Page
Consolidated Balance Sheets
September 30, 2019 (unaudited) and December 31, 2018	6

Consolidated Statements of Income (Loss)
For the three and nine months ended September 30, 2019 and 2018 (unaudited)	7

Consolidated Statements of Comprehensive Income (Loss)
For the three and nine months ended September 30, 2019 and 2018 (unaudited)	8

Consolidated Statements of Changes in Shareholders’ Equity
For the three and nine months ended September 30, 2019 and 2018 (unaudited)	9

Consolidated Statements of Cash Flows
For the nine months ended September 30, 2019 and 2018 (unaudited)	10

Notes to the Consolidated Financial Statements (unaudited)
Note 1 - Organization	11
Note 2 - Basis of Presentation and Significant Accounting Policies	11
Note 3 - Segment Information	14
Note 4 - Reinsurance	15
Note 5 - Reserves for Losses and Loss Adjustment Expenses	16
Note 6 - Investment Information	17
Note 7 - Fair Value	28
Note 8 - Derivative Instruments	35
Note 9 - Share Transactions	37
Note 10 - Earnings Per Common Share	38
Note 11 - Income Taxes	38
Note 12 - Transactions With Related Parties	39
Note 13 - Commitments and Contingencies	44
Note 14 - Leases	46
Note 15 - Contingently Redeemable Preference Shares	47
Note 16 - Senior Notes	48
Note 17 - Legal Proceedings	48

WATFORD HOLDINGS LTD.

CONSOLIDATED BALANCE SHEETS

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



	(Unaudited)
	September 30,		December 31,
	2019		2018
Assets
Investments:
Term loans, fair value option (Amortized cost: $1,109,393 and $1,055,664)	$	1,040,983	$	1,000,652
Fixed maturities, fair value option (Amortized cost: $583,530 and $972,653)	563,214		922,819
Short-term investments, fair value option (Cost: $359,837 and $281,959)	357,611		282,132
Equity securities, fair value option	56,905		56,638
Other investments, fair value option (1)	29,583		49,762
Investments, fair value option	2,048,296		2,312,003
Fixed maturities, available for sale (Amortized cost: $675,542 and $397,509)	678,094		393,351
Equity securities, fair value through net income	43,488		33,013
Total investments (1)	2,769,878		2,738,367
Cash and cash equivalents	80,390		63,529
Accrued investment income	18,277		19,461
Premiums receivable (1)	302,265		227,301
Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses (1)	144,437		86,445
Prepaid reinsurance premiums (1)	129,909		61,587
Deferred acquisition costs, net (1)	67,241		80,858
Receivable for securities sold	25,283		24,507
Intangible assets	7,650		7,650
Funds held by reinsurers (1)	51,134		44,830
Other assets (1)	15,031		18,321
Total assets	$	3,611,495	$	3,372,856
Liabilities
Reserve for losses and loss adjustment expenses (1)	$	1,164,945	$	1,032,760
Unearned premiums (1)	454,148		390,114
Losses payable (1)	63,731		24,750
Reinsurance balances payable (1)	79,264		21,034
Payable for securities purchased	40,586		60,142
Payable for securities sold short	65,736		8,928
Revolving credit agreement borrowings	519,197		693,917
Senior notes (1)	172,350		—
Amounts due to affiliates (1)	4,700		5,888
Investment management and performance fees payable (1)	13,647		3,807
Other liabilities	20,137		20,916
Total liabilities	$	2,598,441	$	2,262,256
Commitments and contingencies
Contingently redeemable preference shares (1)	52,281		220,992
Shareholders’ equity
Common shares ($0.01 par; shares authorized: 120 million; shares issued and outstanding: 22,692,300 and 22,682,875)	227		227
Additional paid-in capital	897,900		895,386
Retained earnings (deficit)	60,334		(1,275		)
Accumulated other comprehensive income (loss)	2,312		(4,730		)
Total shareholders’ equity	960,773		889,608
Total liabilities, contingently redeemable preference shares and shareholders’ equity	$	3,611,495	$	3,372,856

(1) See Note 12 - “Transactions with related parties” for disclosure of related party amounts.

WATFORD HOLDINGS LTD.

CONSOLIDATED STATEMENTS OF INCOME (LOSS)

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



	(Unaudited)						(Unaudited)
	Three Months Ended September 30,						Nine Months Ended September 30,
	2019			2018			2019			2018
Revenues
Gross premiums written (1)	$	249,960		$	185,033		$	598,627		$	574,078
Gross premiums ceded (1)	(94,208		)	(33,356		)	(178,118		)	(102,263		)
Net premiums written (1)	155,752			151,677			420,509			471,815
Change in unearned premiums (1)	(29,920		)	(16,053		)	2,735			(39,926		)
Net premiums earned (1)	125,832			135,624			423,244			431,889
Other underwriting income (loss)	579			703			1,844			2,092
Interest income	41,376			38,704			123,113			109,830
Investment management fees - related parties (1)	(4,606		)	(4,314		)	(13,585		)	(12,616		)
Borrowing and miscellaneous other investment expenses	(7,234		)	(6,993		)	(23,143		)	(19,636		)
Net interest income	29,536			27,397			86,385			77,578
Realized and unrealized gains (losses) on investments	(14,646		)	(3,617		)	18,138			(16,237		)
Investment performance fees - related parties (1)	(850		)	(2,407		)	(8,342		)	(6,606		)
Net investment income (loss)	14,040			21,373			96,181			54,735
Total revenues	140,451			157,700			521,269			488,716

Expenses
Loss and loss adjustment expenses (1)	(96,214		)	(96,957		)	(318,480		)	(312,087		)
Acquisition expenses (1)	(27,612		)	(33,778		)	(97,003		)	(106,708		)
General and administrative expenses (1)	(7,027		)	(5,801		)	(24,018		)	(16,274		)
Interest expense (1)	(2,841		)	—			(2,841		)	—
Net foreign exchange gains (losses)	167			2,582			(711		)	1,847
Total expenses	(133,527		)	(133,954		)	(443,053		)	(433,222		)
Income (loss) before income taxes	6,924			23,746			78,216			55,494
Income tax expense	—			—			(20		)	(27		)
Net income (loss) before preference dividends and redemption costs	6,924			23,746			78,196			55,467
Preference dividends (1)	(2,608		)	(4,909		)	(12,423		)	(14,724		)
Accelerated amortization of costs related to the redemption of preference shares (1)	(4,164		)	—			(4,164		)	—
Net income (loss) available to common shareholders	$	152		$	18,837		$	61,609		$	40,743

Earnings (loss) per common share:
Basic	$	0.01		$	0.83		$	2.71		$	1.80
Diluted	$	0.01		$	0.83		$	2.71		$	1.80
Weighted average number of common shares used in the determination of earnings (loss) per share:
Basic	22,765,802			22,682,875			22,729,848			22,682,875
Diluted	22,776,204			22,682,875			22,734,464			22,682,875

(1) See Note 12 - “Transactions with related parties” for disclosure of related party amounts.

See Notes to Consolidated Financial Statements

WATFORD HOLDINGS LTD.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(U.S. dollars in thousands)



	(Unaudited)						(Unaudited)
	Three Months Ended September 30,						Nine Months Ended September 30,
	2019			2018			2019			2018
Comprehensive income (loss)
Net income (loss) available to common shareholders	$	152		$	18,837		$	61,609		$	40,743
Other comprehensive income (loss) net of income tax:
Available for sale investments:
Unrealized holding gains (losses) arising during the year	109			(1,429		)	10,174			(4,194		)
Reclassification of net realized (gains) losses, net of income taxes, included in net income	(1,254		)	38			(3,465		)	684
Foreign currency translation adjustments	286			88			333			240
Other comprehensive income (loss) net of income tax	(859		)	(1,303		)	7,042			(3,270		)
Comprehensive income (loss)	$	(707	)	$	17,534		$	68,651		$	37,473

See Notes to Consolidated Financial Statements

WATFORD HOLDINGS LTD.

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(U.S. dollars in thousands)



	(Unaudited)						(Unaudited)
	Three Months Ended September 30,						Nine Months Ended September 30,
	2019			2018			2019			2018
Common shares
Balance at beginning of period	$	227		$	227		$	227		$	227
Common shares issued	—			—			—			—
Balance at end of period	227			227			227			227

Additional paid-in capital
Balance at beginning of period	897,716			895,386			895,386			895,386
Common shares issued under share plans	—			—			250			—
Share-based compensation	184			—			2,264			—
Balance at end of period	897,900			895,386			897,900			895,386

Accumulated other comprehensive income (loss)
Balance at beginning of period	3,171			(2,939		)	(4,730		)	(972		)
Unrealized holding gains (losses) of available for sale investments:
Balance at beginning of period	3,696			(2,119		)	(4,158		)	—
Unrealized holding gains (losses) of available for sale investments, net of reclassification adjustment	(1,145		)	(1,391		)	6,709			(3,510		)
Balance at end of period	2,551			(3,510		)	2,551			(3,510		)
Currency translation adjustment:
Balance at beginning of period	(525		)	(820		)	(572		)	(972		)
Currency translation adjustment	286			88			333			240
Balance at end of period	(239		)	(732		)	(239		)	(732		)
Balance at end of period	2,312			(4,242		)	2,312			(4,242		)

Retained earnings (deficit)
Balance at beginning of period	60,182			75,147			(1,275		)	53,241
Net income (loss) before preference dividends	6,924			23,746			78,196			55,467
Preference share dividends paid and accrued	(2,608		)	(4,909		)	(12,423		)	(14,724		)
Accelerated amortization of costs related to the redemption of preference shares	(4,164		)	—			(4,164		)	—
Balance at end of period	60,334			93,984			60,334			93,984
Total shareholders’ equity	$	960,773		$	985,355		$	960,773		$	985,355

See Notes to Consolidated Financial Statements

WATFORD HOLDINGS LTD.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(U.S. dollars in thousands)



	(Unaudited)
	Nine Months Ended September 30,
	2019			2018
Operating Activities
Net income (loss) before preference dividends	$	78,196		$	55,467
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Net realized and unrealized (gains) losses on investments	(14,509		)	20,912
Amortization of fixed assets	84			119
Share-based compensation	2,514			—
Changes in:
Accrued investment income	1,179			603
Premiums receivable	(74,695		)	(49,188		)
Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses	(56,418		)	(26,507		)
Prepaid reinsurance premiums	(68,322		)	(39,010		)
Deferred acquisition costs, net	15,635			1,599
Reserve for losses and loss adjustment expenses	141,325			182,637
Unearned premiums	65,587			78,936
Reinsurance balances payable	58,945			7,301
Funds held with reinsurers	(8,322		)	(19,143		)
Other liabilities	40,818			(26,248		)
Other items	(4,835		)	(13,191		)
Net Cash Provided By Operating Activities	177,182			174,287
Investing Activities
Purchase of term loans	(343,110		)	(629,478		)
Purchase of fixed maturity investments	(957,250		)	(934,669		)
Purchase of short-term investments with maturities over three months	(8,712		)	(8,282		)
Proceeds from sale, redemptions and maturity of term loans	283,126			524,423
Proceeds from sales, redemptions and maturities of fixed maturity investments	1,116,398			762,672
Proceeds from sales, redemptions and maturities of other investments	47,288			—
Proceeds from sales, redemptions and maturities of short-term investments with maturities over three months	28,791			5,642
Net (purchases) sales of short-term investments with maturities less than three months	(98,835		)	103,340
Purchases of equity securities	(66,593		)	(87,316		)
Proceeds from sales of equity securities	25,894			39,083
Net settlements of derivative instruments	1,488			330
Purchases of furniture, equipment and other assets	—			(11		)
Net Cash Provided by (Used For) Investing Activities	28,485			(224,266		)
Financing Activities
Dividends paid on redeemable preference shares	(12,216		)	(14,448		)
Repayments on borrowings	(237,239		)	(177,000		)
Proceeds from borrowings	62,800			253,365
Repurchase of preference shares	(173,081		)	—
Net proceeds from issuance of senior notes	172,283			—
Net Cash Provided By (Used For) Financing Activities	(187,453		)	61,917
Effects of exchange rate changes on foreign currency cash	(1,353		)	(1,757		)
Increase (decrease) in cash	16,861			10,181
Cash and cash equivalents, beginning of period	63,529			54,503
Cash and cash equivalents, end of period	$	80,390		$	64,684
Supplementary information
Income taxes paid	$	20		$	27
Interest paid	$	21,998		$	19,046
Non-cash exchange of investments	$	28,673		$	—

See Notes to Consolidated Financial Statements

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

1. Organization

Watford Holdings Ltd. (the “Parent”) and its wholly-owned subsidiary, Watford Re Ltd. (“Watford Re”), were incorporated under the laws of Bermuda on July 19, 2013.

As used herein, the terms “Company” or “Companies,” or “we,” “us” and “our,” collectively refer to the Parent and/or, as applicable, its subsidiaries. Watford Re is licensed as a Class 4 multi-line insurer under the Insurance Act 1978 of Bermuda, as amended, and related regulations (the “Insurance Act”) and is licensed to underwrite general business on an insurance and reinsurance basis. Through Watford Re, the Company primarily underwrites reinsurance on exposures worldwide.

On March 28, 2019, the Company completed a direct listing of its common shares on the Nasdaq Global Select Market. On June 28, 2019, the Company completed a direct listing of its 8½% Cumulative Redeemable Preference Shares (the “preference shares”) on the Nasdaq Global Select Market. The Company did not issue any new common shares or preference shares, nor did the Company receive any proceeds from the sale of common shares or preference shares by the selling shareholders.

Watford Re and Watford Insurance Company Europe Limited (“WICE”) have engaged Arch Underwriters Ltd. (“AUL”), a company incorporated in Bermuda and a wholly-owned subsidiary of Arch Capital Group Ltd. (“ACGL”), to act as their insurance and reinsurance manager pursuant to services agreements between AUL and Watford Re and WICE, respectively. AUL manages the day-to-day underwriting activities of Watford Re and WICE, subject to the provisions of the services agreement and the oversight of our board of directors. See Note 12 - “Transactions with related parties” for further details.

Watford Specialty Insurance Company (“WSIC”) and Watford Insurance Company (“WIC”), which are wholly-owned, indirect subsidiaries of Watford Re, have engaged Arch Underwriters Inc. (“AUI”), a company incorporated in Delaware and a wholly-owned subsidiary of ACGL, to act as their insurance and reinsurance manager pursuant to services agreements between AUI and WSIC and WIC, respectively. AUI manages the day-to-day underwriting activities of WSIC and WIC, subject to the provisions of the services agreement and the oversight of our board of directors. See Note 12 - “Transactions with related parties” for further details.

The Company has engaged HPS Investment Partners, LLC (“HPS”), as investment manager of the assets in its non-investment grade portfolio pursuant to various investment management agreements. HPS invests the Company’s non-investment grade assets and a portion of its investment grade assets, subject to the terms of the applicable investment management agreements. See Note 12 - “Transactions with related parties” for further details.

The Company has engaged Arch Investment Management Ltd. (“AIM”), a Bermuda exempted company and a subsidiary of ACGL, as investment manager of assets in its investment grade portfolio pursuant to various investment management agreements. AIM manages the majority of the Company’s investment grade assets pursuant to the terms of the investment management agreements with AIM. See Note 12 - “Transactions with related parties” for further details.

The results for the three and nine months ended September 30, 2019 are not necessarily indicative of the results expected for the full calendar year.

2. Basis of presentation and significant accounting policies

There has been no material change to the Company’s significant accounting policies as described in its audited consolidated financial statements and the accompanying notes as of December 31, 2018 and 2017 and for each of the years in the periods ended December 31, 2018, 2017 and 2016, except as noted below.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

(a) Basis of presentation

The unaudited interim consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) on a basis consistent with reporting interim financial information in accordance with instructions to Form 10-Q and Article 10 of Regulation S-X under the Securities and Exchange Act of 1934, as amended. All significant intercompany transactions and balances have been eliminated on 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 and assumptions. In the opinion of management, the accompanying unaudited interim consolidated financial statements reflect all adjustments (consisting of recurring accruals) necessary for a fair statement of results on an interim basis.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted; 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 audited consolidated financial statements and the accompanying notes for the years ended December 31, 2018, 2017 and 2016.

(b) Share-based compensation

The Company applies a fair value-based measurement method in accounting for its share-based compensation plans with eligible employees and directors. Compensation expense is estimated based on the fair value of the award at the grant date and is recognized in net income over the requisite service period with a corresponding increase in shareholders’ equity. No value is attributed to awards that employees forfeit because they fail to satisfy vesting conditions. The Company’s time-based awards generally vest over a three-year period with one-third vesting on each of the first, second and third anniversaries of the grant date. The share-based compensation expense associated with awards that have graded vesting features and vest based only on service conditions is calculated on a straight-line basis over the requisite service period for the entire award. Compensation expense recognized in connection with performance awards is based on the achievement of the specified performance and service conditions. The final measure of compensation expense recognized over the requisite service period reflects the final performance outcome. During the recognition period, compensation expense is accrued based on the specified performance conditions that are probable of achievement. For awards granted to retirement-eligible employees where no service is required for the employee to retain the award, the grant date fair value is immediately recognized as compensation expense at the grant date because the employee is able to retain the award without continuing to provide service. For employees near retirement eligibility, the attribution of compensation expense is over the period from the grant date to the retirement eligibility date. The Company accounts for forfeitures of share-based awards as such forfeitures occur. See Note 9, “Share transactions” for information relating to the Company’s share-based compensation.

Recently adopted accounting standards

In August 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update 2017-12, Derivatives and Hedging (Topic 815), Targeted Improvements to Accounting for Hedging Activities (“ASU 2017-12”). ASU 2017-12 intends to improve the financial reporting of hedging relationships to better portray the economic results of an entity’s risk management activities in its financial statements. ASU 2017-12 is effective January 1, 2019. This ASU was adopted on January 1, 2019, and did not have a material impact on the Company’s consolidated financial statements.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

In February 2018, the FASB issued Accounting Standards Update 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220), Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income (“ASU 2018-02”). ASU 2018-02 permits companies to reclassify disproportionate tax effects in accumulated other comprehensive income caused by the Tax Cuts and Jobs Act of 2017 to retained earnings. ASU 2018-02 is effective for fiscal years beginning after December 31, 2018 and interim periods within those fiscal years. This ASU was adopted on January 1, 2019, and did not have a material impact on the Company’s consolidated financial statements and disclosures.

In February 2016, the FASB issued Accounting Standards Update 2016-02, Leases and subsequently issued several improvements to that update (collectively “ASU 2016-02”). The new accounting guidance requires that the lessee recognize an asset and a liability for leases with a lease term greater than 12 months regardless of whether the lease is classified as operating or financing. Under the previous accounting standard, operating leases were not reflected in the balance sheet.

The Company adopted ASU 2016-02 on January 1, 2019. The adoption of the updated guidance resulted in the Company recognizing a right-of-use asset of $1.1 million and a lease liability of $1.1 million in other assets and other liabilities, respectively, in the Company’s consolidated balance sheets. The cumulative effect adjustment to the opening balance of retained earnings was $Nil. The adoption of the updated guidance did not have a material effect on the Company’s results of operations or liquidity.

Recently issued accounting standards not yet adopted

In April 2019, the FASB issued Accounting Standards Update 2019-04, Codification Improvements to Topic 326, Financial Instruments - Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments (“ASU 2019-04”), which will identify and clarify issues relevant to the implementation of Accounting Standards Update 2016-01, Financial Instruments - Overall (Subtopic 825-10), Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), Accounting Standards Update 2016-13, Financial Instruments - Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”) and ASU 2017-12. The Company is assessing the impact the implementation will have on its consolidated financial statements and disclosures.


•	For amendments related to ASU 2016-01, the effective date is for fiscal years and interim periods beginning after December 15, 2019; early adoption in any interim period is permitted.


•	For amendments related to ASU 2016-13, the effective date is for fiscal years and interim periods beginning after December 15, 2019.


•	For amendments related to ASU 2017-12, the effective date is as of the beginning of the first annual reporting period beginning after April 25, 2019. As the Company has implemented ASU 2017-12, early adoption in any interim period is permitted.

In May 2019, the FASB issued Accounting Standards Update 2019-05, Financial Instruments - Credit Losses - Targeted Transition Relief (Topic 326) (“ASU 2019-05”), which gives entities the option to irrevocably elect the fair value option on instruments previously measured on an amortized cost basis, selected on an instrument-by-instrument basis. ASU 2019-05 will have the same implementation date as ASU 2016-13, effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Upon adoption, the Company expects the new standard to have an impact on certain types of investment securities and reinsurance recoverables. The Company is currently assessing the impact the implementation of this ASU will have on its consolidated financial statements.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

3. Segment information

The Company reports results under one segment, referred to as the “underwriting segment.” The underwriting segment captures the results of the Company’s underwriting lines of business, which are comprised of specialty products on a worldwide basis. Lines of business include: (i) casualty reinsurance; (ii) property catastrophe reinsurance; (iii) other specialty reinsurance; and (iv) insurance programs and coinsurance.

The accounting policies of the underwriting segment are the same as those used for the preparation of the Company’s consolidated financial statements.

The Company has a corporate function that includes certain general and administrative expenses related to corporate activities, interest expense, net foreign exchange gains (losses), income tax expense and items related to the Company’s contingently redeemable preference shares.

The following table provides summary information regarding premiums written and earned by line of business and net premiums written by underwriting location:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019		2018
	($ in thousands)
Gross premiums written:
Casualty reinsurance	$	145,129	$	80,274	$	253,287	$	222,636
Other specialty reinsurance	22,453		37,434		84,587		151,083
Property catastrophe reinsurance	3,461		1,353		15,382		8,740
Insurance programs and coinsurance	78,917		65,972		245,371		191,619
Total	$	249,960	$	185,033	$	598,627	$	574,078

Net premiums written:
Casualty reinsurance	$	92,084	$	80,149	$	199,226	$	221,669
Other specialty reinsurance	22,093		35,466		81,798		138,259
Property catastrophe reinsurance	3,040		1,342		14,643		8,515
Insurance programs and coinsurance	38,535		34,720		124,842		103,372
Total	$	155,752	$	151,677	$	420,509	$	471,815

Net premiums earned:
Casualty reinsurance	$	52,266	$	63,292	$	183,085	$	206,532
Other specialty reinsurance	31,563		36,987		118,759		125,271
Property catastrophe reinsurance	3,617		2,481		9,707		7,443
Insurance programs and coinsurance	38,386		32,864		111,693		92,643
Total	$	125,832	$	135,624	$	423,244	$	431,889

Net premiums written by underwriting location:
United States	$	20,649	$	13,712	$	61,436	$	37,554
Europe	18,412		21,614		65,597		66,959
Bermuda	116,691		116,351		293,476		367,302
Total	$	155,752	$	151,677	$	420,509	$	471,815

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

4. Reinsurance

Through reinsurance agreements with Arch Reinsurance Ltd. (“ARL”) and Arch Reinsurance Company (“ARC”), which are subsidiaries of ACGL, as well as through other third-party reinsurance agreements, the Company cedes a portion of its premiums. The effects of reinsurance on the Company’s written and earned premiums, losses and loss adjustment expenses were as follows:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2019			2018			2019			2018
Premiums written	($ in thousands)
Direct	$	78,917		$	65,972		$	245,371		$	191,619
Assumed	171,043			119,061			353,256			382,459
Ceded	(94,208		)	(33,356		)	(178,118		)	(102,263		)
Net	$	155,752		$	151,677		$	420,509		$	471,815
Premiums earned
Direct	$	73,741		$	54,726		$	207,704		$	141,352
Assumed	94,028			105,849			323,131			351,978
Ceded	(41,937		)	(24,951		)	(107,591		)	(61,441		)
Net	$	125,832		$	135,624		$	423,244		$	431,889
Losses and loss adjustment expenses
Direct	$	65,310		$	46,027		$	176,690		$	106,388
Assumed	69,072			73,554			242,247			244,909
Ceded	(38,168		)	(22,624		)	(100,457		)	(39,210		)
Net	$	96,214		$	96,957		$	318,480		$	312,087

The Company monitors the financial condition of its reinsurers and attempts to place coverages only with financially sound carriers. At September 30, 2019 and December 31, 2018, approximately 48% and 53%, respectively, of the Company’s reinsurance recoverables on paid and unpaid losses (not including prepaid reinsurance premiums) were due from ARL and ARC, each of which have ratings of “A+” from A.M. Best. Although the Company has not experienced any material credit losses to date, an inability of its reinsurers to meet their obligations to it over the relevant exposure periods for any reason could have a material adverse effect on its financial condition and results of operations.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

5. Reserve for losses and loss adjustment expenses

The following table represents an analysis of losses and loss adjustment expenses and a reconciliation of the beginning and ending reserve for losses and loss adjustment expenses for the nine months ended September 30, 2019 and 2018.



	Nine Months Ended September 30,
	2019			2018
	($ in thousands)
Gross reserve for losses and loss adjustment expenses at beginning of period	$	1,032,760		$	798,262
Unpaid losses and loss adjustment expenses recoverable	81,267			39,856
Net reserve for losses and loss adjustment expenses at beginning of period	951,493			758,406

Net incurred losses and loss adjustment expenses relating to losses occurring in:
Current period	318,812			314,381
Prior years	(332		)	(2,294		)
Total net losses and loss adjustment expenses	318,480			312,087

Foreign exchange gains (losses)	(9,971		)	(18,582		)

Net paid losses and loss adjustment expenses relating to losses occurring in:
Current period	(35,686		)	(25,891		)
Prior years	(198,682		)	(130,577		)
Total paid losses and loss adjustment expenses	(234,368		)	(156,468		)

Net reserve for losses and loss adjustment expenses at end of period	1,025,634			895,443
Unpaid losses and loss adjustment expenses recoverable	139,311			67,484
Gross reserve for losses and loss adjustment expenses at end of period	$	1,164,945		$	962,927

During the nine months ended September 30, 2019, the Company recorded net favorable development on prior year loss reserves of $0.3 million. Net favorable development was experienced on property catastrophe reinsurance losses of $1.5 million, casualty reinsurance losses of $0.6 million, and other specialty reinsurance losses $0.3 million, offset by unfavorable development on insurance losses of $2.0 million.

During the nine months ended September 30, 2018, the Company recorded net favorable development on prior year loss reserves of $2.3 million. Net favorable development was experienced on property catastrophe reinsurance losses of $4.4 million, and other specialty reinsurance losses of $1.2 million. This favorable development was offset by adverse development on casualty reinsurance losses of $2.6 million and $0.7 million on insurance programs.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

6. Investment information

Available for Sale Investments

The following table summarizes the fair value of the Company’s securities classified as available for sale as of September 30, 2019 and December 31, 2018:



	Cost or Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
September 30, 2019	($ in thousands)
Fixed maturities:
U.S. government and government agency bonds	$	292,475	$	4,004	$	(28	)	$	296,451
Non-U.S. government and government agency bonds	127,784		4,037		(6,380		)	125,441
Corporate bonds	89,824		2,110		(24		)	91,910
Asset-backed securities	141,965		367		(1,593		)	140,739
Mortgage-backed securities	22,488		44		(27		)	22,505
Municipal government and government agency bonds	1,006		42		—			1,048
Total investments, available for sale	$	675,542	$	10,604	$	(8,052	)	$	678,094



	Cost or Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
December 31, 2018	($ in thousands)
Fixed maturities:
U.S. government and government agency bonds	$	156,884	$	672	$	(127	)	$	157,429
Non-U.S. government and government agency bonds	89,661		670		(2,859		)	87,472
Corporate bonds	77,178		19		(1,204		)	75,993
Asset-backed securities	58,369		72		(1,351		)	57,090
Mortgage-backed securities	14,344		17		(81		)	14,280
Municipal government and government agency bonds	1,073		14		—			1,087
Total investments, available for sale	$	397,509	$	1,464	$	(5,622	)	$	393,351

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

The following table summarizes, for all available for sale securities in an unrealized loss position, the fair value and gross unrealized losses by length of time the security has been in a continual unrealized loss position:



	Less than 12 Months					12 Months or More					Total
	Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses
September 30, 2019	($ in thousands)
Fixed maturities:
U.S. government and government agency bonds	$	16,171	$	(28	)	$	—	$	—		$	16,171	$	(28	)
Non-U.S. government and government agency bonds	98,521		(6,378		)	5,077		(2		)	103,598		(6,380		)
Corporate bonds	5,459		(24		)	—		—			5,459		(24		)
Asset-backed securities	100,540		(1,593		)	—		—			100,540		(1,593		)
Mortgage-backed securities	6,991		(27		)	—		—			6,991		(27		)
Total	$	227,682	$	(8,050	)	$	5,077	$	(2	)	$	232,759	$	(8,052	)
December 31, 2018
Fixed maturities:
U.S. government and government agency bonds	$	66,422	$	(127	)	$	—	$	—		$	66,422	$	(127	)
Non-U.S. government and government agency bonds	78,084		(2,859		)	—		—			78,084		(2,859		)
Corporate bonds	70,443		(1,204		)	—		—			70,443		(1,204		)
Asset-backed securities	49,400		(1,351		)	—		—			49,400		(1,351		)
Mortgage-backed securities	8,478		(81		)	—		—			8,478		(81		)
Total	$	272,827	$	(5,622	)	$	—	$	—		$	272,827	$	(5,622	)

At September 30, 2019, 49 positions out of a total of 113 positions were in an unrealized loss position; however, the unrealized loss was less than 10% for all 49 positions. The unrealized loss position increased during the nine-month period from $5.6 million to $8.1 million. The decrease in value can be attributed to unfavorable foreign exchange rates for the non-U.S. government agency bonds during the period. The Company believes that such securities were temporarily impaired at September 30, 2019.

At December 31, 2018, 60 positions out of a total of 73 positions were in an unrealized loss position; however, the unrealized loss was less than 10% for all 60 positions. The decrease in value can be attributed to an increase in interest rates and unfavorable foreign exchange rates for the non-U.S. government agency bonds during the year ended December 31, 2018. The Company believes that such securities were temporarily impaired at December 31, 2018.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

The amortized cost and fair value of our fixed maturities classified as available for sale, summarized by contractual maturity as of September 30, 2019 and December 31, 2018 are shown in the following tables.



	September 30, 2019
	Amortized Cost		Estimated Fair Value		% of Fair Value
	($ in thousands)
Due in one year or less	$	9,397	$	9,330	1.4	%
Due after one year through five years	391,182		394,120		58.1	%
Due after five years through ten years	104,510		105,148		15.5	%
Due after ten years	6,000		6,252		0.9	%
Asset-backed securities	141,965		140,739		20.8	%
Mortgage-backed securities	22,488		22,505		3.3	%
Total investments, available for sale	$	675,542	$	678,094	100.0	%



	December 31, 2018
	Amortized Cost		Estimated Fair Value		% of Fair Value
	($ in thousands)
Due after one year through five years	$	278,443	$	276,706	70.4	%
Due after five years through ten years	46,353		45,275		11.5	%
Asset-backed securities	58,369		57,090		14.5	%
Mortgage-backed securities	14,344		14,280		3.6	%
Total investments, available for sale	$	397,509	$	393,351	100.0	%

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

Fair Value Option and Fair Value Through Net Income

The following table summarizes the fair value of the Company’s securities held as of September 30, 2019 and December 31, 2018, classified as fair value through net income or for which the fair value option was elected:



	Cost or Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
September 30, 2019	($ in thousands)
Term loan investments	$	1,109,393	$	4,781	$	(73,191	)	$	1,040,983
Fixed maturities:
Corporate bonds	355,954		14,537		(28,300		)	342,191
U.S. government and government agency bonds	1,999		1		(4		)	1,996
Asset-backed securities	205,916		3,297		(10,279		)	198,934
Mortgage-backed securities	7,680		1,385		(252		)	8,813
Non-U.S. government and government agency bonds	10,853		120		(835		)	10,138
Municipal government and government agency bonds	1,128		15		(1		)	1,142
Short-term investments	359,837		78		(2,304		)	357,611
Other investments	28,673		910		—			29,583
Equities	54,894		8,932		(6,921		)	56,905
Investments, fair value option	$	2,136,327	$	34,056	$	(122,087	)	$	2,048,296
Fair Value Through Net Income:
Equities, fair value through net income (1)	$	52,803	$	1,533	$	(10,848	)	$	43,488



	Cost or Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
December 31, 2018	($ in thousands)
Term loan investments	$	1,055,664	$	767	$	(55,779	)	$	1,000,652
Fixed maturities:
Corporate bonds	617,013		6,468		(44,867		)	578,614
U.S. government and government agency bonds	113,452		—		(2,206		)	111,246
Asset-backed securities	174,846		673		(6,626		)	168,893
Mortgage-backed securities	9,122		—		(1,241		)	7,881
Non-U.S. government and government agency bonds	50,914		1		(1,874		)	49,041
Municipal government and government agency bonds	7,306		—		(162		)	7,144
Short-term investments	281,959		570		(397		)	282,132
Other investments	50,000		—		(238		)	49,762
Equities	56,609		5,136		(5,107		)	56,638
Investments, fair value option	$	2,416,885	$	13,615	$	(118,497	)	$	2,312,003
Fair Value Through Net Income:
Equities, fair value through net income (1)	$	41,358	$	2,030	$	(10,375	)	$	33,013

(1) Effective January 1, 2018, the Company adopted new accounting guidance for financial instruments. As a result, equity securities acquired after January 1, 2018 are classified as fair value through net income and are shown separately above.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

The amortized cost and fair value of our term loans, fixed maturities and short-term investments, excluding securities classified as available for sale, summarized by contractual maturity as of September 30, 2019 and December 31, 2018 are shown in the following tables.



	September 30, 2019
	Amortized Cost		Estimated Fair Value		% of Fair Value
	($ in thousands)
Due in one year or less	$	334,794	$	332,417	17.0	%
Due after one year through five years	808,744		760,323		38.8	%
Due after five years through ten years	631,351		598,649		30.5	%
Due after ten years	64,275		62,672		3.2	%
Asset-backed securities	205,916		198,934		10.1	%
Mortgage-backed securities	7,680		8,813		0.4	%
Total	$	2,052,760	$	1,961,808	100.0	%



	December 31, 2018
	Amortized Cost		Estimated Fair Value		% of Fair Value
	($ in thousands)
Due in one year or less	$	300,554	$	300,519	13.6	%
Due after one year through five years	1,044,539		992,834		45.0	%
Due after five years through ten years	777,290		731,662		33.2	%
Due after ten years	3,925		3,814		0.2	%
Asset-backed securities	174,846		168,893		7.6	%
Mortgage-backed securities	9,122		7,881		0.4	%
Total	$	2,310,276	$	2,205,603	100.0	%

Variable Interest Entities

In the normal course of its investing activities, the Company invests in limited partnerships, limited liability companies and other investment securities. Due to the legal forms of the entities and the fact that the investors lack the ability, through voting rights or similar rights, to make decisions that have a significant effect on the entities, such investments are considered variable interest entities. Since the Company lacks the ability to control the activities that most significantly impact the economic performance of these variable interest entities, the Company is not considered the primary beneficiary and does not consolidate these investments.

The activities of these entities is generally limited to holding and managing the underlying investments. The Company’s maximum exposure to loss with respect to these investments is limited to the investment carrying amounts reported as “other investments” in the Company’s consolidated balance sheet and any unfunded commitments. Realized and unrealized gains and losses from such investments are included in “realized and unrealized gains (losses) on investments” in the Company’s consolidated statements of net income (loss).

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

The table below summarizes the credit quality of our total investments as of September 30, 2019 and December 31, 2018, as rated by Standard & Poor’s Financial Services, LLC, or Standard & Poor’s, Moody’s Investors Service, or Moody’s, Fitch Ratings Inc., or Fitch, or Kroll Bond Rating Agency, or KBRA, as applicable:



	Credit Rating (1)
September 30, 2019	Fair Value		AAA		AA		A		BBB		BB		B		CCC		CC		D		Not Rated
	($ in thousands)
Term loan investments	$	1,040,983	$	—	$	—	$	—	$	—	$	16,766	$	683,504	$	274,946	$	2,502	$	—	$	63,265
Fixed maturities:
Corporate bonds	434,101		—		34,645		69,062		52,038		15,507		59,544		171,951		—		—		31,354
U.S. government and government agency bonds	298,447		—		298,447		—		—		—		—		—		—		—		—
Asset-backed securities	339,673		2,894		—		31,636		214,387		34,789		18,659		—		—		—		37,308
Mortgage-backed securities	31,318		—		—		—		22,505		1,123		—		—		—		2,800		4,890
Non-U.S. government and government agency bonds	135,579		2,498		133,081		—		—		—		—		—		—		—		—
Municipal government and government agency bonds	2,190		1,142		572		476		—		—		—		—		—		—		—
Total fixed income instruments	2,282,291		6,534		466,745		101,174		288,930		68,185		761,707		446,897		2,502		2,800		136,817
Short-term investments	357,611		15,300		187,484		36,413		109,865		—		—		3,037		—		—		5,512
Total fixed income instruments and short-term investments	2,639,902		21,834		654,229		137,587		398,795		68,185		761,707		449,934		2,502		2,800		142,329
Other Investments	29,583
Equities	100,393
Total	$	2,769,878	$	21,834	$	654,229	$	137,587	$	398,795	$	68,185	$	761,707	$	449,934	$	2,502	$	2,800	$	142,329

(1) For individual fixed maturity investments, Standard & Poor’s ratings are used. In the absence of a Standard & Poor’s rating, ratings from Moody’s are used, followed by ratings from Fitch, followed by ratings from KBRA.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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



	Credit Rating (1)
December 31, 2018	Fair Value		AAA		AA		A		BBB		BB		B		CCC		CC		C		D		Not Rated
	($ in thousands)
Term loan investments	$	1,000,652	$	—	$	—	$	—	$	—	$	57,844	$	677,211	$	201,116	$	2,438	$	—	$	—	$	62,043
Fixed maturities:
Corporate bonds	654,607		3,961		58,185		100,590		63,791		15,246		174,867		203,505		—		2,200		—		32,262
U.S. government and government agency bonds	268,675		—		268,675		—		—		—		—		—		—		—		—		—
Asset-backed securities	225,983		4,532		4,973		10,278		113,075		36,643		20,818		—		—		—		—		35,664
Mortgage-backed securities	22,161		—		—		944		13,336		742		—		—		—		—		2,962		4,177
Non-U.S. government and government agency bonds	136,513		5,173		122,715		8,625		—		—		—		—		—		—		—		—
Municipal government and government agency bonds	8,231		6,490		715		1,026		—		—		—		—		—		—		—		—
Total fixed income instruments	2,316,822		20,156		455,263		121,463		190,202		110,475		872,896		404,621		2,438		2,200		2,962		134,146
Short-term investments	282,132		4,450		128,015		54,970		68,853		—		25,844		—		—		—		—		—
Total fixed income instruments and short-term investments	2,598,954		24,606		583,278		176,433		259,055		110,475		898,740		404,621		2,438		2,200		2,962		134,146
Other Investments	49,762
Equities	89,651
Total	$	2,738,367	$	24,606	$	583,278	$	176,433	$	259,055	$	110,475	$	898,740	$	404,621	$	2,438	$	2,200	$	2,962	$	134,146

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

Fair value option

The Company elected to carry the majority of fixed maturity securities and other investments at fair value under the fair value option afforded by accounting guidance regarding the fair value option for financial assets and liabilities. Changes in fair value of investments accounted for using the fair value option are included in “realized and unrealized gain (loss) on investments” in the consolidated statements of income (loss). The Company elected to use this option as investments are not necessarily held to maturity, and in order to address simplification and cost-benefit considerations.

Net investment income (loss)

The components of net investment income (loss) for the three and nine months ended September 30, 2019 and 2018 were derived from the following sources:



	Three Months Ended September 30, 2019
	Net Interest Income			Net Unrealized Gains (Losses)			Net Realized Gains (Losses)			Net Investment Income (Loss)
Net investment income (loss) by asset class:	($ in thousands)
Term loan investments	$	21,981		$	(11,535	)	$	(5,851	)	$	4,595
Fixed maturities - Fair value option	12,790			(3,505		)	6,032			15,317
Fixed maturities - Available for sale (1)	4,868			—			1,254			6,122
Short-term investments	1,326			(34		)	—			1,292
Equities (2)	2			382			—			384
Equities, fair value through net income (2)	409			(2,291		)	865			(1,017		)
Other investments	—			1,567			(2,510		)	(943		)
Other (3)	—			125			855			980
Investment management fees - related parties	(4,606		)	—			—			(4,606		)
Borrowing and miscellaneous other investment expenses	(7,234		)	—			—			(7,234		)
Investment performance fees - related parties	—			—			—			(850		)
	$	29,536		$	(15,291	)	$	645		$	14,040

(1) Net realized gains (losses) from the fixed maturities available for sale portfolio consists of realized gains and realized losses of $1,426 thousand and $172 thousand, respectively.

(2) Net interest income includes dividends for securities held in long and short positions.

(3) Other includes unrealized gains and unrealized losses for total return swaps.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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



	Three Months Ended September 30, 2018
	Net Interest Income			Net Unrealized Gains (Losses)			Net Realized Gains (Losses)			Net Investment Income (Loss)
Net investment income (loss) by asset class:	($ in thousands)
Term loan investments	$	20,249		$	(3,510	)	$	972		$	17,711
Fixed maturities - Fair value option	15,997			(4,261		)	3,090			14,826
Fixed maturities - Available for sale (1)	1,579			—			(38		)	1,541
Short-term investments	779			(283		)	—			496
Equities (2)	(545		)	2,439			—			1,894
Equities, fair value through net income (2)	645			727			(20		)	1,352
Other investments	—			(2,800		)	—			(2,800		)
Other (3)	—			67			—			67
Investment management fees - related parties	(4,314		)	—			—			(4,314		)
Borrowing and miscellaneous other investment expenses	(6,993		)	—			—			(6,993		)
Investment performance fees - related parties	—			—			—			(2,407		)
	$	27,397		$	(7,621	)	$	4,004		$	21,373

(1) Net realized gains (losses) from the fixed maturities available for sale portfolio consists of realized gains and realized losses of $7 thousand and $45 thousand, respectively.

(2) Net interest income includes dividends for securities held in long and short positions.

(3) Other includes unrealized gains and unrealized losses for total return swaps.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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



	Nine Months Ended September 30, 2019
	Net Interest Income			Net Unrealized Gains (Losses)			Net Realized Gains (Losses)			Net Investment Income (Loss)
Net investment income (loss) by asset class:	($ in thousands)
Term loan investments	$	67,056		$	(13,606	)	$	(5,639	)	$	47,811
Fixed maturities - Fair value option	38,425			25,465			6,938			70,828
Fixed maturities - Available for sale (1)	12,701			—			3,465			16,166
Short-term investments	2,905			(530		)	25			2,400
Equities (2)	202			1,444			—			1,646
Equities, fair value through net income (2)	1,824			(593		)	(1,162		)	69
Other investments	—			1,148			(2,712		)	(1,564		)
Other (3)	—			2,094			1,801			3,895
Investment management fees - related parties	(13,585		)	—			—			(13,585		)
Borrowing and miscellaneous other investment expenses	(23,143		)	—			—			(23,143		)
Investment performance fees - related parties	—			—			—			(8,342		)
	$	86,385		$	15,422		$	2,716		$	96,181

(1) Net realized gains (losses) from the fixed maturities available for sale portfolio consists of realized gains and realized losses of $3.8 million and $0.4 million, respectively.

(2) Net interest income includes dividends for securities held in long and short positions.

(3) Other includes unrealized gains and unrealized losses for total return swaps.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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



	Nine Months Ended September 30, 2018
	Net Interest Income			Net Unrealized Gains (Losses)			Net Realized Gains (Losses)			Net Investment Income (Loss)
Net investment income (loss) by asset class:	($ in thousands)
Term loan investments	$	56,668		$	(331	)	$	(1,435	)	$	54,902
Fixed maturities - Fair value option	46,887			(9,687		)	(7,638		)	29,562
Fixed maturities - Available for sale (1)	3,543			—			(684		)	2,859
Short-term investments	2,269			(283		)	36			2,022
Equities (2)	(714		)	8,772			(348		)	7,710
Equities, fair value through net income (2)	1,177			(4,167		)	682			(2,308		)
Other investments	—			(1,221		)	—			(1,221		)
Other (3)	—			67			—			67
Investment management fees - related parties	(12,616		)	—			—			(12,616		)
Borrowing and miscellaneous other investment expenses	(19,636		)	—			—			(19,636		)
Investment performance fees - related parties	—			—			—			(6,606		)
	$	77,578		$	(6,850	)	$	(9,387	)	$	54,735

(1) Net realized gains (losses) from the fixed maturities available for sale portfolio consists of realized gains and realized losses of $44 thousand and $728 thousand, respectively.

(2) Net interest income includes dividends for securities held in long and short positions.

(3) Other includes unrealized gains and unrealized losses for total return swaps.

Other-than-temporary impairments

The Company reviews its available for sale investments on a quarterly basis to determine whether declines in fair value below the amortized cost basis are considered other-than-temporary in accordance with applicable guidance. As of September 30, 2019, the Company did not identify any other-than-temporary impairments. As such, the Company did not intend to sell these investments, and it was not more likely than not that the Company would be required to sell these investments before the anticipated recovery of the remaining amortized cost basis as of September 30, 2019.

Pledged and restricted assets

For the benefit of certain Arch entities and other third parties that cede business to the Company, the Company is required to post and maintain collateral to support its potential obligations under reinsurance contracts written. This collateral can be in the form of either investment assets held in collateral trust accounts or letters of credit. Under its secured credit facilities, in order for the Company to have the bank issue a letter of credit to the Company’s reinsurance contract counterparty, the Company must post investment assets or cash as collateral to the bank. In either case, the amounts remain restricted for the duration of the term of the trust or letter of credit, as applicable.

At September 30, 2019 and December 31, 2018, the Company held $2.2 billion and $2.4 billion, respectively, in pledged assets in support of insurance and reinsurance liabilities as well as to collateralize the Company’s secured credit facilities and investment derivatives. Included within total pledged assets, the Company held $6.4 million and $5.5 million, respectively, in deposits with U.S. regulatory authorities.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

Non-cash investing activities

During the three months ended September 30, 2019, the Company exchanged a preference share position of $28.7 million, which was held within “equity securities, fair value through net income,” for a limited partnership interest of $28.7 million, held under “other investments, fair value option.” HPS acts as the general partner and manager of the limited partnership. At September 30, 2019, the Company’s investment had a fair value of $29.6 million and represented approximately 12% of the outstanding partnership interest.

7. Fair value

Fair value hierarchy

Accounting guidance regarding fair value measurements addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP and provides a common definition of fair value to be used throughout GAAP. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In addition, it establishes a three-level valuation hierarchy for the disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement (Level 1 being the highest priority and Level 3 being the lowest priority).

The levels in the hierarchy are defined as follows:


•	Level 1: Inputs to the valuation methodology are observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets;


•	Level 2: Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument; and


•	Level 3: Inputs to the valuation methodology are unobservable and significant to the fair value measurement.

The availability of observable inputs can vary by financial instrument and is affected by a wide variety of factors including, for example, the type of financial instrument, whether the financial instrument is new and not yet established in the marketplace, and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires significantly more judgment. The degree of judgment exercised by the Company in determining fair value is greatest for financial instruments categorized in Level 3. In periods of market dislocation, the observability of prices and inputs may be reduced for many financial instruments. This may lead to a change in the valuation techniques used to estimate the fair value measurement and cause an instrument to be reclassified between levels within the fair value hierarchy.

Fair value measurements on a recurring basis

The following is a description of the valuation methodologies used for securities measured at fair value, as well as the general classification of such securities pursuant to the valuation hierarchy.

The Company determines the existence of an active market based on its judgment as to whether transactions for the financial instrument occur in such market with sufficient frequency and volume to provide reliable pricing information. The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. The Company uses quoted values and other data provided by nationally recognized independent pricing sources as inputs into its process for determining fair values of its fixed maturity investments. Each price

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

source has its own proprietary method for determining the fair value of securities that are not actively traded. In general, these methods involve the use of “matrix pricing” in which the independent pricing source uses observable market inputs including, but not limited to, investment yields, credit risks and spreads, benchmarking of like securities, broker-dealer quotes, reported trades and sector groupings to determine a reasonable fair value.

Where multiple quotes or prices are obtained, a price source hierarchy is maintained in order to determine which price source would be used (i.e., a price obtained from a pricing service with more seniority in the hierarchy will be used over a less senior one in all cases). The hierarchy prioritizes pricing services based on availability and reliability and assigns the highest priority to index providers. Based on the above review, the Company will challenge any prices for a security or portfolio which are considered not to be representative of fair value.

In certain circumstances, when fair values are unavailable from these independent pricing sources, quotes are obtained directly from broker-dealers who are active in the corresponding markets. Such quotes are subject to the validation procedures noted above. Where quotes are unavailable, fair value is determined by the investment manager using quantitative and qualitative assessments such as internally modeled values, which are reviewed by the Company’s management.

Of the $2.7 billion of net financial assets and liabilities measured at fair value at September 30, 2019, approximately $169.6 million, or 6.3%, were priced using non-binding broker-dealer quotes or modeled valuations. Of the $2.7 billion of net financial assets and liabilities measured at fair value at December 31, 2018, approximately $178.3 million, or 6.5%, were priced using non-binding broker-dealer quotes or modeled valuations.

The Company reviews its securities measured at fair value and discusses the proper classification of such investments with its investment managers and others. A discussion of the general classification of the Company’s financial instruments follows:

Fixed Maturities. The Company uses the market approach valuation technique to estimate the fair value of its fixed maturity securities, when possible. The market approach includes obtaining prices from independent pricing services, such as index providers and pricing vendors, as well as to a lesser extent quotes from broker-dealers. The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. Each source has its own proprietary method for determining the fair value of securities that are not actively traded. In general, these methods involve the use of “matrix pricing” in which the independent pricing source uses observable market inputs including, but not limited to, investment yields, credit risks and spreads, benchmarking of like securities, broker-dealer quotes, reported trades and sector groupings to determine a reasonable fair value.

The following describes the significant inputs generally used to determine the fair value of the Company’s investment securities by asset class:

Term Loans. Fair values are estimated by using quoted prices obtained from independent pricing services for term loan investments with similar characteristics, pricing models or matrix pricing. Such investments are generally classified within Level 2. The fair values for certain of the Company’s term loans are determined by the investment manager using quantitative and qualitative assessments such as internally modeled values, which are reviewed by the Company’s management. The modeled values are based on peer loans and comparison to industry-specific market data. Significant unobservable inputs used to price these securities may include changes in peer and/or comparable credit spreads, accretion of any original issue discount and changes in the issuer’s debt leverage since issue. Changes in peer credit spreads, comparable credits spreads, and issuer debt leverage are negatively correlated with the modeled fair value measurement. Such investments are generally classified within Level 3.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

Corporate Bonds. Valuations are provided by independent pricing services, substantially all through index providers and pricing vendors, with a small amount through broker-dealers. The fair values of these securities are generally determined using the spread above the risk-free yield curve. These spreads are generally obtained from the new issue market, secondary trading and from broker-dealers who trade in the relevant security market. As the significant inputs used in the pricing process for corporate bonds are observable market inputs, the fair value of the majority of these securities are classified within Level 2. The fair values for certain of the Company’s corporate bonds are determined by the investment manager using quantitative and qualitative assessments such as internally modeled values, which are reviewed by the Company’s management. The modeled values are based on peer bonds and comparison to industry-specific market data. In addition, the investment manager assesses the fair value based on the valuation of the underlying holdings in accordance with the bonds’ governing documents. Significant unobservable inputs used to price these securities may include changes in peer and/or comparable credit spreads, accretion of any original issue discount and changes in the issuer’s debt leverage since issue. Changes in peer credit spreads, comparable credits spreads, and issuer debt leverage are negatively correlated with the modeled fair value measurement. Such investments are generally classified within Level 3.

Asset-Backed Securities. Valuations are provided by independent pricing services, substantially all through index providers and pricing vendors, with a small amount through broker-dealers. The fair values of these securities are generally determined through the use of pricing models (including option adjusted spread) which use spreads to determine the appropriate average life of the securities. These spreads are generally obtained from the new issue market, secondary trading and from broker-dealers who trade in the relevant security market. The pricing services also review prepayment speeds and other indicators, when applicable. As the significant inputs used in the pricing process for asset-backed securities are observable market inputs, the fair value of these securities are classified within Level 2.

Mortgage-Backed Securities. Valuations are provided by independent pricing services, substantially all through pricing vendors and index providers with a small amount through broker-dealers. The fair values of these securities are generally determined through the use of pricing models (including option adjusted spread) which use spreads to determine the expected average life of the securities. These spreads are generally obtained from the new issue market, secondary trading and from broker-dealers who trade in the relevant security market. The pricing services also review prepayment speeds and other indicators, when applicable. As the significant inputs used in the pricing process for mortgage-backed securities are observable market inputs, the fair value of these securities are classified within Level 2.

U.S. Government and Government Agencies. Valuations are provided by independent pricing services, with all prices provided through index providers and pricing vendors. The Company determined that all U.S. Treasuries would be classified as Level 1 securities due to observed levels of trading activity, the high number of strongly correlated pricing quotes received on U.S. Treasuries and other factors. The fair values of U.S. government agency securities are generally determined using the spread above the risk-free yield curve. As the yields for the risk-free yield curve and the spreads for these securities are observable market inputs, the fair values of U.S. government agency securities are classified within Level 2.

Non-U.S. Government Securities. Valuations are provided by independent pricing services, with all prices provided through index providers and pricing vendors. The fair values of these securities are generally based on international indices or valuation models which include daily observed yield curves, cross-currency basis index spreads and country credit spreads. As the significant inputs used in the pricing process for non-U.S. government securities are observable market inputs, the fair value of these securities are classified within Level 2.

Municipal Government Bonds. Valuations are provided by independent pricing services, with all prices provided through index providers and pricing vendors. The fair values of these securities are

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

generally determined using spreads obtained from broker-dealers who trade in the relevant security market, trade prices and the new issue market. As the significant inputs used in the pricing process for municipal bonds are observable market inputs, the fair value of these securities are classified within Level 2.

Short-Term Investments. The Company determined that certain of its short-term investments, held in highly liquid money market-type funds, and equities would be included in Level 1 as their fair values are based on quoted market prices in active markets. The fair values of other short-term investments are generally determined using the spread above the risk-free yield curve and are classified within Level 2.

Equity Securities. The Company determined that exchange-traded equity securities would be included in Level 1 as their values are based on quoted market prices in active markets. Other equity securities are initially valued at cost which approximates fair value. In subsequent measurement periods, the fair values of these securities are determined using non-binding broker-dealer quotes. These equity securities are included in Level 2 of the valuation hierarchy. Where such quotes are unavailable, fair value is determined by the investment manager using quantitative and qualitative assessments such as internally modeled values, which are reviewed by the Company’s management. As the significant inputs used to price these securities are unobservable, the fair value of these securities are classified as Level 3. Significant unobservable inputs used to price preferred stock may include changes in peer and/or comparable credit spreads, accretion of any original issue discount and changes in the issuer’s debt leverage since issue. Changes in peer credit spreads, comparable credit spreads, and issuer debt leverage are negatively correlated with the modeled fair value measurement.

Underwriting Derivative Instruments. The Company values the government-sponsored enterprise credit-risk sharing transactions using a valuation methodology based on observable inputs from non-binding broker-dealer quotes and/or recent trading activity. As the inputs used in the valuation process are observable market inputs, the fair value of these securities are classified within Level 2. Refer to Note 8, “Derivative instruments” for more information.

Investment Derivative Instruments. The Company values the investment derivatives, including total return swaps and options, at fair value. As the underlying investments have observable inputs, the fair value of these securities are classified within Level 2. Refer to Note 8, “Derivative instruments” for more information.

Other Investments. The fair value of the Company’s investment in the private fund is measured using the most recently available NAVs, as advised by a third-party administrator.

Measuring the Fair Value of Other Investments Using Net Asset Valuations

The fair value of the Company’s investment in the private fund is measured using the most recently available NAVs as advised by the third-party administrator. The fund NAVs are based on the administrator’s valuation of the underlying holdings in accordance with the fund’s governing documents and in accordance with GAAP.

The Company often does not have access to financial information relating to the underlying securities held within the fund therefore management is unable to corroborate the fair values placed on the securities underlying the asset valuations provided by the fund manager or fund administrator. In order to assess the reasonableness of the NAVs, the Company performs a number of monitoring procedures on a quarterly basis, to assess the quality of the information provided by the fund manager and fund administrator. These procedures include, but are not limited to, regular review and discussion of the fund’s performance with its manager.

The fair value of the private fund is measured using the NAV as a practical expedient, therefore the fair value of the fund has not been categorized within the fair value hierarchy.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

The following table presents the Company’s financial assets and liabilities measured at fair value by level as of September 30, 2019 and December 31, 2018:



			Fair Value Measurement Using:
September 30, 2019	Estimated Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets measured at fair value:	($ in thousands)
Term loans	$	1,040,983	$	—	$	992,714	$	48,269
Fixed maturities:
Corporate bonds	434,101		—		411,322		22,779
U.S. government and government agency bonds	298,447		298,337		110		—
Asset-backed securities	339,673		—		339,673		—
Mortgage-backed securities	31,318		—		31,318		—
Non-U.S. government and government agencies	135,579		—		135,579		—
Municipal government and government agency bonds	2,190		—		2,190		—
Short-term investments	357,611		349,061		8,550		—
Equities	100,393		10,651		3,414		86,328
Other underwriting derivative assets	167		—		167		—
Investment derivative assets (1)	1,452		—		1,452		—
Other investments measured at net asset value (2)	29,583		—		—		—
Total assets measured at fair value	$	2,771,497	$	658,049	$	1,926,489	$	157,376

Investment derivative liabilities (1)	604		—		604		—
Payable for securities sold short:
Corporate bonds	65,736		—		65,736		—
Equities	—		—		—		—
Total liabilities measured at fair value	$	66,340	$	—	$	66,340	$	—

(2) In accordance with applicable accounting guidance, other investments that are measured at fair value using the net asset value practical expedient have not been classified in the fair value hierarchy. The fair value amounts presented in this table are intended to permit reconciliation of the fair value hierarchy to the amounts presented in the consolidated balance sheets.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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



			Fair Value Measurement Using:
December 31, 2018	Estimated Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets measured at fair value:	($ in thousands)
Term loans	$	1,000,652	$	—	$	953,173	$	47,479
Fixed maturities:
Corporate bonds	654,607		—		630,330		24,277
U.S. government and government agency bonds	268,675		268,567		108		—
Asset-backed securities	225,983		—		203,423		22,560
Mortgage-backed securities	22,161		—		22,161		—
Non-U.S. government and government agencies	136,513		—		136,513		—
Municipal government and government agency bonds	8,231		—		8,231		—
Short-term investments	282,132		256,288		25,844		—
Equities	89,651		7,977		11,223		70,451
Other underwriting derivative assets	249		—		249		—
Investment derivative assets (1)	51		—		51		—
Other investments measured at net asset value (2)	49,762		—		—		—
Total assets measured at fair value	$	2,738,667	$	532,832	$	1,991,306	$	164,767

Investment derivative liabilities (1)	1,279		—		1,279		—
Payable for securities sold short:
Corporate bonds	7,790		—		7,790		—
Equities (1)	1,138		—		1,138		—
Total liabilities measured at fair value	$	10,207	$	—	$	10,207	$	—

(1) Investment derivative assets and liabilities represent the fair value of total return swaps, which are recorded in other assets and other liabilities, respectively, in the consolidated balance sheets as of December 31, 2018. The Company’s call options are recorded as equities in payable for securities sold short in the consolidated balance sheets as of December 31, 2018. The Company’s put options are recorded as equities in the consolidated balance sheets as of December 31, 2018.

When the fair value of financial assets and financial liabilities cannot be derived from active markets, the fair value is determined using a variety of valuation techniques that include the use of models. The inputs to these models are taken from observable markets where possible, but where this is not feasible, estimation is required to establish fair values. Changes in assumptions about these factors could affect the reported fair value of financial instruments and the level where the instruments are disclosed in the fair value hierarchy.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

The following table presents a reconciliation of the beginning and ending balances for all the financial assets measured at fair value on a recurring basis using Level 3 inputs for the three and nine months ended September 30, 2019 and 2018:



Three Months Ended September 30, 2019	Beginning Balance		Net Purchases (Sales)(1)			Net Unrealized Gains (Losses)(2)			Net Unrealized Foreign Exchange Gains (Losses)			Ending Balance
Term loans	$	48,585	$	94		$	(410	)	$	—		$	48,269
Corporate bonds	23,920		—			(185		)	(956		)	22,779
Equities	102,206		(16,050		)	172			—			86,328
Total	$	174,711	$	(15,956	)	$	(423	)	$	(956	)	$	157,376



Three Months Ended September 30, 2018	Beginning Balance		Net Purchases (Sales)(1)			Net Unrealized Gains (Losses)(2)			Net Unrealized Foreign Exchange Gains (Losses)			Ending Balance
Term loans	$	33,616	$	1,843		$	(1,369	)	$	—		$	34,090
Corporate bonds	24,969		—			(70		)	(120		)	24,779
Equities	100,200		(11,922		)	1,355			—			89,633
Total	$	158,785	$	(10,079	)	$	(84	)	$	(120	)	$	148,502

(1) For the three months ended September 30, 2019, the net purchases (sales) consisted of sales of equities of $28.0 million and calls and redemptions of $74.0 thousand of term loans, offset by purchases of $11.9 million of equities and $168.0 thousand of term loans. For the three months ended September 30, 2018, the net purchases (sales) consisted of redemptions and disposals of $11.9 million of equities and $0.1 million of calls and redemptions of term loans, offset by purchases of $1.9 million of term loans.

(2) Realized and unrealized gains or losses on Level 3 investments are included in “realized and unrealized gain (loss) on investments” in the Company’s consolidated statements of income (loss).



Nine Months Ended September 30, 2019	Beginning Balance		Transfers in (out) of Level 3 (1)			Net Purchases (Sales)(2)			Net Unrealized Gains (Losses)(3)			Net Unrealized Foreign Exchange Gains (Losses)			Ending Balance
Term loans	$	47,479	$	—		$	427		$	363		$	—		$	48,269
Corporate bonds	24,277		—			(90		)	(364		)	(1,044		)	22,779
Asset-backed securities	22,560		(22,560		)	—			—			—			—
Equities	70,451		—			14,484			1,393			—			86,328
Total	$	164,767	$	(22,560	)	$	14,821		$	1,392		$	(1,044	)	$	157,376



Nine Months Ended September 30, 2018	Beginning Balance		Net Purchases (Sales)(2)			Net Unrealized Gains (Losses)(3)			Net Unrealized Foreign Exchange Gains (Losses)			Ending Balance
Term loans	$	62,478	$	(26,718	)	$	(1,670	)	$	—		$	34,090
Corporate bonds	24,710		985			(144		)	(772		)	24,779
Equities	52,921		33,906			2,806			—			89,633
Total	$	140,109	$	8,173		$	992		$	(772	)	$	148,502

(1) During the nine months ended September 30, 2019, the Company obtained pricing for an asset-backed security, in which pricing was not available as of December 31, 2018. As such, the security was transferred from Level 3 to Level 2 at its fair value as of December 31, 2018.

(2) For the nine months ended September 30, 2019, the net purchases (sales) consisted of purchases of $48.3 million of equities and $0.6 million of term loans, offset in part by the sale of $33.8 million of equities, $222 thousand of redemptions of term loans and $90.0 thousand of calls and redemptions of corporate bonds. For the nine months ended September 30, 2018, the net purchases (sales) consisted of purchases of: $51.3 million of equities, $1.9 million of term loans and $1.0 million of corporate bonds, offset in part by redemptions and disposals of $28.6 million of term loans and redemptions and disposals of $17.4 million of equities.

(3) Realized and unrealized gains or losses on Level 3 investments are included in “realized and unrealized gain (loss) on investments” in the Company’s consolidated statements of income (loss).

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

Financial instruments disclosed, but not carried, at fair value

The Company uses various financial instruments in the normal course of its business. The carrying values of cash and cash equivalents, accrued investment income, receivable for securities sold, certain other assets, payable for securities purchased and certain other liabilities approximated their fair values at September 30, 2019 and December 31, 2018 due to their respective short maturities. As these financial instruments are not actively traded, their respective fair values are classified within Level 2.

On July 2, 2019, the Company completed a private offering of $175.0 million in aggregate principal amount of its 6.5% senior notes due July 2, 2029 (the “senior notes”). At September 30, 2019, the Company’s senior notes were carried at cost, net of debt issuance costs, of $172.3 million and had a fair value of $179.4 million. The fair value of the senior notes was obtained from a third party pricing service and was based on observable market inputs. As such, the fair values of the senior notes are classified within Level 2.

Fair value measurements on a non-recurring basis

The Company measures the fair value of certain assets on a non-recurring basis, generally quarterly, annually, or when events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. The Company uses a variety of techniques to determine the fair value of these assets when appropriate, as described below.

Intangible Assets

The Company tests intangible assets for impairment whenever events or changes in circumstances indicate the carrying amount may not be recoverable. When the Company determines intangible assets may be impaired, the Company uses techniques including discounted expected future cash flows, to measure fair value. There were no such triggering events or changes in circumstances as of September 30, 2019.

8. Derivative instruments

Underwriting Derivatives

The Company’s underwriting strategy allows it to enter into government-sponsored enterprise credit-risk sharing transactions. These transactions are accounted for as derivatives. The derivative assets and derivative liabilities relating to these transactions are included in other assets and other liabilities, respectively, in the Company’s consolidated balance sheets. Realized and unrealized gains and losses from other derivatives are included in other underwriting income (loss) in the Company’s consolidated statements of net income (loss). The risk in force of these transactions is considered the notional amount.

As of September 30, 2019 and December 31, 2018, the Company posted $14.2 million and $15.5 million, respectively, in assets as collateral. These assets are included in fixed maturities, which are recorded at fair value in the Company’s consolidated balance sheets.

Investment Derivatives

The Company’s investment strategy allows for the use of derivative securities. Beginning in the third quarter of 2018, the Company invested in call options to manage specific market risks; such derivative instruments are recorded at fair value, and shown as part of payable for securities sold short on its consolidated balance sheets. Such call options matured in the first quarter of 2019.

Additionally, beginning in the fourth quarter of 2018, the Company invested in put options to manage specific market risks; such derivative instruments are recorded at fair value, and shown as part of equity investments on its consolidated balance sheets. Such put options were sold in the first quarter of 2019.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

The Company began investing in total return swaps (“swaps”) during 2018, through a Master Confirmation of Total Return Swap Transactions agreement, and recognizes the swap derivatives at fair value. The derivative assets and derivative liabilities relating to these transactions are included in other assets and other liabilities, respectively, in the Company’s consolidated balance sheets. At September 30, 2019 and December 31, 2018, the Company had collateral funds held by the counterparty of $58.8 million and $36.3 million included in short-term investments in the Company’s consolidated balance sheets.

The fair value of such swaps are based on observable inputs and classified in Level 2 of the valuation hierarchy. Realized and unrealized gains and losses from investment derivatives are included in realized and unrealized gains (losses) on investments in the Company’s consolidated statements of net income (loss).

The Company did not hold any derivatives designated as hedging instruments at September 30, 2019 and December 31, 2018.

The following table summarizes information on the fair values and notional amount of the Company’s derivative instruments at September 30, 2019 and December 31, 2018:



	Estimated Fair Value
	Asset Derivatives		Liability Derivatives		Net Derivatives			Notional Amount(1)
	($ in thousands)
September 30, 2019
Other underwriting derivatives	$	167	$	—	$	167		$	64,750
Total return swaps	1,452		604		848			148,653
Total	$	1,619	$	604	$	1,015		$	213,403

December 31, 2018
Other underwriting derivatives	$	249	$	—	$	249		$	72,148
Options	808		1,138		(330		)	24,551
Total return swaps	51		1,279		(1,228		)	91,663
Total	$	1,108	$	2,417	$	(1,309	)	$	188,362

(1) The notional amount represents the absolute value of all outstanding contracts.

The realized and unrealized gains and losses on the Company’s derivative instruments are reflected in the consolidated statements of income, as summarized in the following table:



	Three Months Ended September 30,					Nine Months Ended September 30,
	2019		2018			2019		2018
	($ in thousands)
Underwriting derivatives:
Other underwriting income (loss)	$	579	$	703		$	1,844	$	2,092
Investment derivatives:
Net realized and unrealized gains (losses):
Options	—		106			799		106
Total return swaps	980		(39		)	3,895		(39		)

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

9. Share transactions

Share-based compensation

The Company uses share-based compensation plans for officers, other employees and directors of the Parent and its subsidiaries to provide competitive compensation opportunities, to encourage long-term service, to recognize individual contributions and reward achievement of performance goals and to promote the creation of long-term value for shareholders by aligning the interests of such persons with those of shareholders.

The 2018 Stock Incentive Plan (the “2018 Plan”) became effective as of March 28, 2019 following approval by the Board of Directors of the Company. The 2018 Plan provides for the issuance of restricted share units, performance units, restricted shares, performance shares, share options and share appreciation rights and other equity-based awards to the Company’s employees and directors. The 2018 Plan authorizes the issuance of 907,315 common shares and will terminate on March 28, 2029. As of September 30, 2019, 742,028 shares were available for future issuance.

During the second quarter of 2019, the Company granted 165,287 restricted share units and common shares to certain officers, other employees and directors. On the grant date of April 26, 2019, the fair value of the restricted share units and common shares was approximately $26.53 per share. Of the total restricted share units and common shares granted, 82,927 were vested and fully expensed, including 9,425 common shares issued. The remaining 82,360 restricted share units are being amortized over a three-year vesting period, being the requisite service period. There were no restricted share units or common shares granted during the third quarter of 2019. There were no forfeitures or expired awards during the third quarter of 2019.

The effect of compensation cost arising from share-based payment awards on the consolidated statement of income (loss), within general and administrative expenses, for the three months ended September 30, 2019 and 2018, was $0.2 million and $Nil, respectively. The effect of compensation cost arising from such share-based payment awards for the nine months ended September 30, 2019 and 2018 was $2.5 million and $Nil, respectively, including an accelerated expense recognition for retirement eligible employees.

Share repurchase program

The board of directors of the Parent has authorized the Company’s investment in its common shares through a share repurchase program. At September 30, 2019, approximately $75.0 million of share repurchases were available under the program. Repurchases under the program may be effected from time to time in open market or privately negotiated transactions. The timing and amount of repurchase transactions under this program will depend on a variety of factors, including market conditions and corporate and regulatory considerations. Repurchases of the Company’s common shares in connection with the share repurchase program and other share-based transactions will be recorded at cost and result in a reduction of the Company’s shareholders’ equity in its consolidated balance sheets.

On September 30, 2019, the Parent repurchased 45,838 common shares for an average purchase price of $26.94792 per share, or an aggregate price of $1.2 million. The transaction was settled on October 2, 2019 and was reflected in “other assets” and “other liabilities” in the Company’s consolidated balance sheets as of September 30, 2019; the share count reduction will be reflected in the fourth quarter of 2019.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

10. Earnings per common share

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



	Three Months Ended September 30,						Nine Months Ended September 30,
	2019			2018			2019			2018
Numerator:	($ in thousands except share and per share data)
Net income (loss) before preference dividends and redemption costs	$	6,924		$	23,746		$	78,196		$	55,467
Preference dividends	(2,608		)	(4,909		)	(12,423		)	(14,724		)
Accelerated amortization of costs related to the redemption of preference shares	(4,164		)	—			(4,164		)	—
Net income (loss) available to common shareholders	152			18,837			61,609			40,743

Denominator:
Weighted average common shares outstanding - basic	22,765,802			22,682,875			22,729,848			22,682,875
Effect of dilutive common share equivalents:
Weighted average non-vested restricted share units (1)	10,402			—			4,616			—
Weighted average common shares outstanding - diluted (2)	22,776,204			22,682,875			22,734,464			22,682,875
Earnings (loss) per common share:
Basic	$0.01			$0.83			$2.71			$1.80
Diluted	$0.01			$0.83			$2.71			$1.80

(1) During the three months ended September 30, 2019, the Company did not grant any restricted share units or common shares. During the nine months ended September 30, 2019, the Company granted 165,287 restricted share units and common shares to certain employees and directors, 82,360 of which are non-vested. Refer to Note 9, “Share transactions” for further details.

(2) Warrants held by Arch and HPS were not included in the computation of diluted earnings because the exercise price of the warrants exceeded the market price of the common shares during the period and the exercise of the warrants would have been anti-dilutive. The warrants expire on March 31, 2020. The number of common shares issuable upon exercise of the warrants that was excluded was 1,704,691 common shares.

11. Income taxes

Watford Holdings and Watford Re are incorporated under the laws of Bermuda and, under current law, are not obligated to pay any taxes in Bermuda based upon income or capital gains. In the event that any legislation is enacted in Bermuda imposing such taxes, a written undertaking has been received from the Bermuda Minister of Finance under the Exempted Undertakings Tax Protection Act 1966 that such taxes will not be applicable to Watford Holdings and Watford Re until March 31, 2035.

WICE is incorporated under the laws of Gibraltar and regulated by the Gibraltar Financial Services Commission (the “FSC”) under the Financial Services (Insurance Company) Act (the “Gibraltar Act”). In addition to its operations in Gibraltar, WICE operates a branch in Romania. The current rates of tax on applicable profits in Gibraltar and Romania are 10% and 16%, respectively. The open tax years that are potentially subject to examination are 2016 through 2019 in Gibraltar and 2018 through 2019 in Romania.

Watford Holdings (U.K.) Limited is incorporated in the United Kingdom and is subject to U.K. corporate income tax. The current U.K. corporate income tax rate is 19% and will be reduced to 17% from April 1, 2020. The open tax years that are potentially subject to examination by U.K. tax authorities are 2017 through 2019.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

Watford Holdings (U.S.) Inc. is incorporated in the United States and files a consolidated U.S. federal tax return with its subsidiaries, Watford Specialty Insurance Company, Watford Insurance Company, and Watford Services Inc. The U.S. federal tax rate is 21% for tax years beginning after December 31, 2017. The open tax years that are potentially subject to examination by U.S. tax authorities are 2015 through 2019.

The Company provides a valuation allowance to reduce certain deferred tax assets to an amount which management expects to more likely than not be realized. As of September 30, 2019 and December 31, 2018, the Company’s valuation allowance was $1.3 million and $1.5 million, respectively. The valuation allowance primarily relates to U.S. and Gibraltar operating loss carry-forwards. The U.S. net operating loss carry-forwards begin to expire in 2035. The Gibraltar net operating loss carry-forwards do not expire. After consideration of the valuation allowance, the Company had net deferred tax assets of $Nil as of September 30, 2019 and December 31, 2018.

After taking into account the impact of the decrease in the valuation allowance, the Company recognized income tax expense of $Nil during the three months ended September 30, 2019 and 2018. During the nine months ended September 30, 2019 and 2018, the Company recognized income tax expense of $20.0 thousand and $27.0 thousand, respectively.

The Company recognizes a tax benefit where it concludes that it is more likely than not that the tax benefit will be sustained on audit by the taxing authority based solely on the technical merits of the associated tax position. The Company records interest and penalties related to unrecognized tax benefits in the provision for income taxes. As of both September 30, 2019 and December 31, 2018, the Company’s total unrecognized tax benefits, including interest and penalties, were $Nil.

12. Transactions with related parties

In March 2014, ARL invested $100.0 million in the Parent and acquired approximately 11% of its common equity. AUL acts as the insurance and reinsurance manager for Watford Re and WICE while AUI acts as the insurance and reinsurance manager for WSIC and WIC, all under separate long-term services agreements. HPS manages the Company’s non-investment grade portfolio and a portion of the Company’s investment grade portfolio as investment manager and AIM manages a portion of the Company’s investment grade portfolio as investment manager, each under separate long-term services agreements. ARL and HPS were granted warrants to purchase additional common equity based on performance criteria. In recognition of the sizable ownership interest, two senior executives of ACGL were appointed to the Company’s board of directors. The services agreements with AUL and AUI and the investment management agreements with HPS and AIM provide for services for an extended period of time with limited termination rights by the Company. In addition, these agreements allow for AUL, AUI, HPS and AIM to participate in the favorable results of the Company in the form of performance fees.

AUL and AUI

Watford Re and WICE entered into services agreements with AUL. WSIC and WIC entered into services agreements with AUI. AUL and AUI provide services related to the management of the underwriting portfolio for a term ending on December 2025. The services agreements perpetually renew automatically in five-year increments unless either the Company or Arch gives notice to not renew at least 24 months before the end of the then-current term.

As part of the services agreements, AUL and AUI make available to the Companies, on a non-exclusive basis, certain designated employees who serve as officers of the Companies and underwrite business on behalf of the Companies (the “Designated Employees”). AUL and AUI also provide portfolio management, Designated Employee supervision, exposure modeling, loss reserve recommendations, claims-handling, accounting and other related services as part of the services agreements.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

In return for their services, AUL and AUI receive fees from the Companies, including an underwriting fee and profit commission, as well as reimbursement for the services of the Designated Employees and reimbursements for an allocated portion of the expenses related to seconded employees, plus other expenses incurred on behalf of the Company.

The related AUL and AUI fees and reimbursements incurred in the consolidated statement of income (loss) for the three and nine months ended September 30, 2019 and 2018 were as follows:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019		2018
Consolidated statement of income (loss) items:	($ in thousands)
Acquisition expenses	$	4,540	$	4,159	$	15,349	$	11,479
General and administrative expenses	1,528		2,031		5,547		4,670
Total	$	6,068	$	6,190	$	20,896	$	16,149

HPS

Certain HPS principals and management own common and preference shares of the Company.

In return for its investment services, HPS receives a management fee, a performance fee and allocated operating expenses. The management fee is calculated at an annual rate of 1.0% of the aggregate net asset value of the assets that are managed by HPS, payable quarterly in arrears. For purposes of calculating the management fees, net asset value is determined by HPS in accordance with the investment management agreements and is measured before reduction for any management fees, performance fees or any expense reimbursement and as adjusted for any non-routine intra-month withdrawals. The Company has also agreed to reimburse HPS for certain expenses related to the management of the Company’s investment portfolios as set forth in the investment management agreements.

The base performance fee is equal to 10% of the Income (as defined in the investment management agreements relating to Watford Re, WICE and Watford Trust) or Aggregate Income (as defined in the investment management agreements relating to WSIC and WIC), as applicable, if any, on the assets managed by HPS, calculated and payable as of each fiscal year-end and the date on which the investment management agreements are terminated and not renewed, and HPS is eligible to earn an additional performance fee equal to 25% of any Excess Income (as defined in the investment management agreements) in excess of a net 10% return to Watford after deduction for paid and accrued management fees and base performance fees, with the total performance fees not to exceed 17.5% of the Income or Aggregate Income, as applicable. No performance fees will be paid to HPS if the high water mark (as described in the investment management agreements with HPS) is not met.

During the year ended December 31, 2017, the Company invested $50.0 million in a private fund (“Master Fund”) as part of HPS’s investment strategy. HPS acts as the Trading Manager and provides certain administrative management services to the Master Fund. During the nine months ended September 30, 2019, there were redemptions of $47.3 million and the Company’s investment in the Master Fund was reduced to $Nil.

During the nine months ended September 30, 2019, the Company invested $28.7 million in a limited partnership as part of HPS’s investment strategy. HPS acts as the general partner and manager of the limited partnership. At September 30, 2019, the Company’s investment had a fair value of $29.6 million and represented approximately 12% of the outstanding partnership interests. The management fees and performance fees on the limited partnership will be subject to the existing

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

fee structure of the existing investment management agreement between the Company and HPS, as discussed above.

The related consolidated statement of income (loss) for the three and nine months ended September 30, 2019 and 2018, and consolidated balance sheet account balances for HPS management fees and performance fees as of September 30, 2019 and December 31, 2018 were as follows:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019		2018
Consolidated statement of income (loss) items:	($ in thousands)
Investment management fees - related parties	$	4,327	$	4,008	$	12,771	$	11,728
Investment performance fees - related parties	850		2,407		8,342		6,606
	$	5,177	$	6,415	$	21,113	$	18,334



	September 30,		December 31,
	2019		2018
Consolidated balance sheet items:	($ in thousands)
Other investments, at fair value	$	29,583	$	49,762
Investment management and performance fees payable	13,647		3,807

AIM

Watford Re, WSIC, WICE and WIC entered into investment management agreements with AIM pursuant to which AIM manages a portion of our investment grade portfolio. Each of the Watford Re, WICE, WSIC and WIC investment management agreements with AIM has a one-year term, with the terms ending annually on March 31, July 31, January 31 and July 31, respectively. The terms will continue to renew for successive one-year periods; provided, however, that either party may terminate any of the investment management agreements with AIM at any time upon 45 days prior written notice. To date, there has been no such notice filed under such agreements.

In return for its investment management services, AIM receives a monthly management fee. The management fee is based on a percentage of the aggregate asset value of the AIM managed portfolio. For the purposes of calculating the management fees, asset value is determined by AIM in accordance with the investment management agreements and is measured before deduction of any management fees or expense reimbursement. The Company has also agreed to reimburse AIM for additional services related to investment consulting and oversight services, administrative operations and risk analytic support services related to the management of the Company’s portfolio, as set forth in the investment management agreements.

The related consolidated statement of income (loss) for the three and nine months ended September 30, 2019 and 2018 were as follows:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019		2018
Consolidated statement of income (loss) items:	($ in thousands)
Investment management fees - related parties	$	279	$	306	$	814	$	888

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

ACGL

Certain directors, executive officers and management of ACGL own common and preference shares of the Company.

On July 2, 2019, affiliates of ACGL purchased $35 million in aggregate principal amount of the Company’s 6.5% senior notes due July 2, 2029. On August 1, 2019, affiliates of ACGL received $11.5 million in connection with the Company’s redemption of its preference shares.

The Company reinsures ARL and other ACGL subsidiaries and affiliates for property and casualty risks on a quota share basis. ACGL cedes business to the Company pursuant to inward retrocession agreements the Company’s operating subsidiaries have entered into with ACGL. Pursuant to these inward retrocession agreements, the Company pays a ceding fee based on the business ceded and the applicable retrocession agreement. For the three months ended September 30, 2019 and 2018, the Company incurred ceding fees to Arch, in aggregate, of $3.7 million and $4.0 million, respectively, under these inward retrocession agreements. For the nine months ended September 30, 2019 and 2018, the Company incurred ceding fees to Arch, in aggregate, of $12.7 million and $12.9 million, respectively, under these inward retrocession agreements. Such fees, in addition to origination fees, are reflected in “acquisition expenses” on the consolidated statement of income (loss).

Separately, the Company’s operating subsidiaries have entered into outward quota share retrocession or reinsurance agreements with ACGL subsidiaries. Specifically, each of Watford Re and WICE has entered into a separate outward quota share retrocession or reinsurance agreement with ARL, and each of WSIC and WIC has entered into a separate outward quota share reinsurance agreement with ARC.

The related consolidated statement of income (loss) for the three and nine months ended September 30, 2019 and 2018, and consolidated balance sheets account balances as of September 30, 2019 and December 31, 2018 for the inward and outward retrocession transactions, as well as the acquisition expenses related to direct business sourced by AUL and AUI under the services agreements described above, were as follows:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2019			2018			2019			2018
Consolidated statement of income (loss) items:	($ in thousands)
Gross premiums written	$	49,977		$	63,612		$	160,872		$	202,193
Gross premiums ceded	(63,025		)	(12,787		)	(95,859		)	(41,541		)
Net premiums earned	32,734			52,606			134,134			174,523
Losses and loss adjustment expenses	22,234			37,745			97,576			117,284

Acquisition expenses (1)	10,962			17,880			45,079			61,429
Acquisition expenses (2)	4,540			4,159			15,349			11,479
Total acquisition expenses	15,502			22,039			60,428			72,908
Interest expense	562			—			562			—
Preference dividends	173			325			822			975
Accelerated amortization of costs related to the redemption of preference shares	276			—			276			—

(1) Acquisition expenses relating to the ACGL inward and outward quota share agreements referred to above.

(2) Acquisition expenses relating to the AUL and AUI sourced direct business under the services agreements referred to above.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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



	September 30,		December 31,
	2019		2018
Consolidated balance sheet items:	($ in thousands)
Total investments	$	806,986	$	719,189
Premiums receivable	127,784		118,208
Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses	69,626		45,954
Prepaid reinsurance premiums	77,003		27,598
Deferred acquisition costs, net	36,101		48,380
Funds held by reinsurers	29,472		33,352
Contingent commissions (1)	5,156		2,967
Reserve for losses and loss adjustment expenses	634,918		631,670
Unearned premiums	147,249		166,491
Losses payable	64,322		19,098
Reinsurance balances payable	67,265		20,299
Senior notes	35,000		—
Amounts due to affiliates	4,700		5,888
Contingently redeemable preference shares	3,460		14,627

(1) Other receivables and contingent commissions are recorded in other assets in the consolidated balance sheet.

Artex

In 2015, WICE and AUL entered into an insurance management services agreement with Artex Risk Solutions (Gibraltar) Limited, or Artex, pursuant to which Artex provides services to WICE relating to management, secretarial, governance, underwriting, claims, reinsurance, financial management, investment, regulatory, compliance, risk management and Solvency II. In addition, two principals of Artex have been appointed directors of WICE. In exchange for these services, the Company pays Artex fees based on WICE’s gross premiums written, subject to a minimum amount of £150,000 per annum and a maximum amount of £400,000 per annum, in each case subject to an inflation increase on an annual basis. The insurance management services agreement may be terminated by either Artex or WICE upon twelve months prior written notice; provided that the agreement is subject to earlier termination by WICE or Artex upon the occurrence of certain events.

The table below provides the aggregate fees the Company paid to Artex under the insurance management services agreement for the three and nine months ended September 30, 2019 and 2018.



	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019		2018
	($ in thousands)
Fees paid to Artex under insurance management services agreement	$	83	$	131	$	259	$	406

For the three and nine months ended September 30, 2019 and 2018, the Company paid no fees to Arch under this insurance management services agreement.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

13. Commitments and contingencies

Concentrations of credit risk

For our reinsurance agreements, the creditworthiness of a counterparty is evaluated by the Company, taking into account credit ratings assigned by independent agencies. The credit approval process involves an assessment of factors, including, among others, the counterparty country and industry exposures. Collateral may be required, at the discretion of the Company, on certain transactions based on the creditworthiness of the counterparty.

The areas where significant concentrations of credit risk may exist include unpaid losses and loss adjustment expenses recoverable, prepaid reinsurance premiums and paid losses and loss adjustment expenses recoverable net of reinsurance balances payable (collectively, “net reinsurance recoverables”), investments and cash and cash equivalent balances.

The Company’s reinsurance recoverables, and prepaid reinsurance premiums, net of reinsurance balances payable, resulting from reinsurance agreements entered into with ARL and ARC as of September 30, 2019 and December 31, 2018 amounted to $79.4 million and $53.3 million, respectively. ARL and ARC have “A+” credit ratings from A.M. Best.

A credit exposure exists with respect to reinsurance recoverables as they may become uncollectible. The Company manages its credit risk in its reinsurance relationships by transacting with reinsurers that it considers financially sound and, if necessary, the Company may hold collateral in the form of funds, trust accounts and/or irrevocable letters of credit. This collateral can be drawn on for amounts that remain unpaid beyond specified time periods on an individual reinsurer basis.

In addition, the Company underwrites a significant amount of its business through brokers and a credit risk exists should any of these brokers be unable to fulfill their contractual obligations with respect to the payments of insurance and reinsurance balances owed to the Company.

The Company’s investment portfolios are managed in accordance with investment guidelines that include standards of diversification, which limit the allowable holdings of any single issuer. There were no investments in any entity in excess of 10% of the Company’s shareholders’ equity at September 30, 2019 and December 31, 2018, other than cash and cash equivalents held in operating and investment accounts with financial institutions with credit ratings between “A” and “AA-.”

Lloyds letter of credit facility

On May 14, 2019, Watford Re renewed its letter of credit facility with Lloyds Bank Corporate Markets Plc, New York Branch (the “Lloyds Facility”). The Lloyds Facility amount is $100.0 million and was renewed through to May 16, 2020. Under the renewed Lloyds Facility, the Company may request an increase in the facility amount, up to an aggregate of $50.0 million. The principal purpose of the Lloyds Facility is to issue, as required, evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which the Company has entered into reinsurance arrangements to ensure that such counterparties are permitted to take credit for reinsurance obtained from the Company as required under insurance regulations in the United States. The amount of letters of credit issued is driven by, among other things, the timing and payment of catastrophe losses, loss development of existing reserves, the payment pattern of such reserves, the further expansion of the Company’s business and the loss experience of such business. When issued, the letters of credit are secured by certificates of deposit or cash. In addition, the Lloyds Facility also requires the maintenance of certain covenants, which the Company was in compliance with at September 30, 2019 and December 31, 2018. At such dates, the Company had $51.0 million and $68.9 million, respectively, in restricted assets as collateral for outstanding letters of credit issued from the Lloyds Facility, which were secured by certificates of deposit. These amounts are reflected as short-term investments in the Company’s consolidated balance sheets.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

Unsecured letter of credit facility

On September 20, 2019, Watford Re signed a 364-day letter of credit agreement with Lloyds Bank Corporate Markets Plc and BMO Capital Markets Corp., (the “Unsecured Facility”). The Unsecured Facility amount is $100.0 million, and will be automatically extended for a period of one year unless canceled or not renewed by either counterparty prior to expiration. The principal purpose of the Unsecured Facility is to issue, as required, evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which the Company has entered into reinsurance arrangements to ensure that such counterparties are permitted to take credit for reinsurance obtained from the Company as required under insurance regulations in the United States. The amount of letters of credit issued is driven by, among other things, the timing and payment of catastrophe losses, loss development of existing reserves, the payment pattern of such reserves, the further expansion of the Company’s business and the loss experience of such business. When issued, the letters of credit are secured by certificates of deposit or cash. The Unsecured Facility also requires the maintenance of certain covenants, which the Company was in compliance with at September 30, 2019. In the Unsecured Facility, the Company makes representations, warranties and covenants that are customary for facilities of this type, which the Company was in compliance with at September 30, 2019.

Bank of America secured credit facility

On November 30, 2017, Watford Re amended and restated its $800 million secured credit facility (the “Secured Facility”) with Bank of America, N.A., which expires on November 30, 2021. The purpose of the Secured Facility is to provide borrowings, backed by Watford Re’s investment portfolios. In addition, the Secured Facility allows for Watford Re to issue up to $400.0 million in evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which the Company has entered into reinsurance arrangements. At September 30, 2019, Watford Re had $490.7 million and $52.5 million in borrowings and outstanding letters of credit, respectively. At December 31, 2018, Watford Re had $455.7 million and $52.5 million in borrowings and outstanding letters of credit, respectively. At September 30, 2019 and December 31, 2018, Watford Re was in compliance with all covenants contained in the Secured Facility.

Custodian bank facility

As of September 30, 2019 and December 31, 2018, Watford Re had $28.5 million and $238.2 million, respectively, in borrowings from our custodian bank to purchase USD denominated securities.

As of December 31, 2018, the total borrowed amount of $238.2 million included 2.0 million Swiss Francs, or CHF, (USD equivalent of $2.0 million) to purchase CHF-denominated securities. The Company pays interest based on 3-month LIBOR plus a margin and the borrowed amount is payable upon demand. The foreign exchange gain or loss on revaluation on the borrowed funds is included as a component of foreign exchange gains (losses) included in the consolidated statements of net income (loss).

The custodian bank requires the Company to hold cash and investments on deposit, or in an investment account with respect to the borrowed funds. At September 30, 2019 and December 31, 2018, the Company was required to hold $40.6 million and $339.1 million, respectively, in such deposits and investment accounts.

Employment and other arrangements

The Company has employment agreements with certain of its executive officers. Such employment arrangements provide for compensation in the form of base salary, annual bonus, participation in the Company’s employee benefit programs and the reimbursements of expenses.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

Investment commitments

As of September 30, 2019 and December 31, 2018, the Company had unfunded commitments of $27.7 million and $2.9 million, respectively, relating to equities within its investment portfolios.

14. Leases

The Company has entered into a lease agreement for real estate that is used for office space in the ordinary course of business. The lease is accounted for as an operating lease, whereby the lease expense is recognized on a straight-line basis over the term of the lease. Refer to Note 2, “Basis of presentation and significant accounting policies” for additional information regarding the accounting for leases.

Leases include an option to extend or renew the lease term. The exercise of the renewal option is at the Company’s discretion. The operating lease liability includes lease payments related to options to extend or renew the lease term if the Company is reasonably certain of exercising those options. Such options relating to the extension or renewal of the lease term are not included in the operating lease liability at this time.

Lease expense is included in general and administrative expenses in the Company’s consolidated statements of net income (loss). Additional information regarding the Company’s real estate operating lease is as follows.



	Three Months Ended September 30, 2019			Nine Months Ended September 30, 2019
	($ in thousands)
Lease cost:
Operating lease	$	71		$	213
Other information on operating lease:
Cash payments included in the measurement of lease liability reported in operating cash flows	60			180
Right-of-use assets (1)	1,031			1,031
Operating lease liability (2)	1,031			1,031
Weighted average discount rate	3.9		%	3.9		%
Weighted average remaining lease term in years	4 years			4 years

(1) Included in “other assets” on the Company’s consolidated balance sheet.

(2) Included in “other liabilities” on the Company’s consolidated balance sheet.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

The following tables present the contractual maturity of the Company’s lease liability:



	September 30, 2019
	($ in thousands)
Remainder of 2019	71
2020	283
2021	283
2022	283
2023	189
Total undiscounted lease payments	1,109
Less: present value adjustment	(78	)
Operating lease liability	1,031



	December 31, 2018
	($ in thousands)
Future rental commitments
2019	283
2020	283
2021	283
2022	283
2023	189
Total	1,321

15. Contingently redeemable preference shares

In March 2014, the Company issued 9,065,200 8½% Cumulative Redeemable Preference Shares (the “preference shares”). The preference shares have a par value of $0.01 per share and a liquidation preference of $25.00 per share. The preference shares were issued at a discounted purchase price of $24.50 per share. Holders of the preference shares are entitled to receive, if declared by the board of directors, quarterly cash dividends on the last day of March, June, September, and December of each year. Prior to June 30, 2019, dividends on the preference shares accrued at a fixed rate of 8.5% per annum (the “Fixed Rate Period”). Dividends accrue from (and including) June 30, 2019 (the “Floating Rate Period”), at a floating rate per annum (the “Floating Rate”) equal to three-month U.S. dollar LIBOR plus a margin of 667.85; provided, that, if, at any time, the three-month U.S. dollar LIBOR shall be less than 1%, then the three-month U.S. dollar LIBOR for purposes of calculating the Floating Rate at the time of such calculation shall be 1%. The preference shares may be redeemed by the Company on or after June 30, 2019 or at the option of the preference shareholders at any time on or after June 30, 2034 at the liquidation price of $25.00 per share. Because the redemption features are not solely within the control of the Company, the preference shares have been recorded as mezzanine equity on the Company’s consolidated balance sheets in accordance with applicable accounting guidance. Preference share dividends, including the accretion of the discount and issuance costs, are included in “Preference dividends” in the Company’s consolidated statements of income (loss).

On August 1, 2019, the Company redeemed 6,919,998 of its 9,065,200 total issued and outstanding preference shares, which were redeemed at a total redemption price of $25.19748 per share, inclusive of all declared and unpaid dividends, with accumulation of any undeclared dividends on or after June 30, 2019. After the redemption date, dividends on the preference shares that were

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

redeemed ceased to accrue, and such redeemed preference shares ceased to be outstanding. Affiliates of Arch Capital Group Ltd. received $11.5 million in connection with the redemption of the preference shares.

For the three months ended September 30, 2019 and 2018, dividends paid on the preference shares totaled $2.6 million and $4.9 million, respectively. For the nine months ended September 30, 2019 and 2018, dividends paid on the preference shares totaled $12.4 million and $14.7 million, respectively.

For each of the three and nine months ended September 30, 2019, accelerated amortization of costs related to the redemption of preference shares totaled $4.2 million. During these periods, accretion of the discount and issuance costs was $2.6 million and $1.6 million, respectively.

The following table presents a reconciliation of the preference shares for the nine months ended September 30, 2019 and the year ended December 31, 2018:



	Nine Months Ended September 30,
	2019			2018
Preference shares:	($ in thousands)
Balance at the beginning of the period	$	220,992		$	220,622
Preference shares repurchased during the period	(173,000		)	—
Accelerated amortization of costs related to the redemption of preference shares	4,164			—
Accretion discount and issuance costs on remaining preference shares	125			277
Balance at the end of the period	$	52,281		$	220,899

16. Senior notes

On July 2, 2019, the Company completed a private offering of $175.0 million in aggregate principal amount of its 6.5% senior notes due July 2, 2029. Interest on the senior notes will be paid semi-annually in arrears on each January 2 and July 2, commencing January 2, 2020. The $172.3 million net proceeds from the offering were used to redeem a portion of the Company’s outstanding preference shares, as described above in Note 15, “Contingently redeemable preference shares”. Affiliates of ACGL purchased $35 million in aggregate principal amount of the senior notes.

The senior notes are the Parent’s senior unsecured and unsubordinated obligations and rank equally with all of the other existing and future obligations of the Parent that are unsecured and unsubordinated. The Company may redeem the senior notes at any time, in whole or in part, prior to July 2, 2024, at “make-whole” redemption price, subject to BMA requirements. The senior notes are redeemable, in whole or in part, at a redemption price equal to 100% of the principal amount, subject to BMA requirements at any time after July 2, 2024. The indenture governing the senior notes contains certain customary covenants, including those related to the punctual payment of interest and principal amounts due. The Company was in compliance with such covenants at September 30, 2019.

As of September 30, 2019, the carrying amount of the senior notes was $172.3 million, presented net of unamortized debt issuance costs of $2.7 million. As of December 31, 2018, the carrying amount of the senior notes was $Nil.

17. Legal proceedings

The Company, in common with the insurance industry in general, is subject to litigation and arbitration in the normal course of its business. As of September 30, 2019, the Company was not a

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

party to any litigation or arbitration, which is expected by management to have a material adverse effect on the Company’s results of operations or financial condition and liquidity.

Item 2. Management’s discussion and analysis of financial condition and results of operations

The following discussion and analysis of our financial condition and results of operations contains forward-looking statements, which involve inherent risks and uncertainties. All statements other than statements of historical fact are forward-looking statements. These statements are based on our current assessment of risks and uncertainties. Actual results may differ materially from those expressed or implied in these statements and, therefore, undue reliance should not be placed on them. Important factors that could cause actual events or results to differ materially from those indicated in such statements are discussed elsewhere in this report, including the sections entitled Part I “Financial information - Cautionary note regarding forward-looking statements” and Part II Item 1A “Risk factors.”

This discussion and analysis should be read in conjunction with our consolidated financial statements and notes thereto included in Part I Item 1 “Consolidated financial statements” of this report. Tabular amounts are in U.S. dollars in thousands, except share amounts, unless otherwise noted.

Overview

We are a global property and casualty, or P&C, insurance and reinsurance company with approximately $1.2 billion in capital as of September 30, 2019, comprised of $172.3 million of senior notes, $52.3 million of contingently redeemable preference shares and $960.8 million of common shareholders’ equity. Through operations in Bermuda, the United States and Europe, we write insurance and reinsurance on a worldwide basis. Our objective is to deliver attractive returns to shareholders by combining disciplined underwriting with superior investment management. Our strategy combines a diversified, casualty-focused underwriting portfolio, accessed through our multi-year, renewable strategic underwriting management relationship with Arch, with a disciplined investment strategy comprised primarily of non-investment grade corporate credit assets, managed by HPS. In addition, we have a services arrangement with AIM and other investment managers to manage our investment grade portfolio.

While we are positioned to provide a full range of P&C lines, we focus on writing specialty lines of business. We believe that our experienced management team, our relationship with Arch and our strong capital base have enabled us to successfully compete and establish a meaningful presence in the insurance and reinsurance markets in which we participate.

We seek to generate an attractive return on average equity across the relevant insurance and investment cycles. We opportunistically seek to underwrite new lines that fit our return profile while maintaining a disciplined underwriting approach.

Current outlook

We believe the insurance and reinsurance market environment is showing signs of noticeable improvement. Primary rates in most casualty lines, with the exception of workers compensation, continue to be strong, albeit, we believe, partly in response to higher perceived social inflation. Property catastrophe reinsurance rates are up meaningfully, retrocession capacity is shrinking, and ceding commissions have reduced modestly on some proportional casualty treaties. We believe the factors supporting a continued favorable pricing environment include the low interest rate environment, three consecutive years of significant multiple catastrophe events, and signs of weakness in the adequacy of prior period loss reserves for some industry participants.

Against this backdrop, we are selectively growing our business in areas that we believe present attractive opportunities. In particular, we continue to see good growth opportunities in the insurance market, as new program submission activity is strong.

We also see opportunities on the reinsurance side in general liability, commercial auto liability and other casualty lines. In the 2019 third quarter, we bound a large, 3-year, casualty reinsurance excess of loss contract in which Arch also has a significant participation. Our current portfolio has concentrations in general liability, professional liability, multiline, workers compensation and motor product lines through reinsurance of third-party cedents and retrocessions of Arch. We continue to deploy resources opportunistically in product lines that meet our risk and return profile.

Our insurance underwriting platforms in the United States and Europe continue to grow with higher premiums written in the third quarter of 2019.

Our outsourced business model

We have engaged Arch and HPS to perform certain services for us that are essential to the results of our operations, and have entered into long-term, renewable contracts with each in order to ensure continued access to these services. For our underwriting operations, Arch provides underwriting services including sourcing and evaluating underwriting opportunities as well as related services such as claims-handling, loss control, exposure management, portfolio management, modeling, statistical, actuarial and administrative support services, in each case, subject to our underwriting and operational guidelines and the oversight of our senior management and board of directors. With regard to our investments, HPS manages our non-investment grade portfolio while AIM manages the largest portion of our investment grade portfolio, in each case subject to compliance with our investment guidelines and the oversight of our senior management and board of directors. We outsource these functions in order to cost-effectively leverage the respective expertise and strong market positions of our trusted partners. Through our association with Arch, we access Arch’s worldwide platform on a variable cost basis, thus avoiding the fixed expense of maintaining a multi-line platform for our underwriting operations. Similarly, we believe that the terms of service and structure of the compensation we pay to HPS and AIM provide benefits to us both in terms of cost-effective access to the expertise required to execute our investment strategy and in aligning interests.

Natural catastrophe risk

While we are more casualty-focused and assume less catastrophe exposure than many of our peers, we do underwrite a limited amount of natural catastrophe risk in order to balance and diversify our underwriting portfolio. We carefully monitor our natural catastrophe risk globally for all perils and regions where we believe our underwriting portfolio might have significant exposure.

Limited operating history and comparability of results

We were incorporated in July 2013 and completed our initial funding and began underwriting business in the first quarter of 2014. Our initial underwriting activities focused on writing reinsurance. In 2015, we began our insurance business in connection with the establishment of our U.S. and European insurance platforms. As a result, we have a limited operating history and, given our underwriting and investment strategies, are exposed to volatility in our results of operations that may not be apparent from a review of our historical results. Period-to-period comparisons of our results of operations may not be meaningful. In addition, the amount of premiums written may vary from year to year and period to period as a result of any number of factors, including changes in market conditions and our view of the long-term profit potential of individual lines of business.

Financial measures and ratios

Our management and board of directors use financial indicators and ratios in evaluating our performance and measuring the overall growth in value generated for our common shareholders. The key financial measures that we believe are meaningful in analyzing our performance are: underwriting income (loss), combined ratio, adjusted underwriting income (loss), adjusted combined ratio, net interest income, net interest income yield on average net assets (including the

non-investment grade portfolio and investment grade portfolio components thereof), net investment income (loss), net investment income return on average net assets, net investment income return on average total investments (including the non-investment grade portfolio and investment grade portfolio components thereof), book value per diluted common share, growth in book value per diluted common share and return on average equity.

The table below shows the key performance indicators for the three and nine months ended September 30, 2019 and 2018:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2019			2018			2019			2018
	($ in thousands, except percentages and share amounts)
Key underwriting metrics:
Underwriting income (loss)	$	(5,021	)	$	(912	)	$	(16,257	)	$	(3,180	)
Combined ratio	104.0		%	100.7		%	103.8		%	100.8		%
Adjusted underwriting income (loss)	$	(2,270	)	$	738		$	(5,483	)	$	2,012
Adjusted combined ratio	101.8		%	99.5		%	101.3		%	99.5		%
Key investment return metrics:
Net interest income	$	29,536		$	27,397		$	86,385		$	77,578
Net interest income yield on average net assets (1)	1.4		%	1.3		%	4.1		%	3.9		%
Non-investment grade portfolio (1)	1.7		%	1.7		%	5.2		%	5.1		%
Investment grade portfolio (1)	0.6		%	0.5		%	1.8		%	1.4		%
Net investment income (loss)	$	14,040		$	21,373		$	96,181		$	54,735
Net investment income return on average net assets (1)	0.6		%	1.1		%	4.5		%	2.8		%
Non-investment grade portfolio (1)	0.6		%	1.4		%	5.1		%	4.2		%
Investment grade portfolio (1)	0.8		%	0.4		%	2.9		%	0.1		%

Net investment income return on average total investments (2)	0.5		%	0.8		%	3.5		%	2.1		%
Non-investment grade portfolio (2)	0.5		%	1.1		%	4.3		%	3.4		%
Investment grade portfolio (2)	0.8		%	0.4		%	2.9		%	0.1		%
Key shareholders’ value creation metrics:
Book value per diluted common share (3)	$	42.05		$	43.44		$	42.05		$	43.44
Growth in book value per diluted share (3)	—		%	1.8		%	7.2		%	4.0		%
Annualized return on average equity (4)	0.1		%	7.7		%	8.7		%	5.6		%

(1) Net interest income yield on average net assets and net investment income return on average net assets are calculated by dividing net interest income, and net investment income (loss), respectively, by average net assets. Net assets is calculated as the sum of total investments, accrued investment income and receivables for securities sold, less revolving credit agreement borrowings, payable for securities purchased and payable for securities sold short. For the three and nine month periods, average net assets is calculated using the averages of each quarterly period. However, for the investment grade portfolio component of these returns, the impact of the revolving credit agreement borrowings is not subtracted from net interest income, net investment income (loss), or the net assets calculation. The separate components of these returns (non-investment grade portfolio and investment grade portfolio) are non-U.S. GAAP financial measures. Refer to “-Reconciliation of non-U.S. GAAP financial measures” for a reconciliation of these components of our net interest income yield on average net assets and net investment income return on average net assets.

(2) Net investment income return on average total investments is calculated by dividing net investment income by average total investments. For the three and nine month periods, average total investments is calculated using the averages of each quarterly period. However, for the investment grade portfolio component of these returns, the impact of revolving credit agreement borrowings is not subtracted from net investment income. The separate components of these returns (non-investment grade portfolio and investment grade portfolio) are non-U.S. GAAP financial measures. Refer to “-Reconciliation of non-U.S. GAAP financial measures” for a reconciliation of these components of our net investment income return on average total investments.

(3) Book value per diluted common share is calculated by dividing common shareholders’ equity by the number of diluted common shares outstanding at the end of each reporting period. Growth in book value per diluted common share is calculated as the percentage change in value of beginning and ending book value per diluted common share over the reporting period.

(4) Annualized return on average equity represents net income (loss) expressed as a percentage of average common shareholders’ equity during the period. Annualized return on average equity for the three and nine months ended September 30, 2019 and 2018 is calculated by extrapolating the quarterly return on average equity over a twelve-month period. For the three and nine month periods, the average common shareholders’ equity is calculated as the average of the beginning and ending common shareholders’ equity of each quarterly period.

Underwriting income (loss)

Underwriting income (loss) is a non-U.S. GAAP financial measure. We define underwriting income (loss) as net premiums earned less loss and loss adjustment expenses, acquisition expenses and general and administrative expenses. Underwriting income (loss) is one of the ways we evaluate the performance of our underwriting segment, and does not include other underwriting income (loss), net investment income (loss), interest expense, net foreign exchange gains (losses), income tax expenses and preference dividends. Although these items are an integral part of our operations, with the exception of other underwriting income (loss), they are independent of the underwriting process and result, in large part, from general economic and financial market conditions. We include other underwriting income (loss) in our adjusted underwriting income (loss), as described in more detail below. See “-Reconciliation of non-U.S. GAAP financial measures” for a reconciliation of underwriting income to net income (loss) available to common shareholders.

Combined ratio

The combined ratio is calculated as the sum of loss and loss adjustment expenses, acquisition expenses and general and administrative expenses, divided by net premiums earned, or equivalently, as the sum of the loss ratio, acquisition expense ratio and general and administrative expense ratio. The combined ratio is a measure of underwriting profitability but does not include other underwriting income or net investment income earned on underwriting cash flows.

Adjusted underwriting income (loss)

Adjusted underwriting income (loss) is a non-U.S. GAAP financial measure. We define adjusted underwriting income (loss) as underwriting income (loss) plus other underwriting income (loss) less certain corporate expenses. Adjusted underwriting income (loss) is one of the ways we evaluate the performance of our underwriting segment. We include other underwriting income (loss), as our underwriting strategy allows us to enter into government-sponsored enterprise credit-risk sharing transactions. Certain corporate expenses are generally comprised of non-recurring costs of the holding company, such as costs associated with the initial setup of subsidiaries, as well as costs associated with the ongoing operations of the holding company such as compensation of certain executives. See “-Reconciliation of non-U.S. GAAP financial measures” for a reconciliation of adjusted underwriting income to net income (loss) available to common shareholders.

Adjusted combined ratio

Adjusted combined ratio is a non-U.S. GAAP financial measure. The adjusted combined ratio is calculated as the sum of loss and loss adjustment expenses, acquisition expenses and general and administrative expenses less certain corporate expenses, divided by the sum of net premiums earned and other underwriting income (loss). This ratio is a measure of our underwriting and operational profitability but does not include certain corporate expenses or net investment income earned on underwriting cash flows. Certain corporate expenses are generally comprised of non-recurring costs of the holding company, such as costs associated with the initial setup of subsidiaries, as well as costs associated with the ongoing operations of the holding company such as compensation of certain executives. See “-Reconciliation of non-U.S. GAAP financial measures” for a reconciliation of our adjusted combined ratio to our combined ratio.

Net interest income and net investment income (loss)

Net interest income and net investment income (loss) are important contributors to our financial results. These key investment metrics are impacted by the performance of our Investment Managers as well as the state of the overall financial markets.

Net interest income yield on average net assets

Net interest income yield on average net assets is calculated by dividing net interest income by average net assets. Net assets is calculated as the sum of total investments, accrued investment income and receivables for securities sold, less revolving credit agreement borrowings, payable for securities purchased and payable for securities sold short. Net interest income yield on average net assets is a key indicator by which we measure the performance of our Investment Managers.

Net investment income return on average net assets

Net investment income return on average net assets is calculated by dividing net investment income (loss) by average net assets. Net assets is calculated as the sum of total investments, accrued investment income and receivables for securities sold, less revolving credit agreement borrowings, payable for securities purchased and payable for securities sold short. Net investment income return on average net assets is a key indicator by which we measure the performance of our Investment Managers.

Net investment income return on average total investments

Net investment income return on average total investments is calculated by dividing net investment income (loss) by average total investments. Net investment income return on average total investments is a key indicator by which we measure the performance of our Investment Managers.

Non-investment grade portfolio and investment grade portfolio components of certain of our investment metrics

In order to provide further detail regarding our key investment metrics, we also present the non-investment grade portfolio and investment grade portfolio components of our net interest income yield on average net assets, net investment income return on average net assets and net investment income return on average total investments. In the calculation of the investment grade portfolio component of our net interest income yield on average net assets and net investment income return on average net assets, the impact of the revolving credit agreement borrowings is not subtracted from net interest income, net investment income (loss) or the net assets calculation. The separate components of these returns are non-U.S. GAAP financial measures. See “-Reconciliation of non-U.S. GAAP financial measures” for a reconciliation of these components of our net interest income yield on average net assets, net investment income return on average net assets and net investment income return on average total investments.

Growth in book value per diluted common share

Book value per diluted common share is calculated by dividing common shareholders’ equity by the number of diluted common shares outstanding at the end of each reporting period. We calculate growth in book value per diluted common share as the percentage change in value of beginning and ending book value per diluted share over the reporting period.

We measure our long-term financial success by our ability to compound growth in book value per diluted common share at an attractive rate of return. We believe that long-term growth in book value per diluted common share is the most comprehensive measure of our success because it includes all underwriting, operating and investing results.

Return on average equity

Return on average equity is net income (loss) expressed as a percentage of average common shareholders’ equity during the period and is used to measure profitability. Our goal is to generate an attractive long-term return on our common shareholders’ equity.

Comment on non-U.S. GAAP financial measures

Throughout this report, we present our operations in the way we believe will be the most meaningful and useful to investors, analysts, rating agencies and others who will use our financial information in evaluating the performance of our company. This presentation includes the use of underwriting income (loss), adjusted underwriting income (loss), adjusted combined ratio and the separate components of our investment returns (non-investment grade investment portfolio and investment grade investment portfolio). The presentation of these metrics constitutes non-U.S. GAAP financial measures as defined by applicable SEC rules. We believe that this presentation enables investors and other users of our financial information to analyze our performance in a manner similar to how management analyzes performance. We also believe that this presentation follows industry practice and, therefore, allows the equity analysts and certain rating agencies that follow us and the insurance industry as a whole, as well as other users of our financial information to compare our performance with our industry peer group. See “-Reconciliation of non-U.S. GAAP financial measures” for reconciliations of such measures to the most directly comparable U.S. GAAP financial measures, in accordance with applicable SEC rules.

Components of our results of operations

Revenues

We derive our revenues from two principal sources:


•	premiums from our insurance and reinsurance lines of business; and


•	income from investments.

Premiums from our insurance and reinsurance lines of business are directly related to the number, type, size and pricing of contracts we write. Premiums are earned over the contract period in proportion to the period of risk covered which is typically 12 to 24 months.

Income from our investments is comprised of interest income and net realized and unrealized gains (losses), less investment related expenses as described below.

Expenses

Our expenses consist primarily of the following:


•	loss and loss adjustment expenses;


•	acquisition expenses;


•	general and administrative expenses;


•	investment related expenses; and


•	interest expense.

Loss and loss adjustment expenses are a function of the amount and type of contracts and policies we write and of the loss experience of the underlying coverage. Loss and loss adjustment expenses are based on an actuarial analysis of the estimated losses, including losses incurred during the period and changes in estimates from prior periods. Depending on the nature of the contract, loss and loss adjustment expenses may be paid over a period of years.

Acquisition expenses consist primarily of brokerage fees, ceding commissions, premium taxes, underwriting fees payable to Arch under our services agreements and other direct expenses that relate to our contracts and policies and are presented net of commissions received from reinsurance we purchase. We amortize deferred acquisition expenses over the related contract term in the same proportion that the premiums are earned. Our acquisition expenses may also include profit commissions paid to our sources of business in the event of favorable underwriting experience.

General and administrative expenses consist of salaries and benefits and related costs, legal and accounting fees, travel and client entertainment, fees relating to our letter of credit facilities, information technology, occupancy, the cost of employees made available to us by Arch under the services agreements, and other general operating expenses.

Investment-related expenses primarily consist of management and performance fees we pay to our Investment Managers, as well as interest and other expenses on borrowings from our credit facilities when used to finance a portion of our investments. The fee structure that we pay to HPS related to our non-investment grade portfolio was reduced beginning on January 1, 2018. We currently pay a management fee to HPS related to its management of our non-investment grade portfolio on a quarterly basis equal to 1.0% of net assets. Beginning January 1, 2020, to the extent the aggregate net asset value of the HPS-managed non-investment grade portfolio assets exceeds $1.5 billion, the management fee shall be calculated at a blended annual rate equal to (i) 1.0% of the initial $1.5 billion in net asset value plus (ii) seventy-five basis points (0.75%) of the excess of aggregate net asset value over $1.5 billion, subject to a minimum blended management fee rate of eighty-five basis points (0.85%) on the aggregate net asset value of the HPS-managed non-investment grade portfolio assets. In addition, on an annual basis, subject to then-applicable high water marks, HPS receives a base performance fee equal to 10% of the income generated on the non-investment grade portfolio, and is eligible to earn an additional performance fee equal to 25% of any such investment income in excess of a net 10% return to us after deduction for paid and accrued management fees and base performance fees, with the total performance fees not to exceed 17.5% of the Income (as defined in the investment management agreements relating to Watford Re, WICE and Watford Trust) or Aggregate Income (as defined in the investment management agreements relating to WSIC and WIC), as applicable.

We have also engaged HPS to manage a portion of our investment grade portfolio as a recently-created separate managed account. As this separate managed account is funded, we will pay HPS a management fee equal to 0.60% per annum on the assets. We also pay AIM monthly asset management fees related to the assets it manages for us. We are not obligated to pay performance fees to any of the Investment Managers managing our investment grade portfolios. We include the HPS non-investment grade portfolio base management fee and the AIM investment grade portfolio management fee in “investment management fees - related parties” in our consolidated statement of income, and as management fees are accrued and paid to HPS in connection with its management of a portion of our investment grade portfolio, we will include such fees therein as well. We include interest and other expenses on borrowings in “borrowing and miscellaneous other investment expenses” in our consolidated statement of income. The HPS non-investment grade portfolio performance fee, if applicable, is shown on a separate line in our consolidated statement of income.

Interest expense consists of interest incurred on the $175.0 million aggregate principal amount of 6.5% senior notes due July 2, 2029, or the senior notes, that we issued on July 2, 2019. Interest on the senior notes will be paid semi-annually in arrears on each January 2 and July 2, commencing January 2, 2020.

Reportable segment

We report results under one segment, which we refer to as our “underwriting segment.” Our underwriting segment captures the results of our underwriting lines of business, which are comprised of specialty products on a worldwide basis. We also have a corporate function that

includes accelerated expense for the unamortized original issue discount and underwriting fees relating to the partial redemption of our 8½% cumulative redeemable preference shares, or the preference shares, and interest expense on our senior notes as well as certain operating expenses related to corporate activities referred to as certain corporate expenses. Certain corporate expenses are generally comprised of non-recurring costs of the holding company, such as costs associated with the initial setup of subsidiaries, accelerated compensation expense recognition for retirement eligible employees, and costs associated with the ongoing operations of the holding company such as compensation of certain executives (refer to “- Reconciliation of non-U.S. GAAP financial measures” for a discussion about certain corporate expenses).

Consolidated results - for the three and nine months ended September 30, 2019 and 2018

The following table summarizes our results of operations for the three and nine months ended September 30, 2019 and 2018:



	Three Months Ended September 30,								Nine Months Ended September 30,
	2019			% Change		2018			2019			% Change		2018
	($ in thousands)
Gross premiums written	$	249,960		35.1	%	$	185,033		$	598,627		4.3	%	$	574,078
Gross premiums ceded	(94,208		)			(33,356		)	(178,118		)			(102,263		)
Net premiums written	155,752			2.7	%	151,677			420,509			(10.9	)%	471,815
Net premiums earned	125,832			(7.2	)%	135,624			423,244			(2.0	)%	431,889
Loss and loss adjustment expenses	(96,214		)			(96,957		)	(318,480		)			(312,087		)
Acquisition expenses	(27,612		)			(33,778		)	(97,003		)			(106,708		)
General and administrative expenses (1)	(7,027		)			(5,801		)	(24,018		)			(16,274		)
Underwriting income (loss) (2)	(5,021		)	450.5	%	(912		)	(16,257		)	411.2	%	(3,180		)
Other underwriting income (loss)	579					703			1,844					2,092
Interest income	41,376					38,704			123,113					109,830
Investment management fees - related parties	(4,606		)			(4,314		)	(13,585		)			(12,616		)
Borrowing and miscellaneous other investment expenses	(7,234		)			(6,993		)	(23,143		)			(19,636		)
Net interest income	29,536					27,397			86,385					77,578
Realized and unrealized gain (loss) on investments	(14,646		)			(3,617		)	18,138					(16,237		)
Investment performance fees - related parties	(850		)			(2,407		)	(8,342		)			(6,606		)
Net investment income (loss)	14,040			(34.3	)%	21,373			96,181			75.7	%	54,735
Interest expense	(2,841		)			—			(2,841		)			—
Net foreign exchange gains (losses)	167					2,582			(711		)			1,847
Income tax expense	—					—			(20		)			(27		)
Net income (loss) before preference dividends and redemption costs	6,924					23,746			78,196					55,467
Preference dividends	(2,608		)			(4,909		)	(12,423		)			(14,724		)
Accelerated amortization of costs related to the redemption of preference shares	(4,164		)			—			(4,164		)			—
Net income (loss) available to common shareholders	$	152		(99.2	)%	$	18,837		$	61,609		51.2	%	$	40,743



	Three Months Ended September 30,								Nine Months Ended September 30,
	2019			Change		2018			2019			Change		2018
	($ in thousands)
Loss ratio	76.5		%	5.0	%	71.5		%	75.2		%	2.9	%	72.3		%
Acquisition expense ratio	21.9		%	(3.0	)%	24.9		%	22.9		%	(1.8	)%	24.7		%
General & administrative expense ratio	5.6		%	1.3	%	4.3		%	5.7		%	1.9	%	3.8		%
Combined ratio	104.0		%	3.3	%	100.7		%	103.8		%	3.0	%	100.8		%

Adjusted underwriting income (loss)(2)	$	(2,270	)			$	738		$	(5,483	)			$	2,012
Adjusted combined ratio (2)	101.8		%	2.3	%	99.5		%	101.3		%	1.8	%	99.5		%
Annualized return on average equity (3)	0.1		%			7.7		%	8.7		%			5.6		%

(1) General and administrative expenses include certain corporate expenses. Refer to “Reconciliation of non-U.S. GAAP financial measures-Reconciliation of the adjusted combined ratio,” for a discussion of these certain corporate expenses.

(2) Underwriting income (loss), adjusted underwriting income (loss) and the adjusted combined ratio are non-U.S. GAAP financial measures. Refer to “Reconciliation of non-U.S. GAAP financial measures” for a reconciliation of our underwriting income (loss) to net income (loss) available to common shareholders in accordance with U.S. GAAP, a reconciliation of our adjusted underwriting income (loss) to underwriting income (loss) and a reconciliation of our adjusted combined ratio to our combined ratio.

(3) Annualized return on average equity represents net income (loss) expressed as a percentage of average common shareholders’ equity during the period. Annualized return on average equity for the three and nine months ended September 30, 2019 and 2018 is calculated by extrapolating the quarterly return on average equity over a twelve-month period. For the three and nine month periods, the average common shareholders’ equity is calculated as the average of the beginning and ending common shareholders’ equity of each quarterly period.

Results for the three months ended September 30, 2019 versus 2018:

Net income attributable to common shareholders was $0.2 million for the three months ended September 30, 2019, compared to net income of $18.8 million for the three months ended September 30, 2018. The 2019 third quarter net income decrease over the same prior year period was driven by a decrease in net investment income, an increased underwriting loss and one-time expenses related to the redemption of 76.34% of our then outstanding preference shares.

During the 2019 third quarter, net investment income decreased by $7.3 million, to $14.0 million. The decrease in net investment income was primarily due to realized and unrealized losses increasing by $11.0 million, compared to the 2018 third quarter. The increase was primarily due to slight widening of credit spreads this quarter, resulting in net realized and unrealized losses of $14.6 million. This was partially offset by an increase in net interest income of $2.1 million and a reduction of performance fees of $1.5 million.

The 2019 third quarter underwriting loss of $5.0 million was primarily the result of increased loss and loss adjustment expenses and higher general and administrative expenses during the quarter. This was partially offset by a reduction in acquisition expenses compared to the 2018 third quarter.

The 2019 third quarter loss ratio was 76.5%, 5 points higher than a year ago. The increase in the loss ratio partly reflected changes in the mix and type of business, which also resulted in a 3-point lower acquisition expense ratio versus the prior year quarter. In addition, the 2018 third quarter results benefited from 1.7 points of net favorable loss reserve development, while loss reserve development in the 2019 third quarter was essentially flat.

The 2019 third quarter general and administrative expense ratio was 5.6%, 1.3 points higher than a year ago. The increase this quarter versus the 2018 third quarter reflected ongoing public company corporate expenses that were not present in the comparable prior period.

On July 2, 2019, we completed a private offering of $175.0 million aggregate principal amount of our 6.5% senior notes, due July 2, 2029. Interest expense incurred on the senior notes was $2.8

million in the 2019 third quarter. The net proceeds from the offering were used to redeem 76.34% of our then outstanding 8½% cumulative redeemable preference shares.

We incurred $5.5 million of one-time expenses related to the preference share redemption, comprised of $4.2 million of accelerated amortization of the original discount and issuance costs, plus $1.3 million of final dividends paid on the then redeemed preference shares.

Results for the nine months ended September 30, 2019 versus 2018:

Net income attributable to common shareholders was $61.6 million for the nine months ended September 30, 2019, compared to net income of $40.7 million for the nine months ended September 30, 2018. The nine months ended September 30, 2019 net income increase over the same prior year period was driven by an increase in net investment income, offset in part by an increased underwriting loss and one-time expenses related to the redemption of our preference shares as described above.

During the nine months ended September 30, 2019, net investment income increased by $41.4 million, to $96.2 million. The increase in net investment income was primarily due to an increase in net realized and unrealized gains of $34.4 million, compared to the first nine months of 2018. The increase was primarily due to the narrowing of credit spreads through the first nine months of 2019, resulting in net realized and unrealized gains of $18.1 million. In addition, net interest income increased 11.4%, from $77.6 million in the first nine months of 2018 to $86.4 million in the nine months ended September 30, 2019.

The underwriting loss of $16.3 million for the nine months ended September 30, 2019 was primarily the result of increased loss and loss adjustment expenses and higher general and administrative expenses and a reduction in net premiums earned.

The nine months ended September 30, 2019 loss ratio was 75.2%, 2.9 points higher than a year ago. The increase in the loss ratio partly reflected changes in the mix and type of business, which also resulted in a 1.8 point lower acquisition expense ratio. In addition, results for the first nine months of 2018 benefited from 0.5 points of net favorable loss reserve development, while loss reserve development this year was essentially flat.

The increase in general and administrative expenses reflected ongoing public company expenses and timing of certain long-term incentive compensation expenses reported in the 2019 second quarter, including a one-time accelerated compensation expense.

Premiums

Our underwriting segment captures the results of our underwriting lines of business, which are comprised of specialty products on a worldwide basis. Our four major lines of business are described as follows:


•	Casualty reinsurance: coverage provided to ceding company clients on third-party liability and workers’ compensation exposures, primarily on a treaty basis. Business written includes coverages such as: executive assurance, medical malpractice liability, other professional liability, workers’ compensation, excess and umbrella liability and excess auto liability.


•	Other specialty reinsurance: coverage provided to ceding company clients for personal and commercial auto (other than excess auto liability), mortgage, surety, accident and health, workers’ compensation catastrophe, agriculture, marine and aviation.


•	Property catastrophe reinsurance: protects ceding company clients for most catastrophic losses that are covered in the underlying policies. Perils covered may include hurricane, earthquake, flood, tornado, hail and fire, and coverage for other perils on a case-by-case basis. Property catastrophe reinsurance provides coverage on an excess of loss basis when aggregate losses and

loss adjustment expense from a single occurrence of a covered peril exceed the retention specified in the contract.


•	Insurance programs and coinsurance: targeting program managers and/or coinsurers with unique expertise and niche products offering primary and excess general liability, umbrella liability, professional liability, workers’ compensation, personal and commercial automobile, inland marine and property business with minimal catastrophe exposure.

Gross premiums written

Gross premiums written for the three and nine months ended September 30, 2019 and 2018 were as follows:



	Three Months Ended September 30,								Nine Months Ended September 30,
	2019				2018				2019				2018
	Amount		%		Amount		%		Amount		%		Amount		%
	($ in thousands)
Casualty reinsurance	$	145,129	58.1	%	$	80,274	43.4	%	$	253,287	42.3	%	$	222,636	38.8	%
Other specialty reinsurance	22,453		9.0	%	37,434		20.2	%	84,587		14.1	%	151,083		26.3	%
Property catastrophe reinsurance	3,461		1.4	%	1,353		0.7	%	15,382		2.6	%	8,740		1.5	%
Insurance programs and coinsurance	78,917		31.5	%	65,972		35.7	%	245,371		41.0	%	191,619		33.4	%
Total	$	249,960	100.0	%	$	185,033	100.0	%	$	598,627	100.0	%	$	574,078	100.0	%

Results for the three months ended September 30, 2019 versus 2018:

Gross premiums written were $250.0 million for the three months ended September 30, 2019 compared to $185.0 million for the three months ended September 30, 2018, an increase of $64.9 million, or 35.1%. The results for the three months ended September 30, 2019 included the binding of an $81.1 million multi-year excess of loss contract within casualty, for which all of the written premium for the 3 year term was booked this quarter. When the multi-year contract premiums are annualized, total gross premiums written increased 5.9%.

Premium increases in casualty reinsurance, property catastrophe reinsurance, and insurance programs and coinsurance were offset in part by premium reductions in other specialty reinsurance.

Our casualty reinsurance gross premiums increased due to the large multi-year excess of loss contract written during the quarter as discussed above.

The growth of $12.9 million in our insurance programs and coinsurance line of business was driven by the continued expansion of our U.S. and European insurance programs and coinsurance.

During the 2019 third quarter, WICE increased its insurance gross premiums written by $4.7 million, or 10%, to $51.2 million. The increase in gross premiums written primarily related to increased European motor writings. In addition, during the 2019 third quarter, WSIC and WIC collectively grew their insurance programs’ gross premiums written by $8.2 million, or 42.1%, to $27.8 million.

Additionally, other specialty gross premiums were down due to the 2019 first quarter non-renewal of one motor quota share contract. The remaining decrease primarily related to the 2019 second quarter reduction in one large client’s underlying exposure ceded at this year’s renewal.

Results for the nine months ended September 30, 2019 versus 2018:

Gross premiums written were $598.6 million for the nine months ended September 30, 2019 compared to $574.1 million for the nine months ended September 30, 2018, an increase of $24.5 million, or 4.3%. The nine months ended September 30, 2019 results included the binding of an

$81.1 million multi-year excess of loss contract within casualty, for which all of the written premium for the 3 year term was booked in the 2019 third quarter. When the multi-year contract premiums are annualized, gross premiums written decreased 5.1%.

Premium increases in casualty reinsurance, property catastrophe reinsurance and insurance programs and coinsurance were offset in part by a written premium reduction in other specialty reinsurance.

Our casualty reinsurance gross premiums increased due to the large multi-year excess of loss contract written during the 2019 third quarter as discussed above. The increase was offset in part by the 2019 first quarter non-renewal of one multi-line quota share contract as well as the continued impact of gradually reduced participations over time on one cedent’s professional liability reinsurance program.

The growth of $53.8 million in our insurance programs and coinsurance line of business driven by the continued expansion of our U.S. and European insurance programs and coinsurance. During the nine months ended September 30, 2019, WICE increased its insurance gross premiums written by $24.9 million, or 18.1%, to $162.1 million. The increase in gross premiums written primarily related to increased European motor writings, including a restructured insurance program on which we previously participated on a coinsurance basis, and now write the entire program ourselves and cede a portion of the risk to maintain a similar net position. In addition, during the nine months ended September 30, 2019, WSIC and WIC collectively grew their insurance programs’ gross premiums written by $28.9 million, or 53.1%, to $83.3 million.

Other specialty gross premiums were down primarily due to the 2019 first quarter non-renewal of one motor quota share contract. Additionally, the first quarter 2018 renewal of a $24.0 million multi-year contract, in which all of the written premium for the 3-year term was booked that quarter with no comparable written premium in 2019. The remaining decrease was largely attributable to the 2019 second quarter reduction in one large client’s underlying exposure ceded at this year’s renewal.

Premiums ceded

Premiums ceded were $94.2 million for the three months ended September 30, 2019, compared to $33.4 million for the three months ended September 30, 2018, an increase of $60.9 million. Premiums ceded were $178.1 million for the nine months ended September 30, 2019, compared to $102.3 million for the nine months ended September 30, 2018, an increase of $75.9 million. In each of the three and nine month periods, the increase in premiums ceded primarily related to the binding of the 3-year $81.1 million casualty reinsurance excess of loss contract written during the 2019 third quarter, of which a significant portion was ceded to match our risk tolerances. Premium ceded to Arch increased significantly, primarily due to the casualty excess of loss contract described above, as well as the fact that, as our insurance gross premiums written have grown in our WICE, WSIC, and WIC companies, the outward ceded premiums to Arch have grown in proportion.

Net premiums written

Net premiums written for the three and nine months ended September 30, 2019 and 2018 were as follows:



	Three Months Ended September 30,								Nine Months Ended September 30,
	2019				2018				2019				2018
	Amount		%		Amount		%		Amount		%		Amount		%
	($ in thousands)
Casualty reinsurance	$	92,084	59.1	%	$	80,149	52.8	%	$	199,226	47.3	%	$	221,669	47.0	%
Other specialty reinsurance	22,093		14.2	%	35,466		23.4	%	81,798		19.5	%	138,259		29.3	%
Property catastrophe reinsurance	3,040		2.0	%	1,342		0.9	%	14,643		3.5	%	8,515		1.8	%
Insurance programs and coinsurance	38,535		24.7	%	34,720		22.9	%	124,842		29.7	%	103,372		21.9	%
Total	$	155,752	100.0	%	$	151,677	100.0	%	$	420,509	100.0	%	$	471,815	100.0	%

Results for the three months ended September 30, 2019 versus 2018:

Net premiums written were $155.8 million for the three months ended September 30, 2019 compared to $151.7 million for the three months ended September 30, 2018, an increase of $4.1 million or 3.0%. The increase of our net premiums written was a result of our gross premiums written and ceded premium movements discussed above.

Results for the nine months ended September 30, 2019 versus 2018:

Net premiums written were $420.5 million for the nine months ended September 30, 2019 compared to $471.8 million for the nine months ended September 30, 2018, a decrease of $51.3 million or 10.9%. The reduction of our net premiums written was in line with our gross premiums written and ceded premium movements discussed above.

Net premiums earned

Net premiums earned for the three and nine months ended September 30, 2019 and 2018 were as follows:



	Three Months Ended September 30,								Nine Months Ended September 30,
	2019				2018				2019				2018
	Amount		%		Amount		%		Amount		%		Amount		%
	($ in thousands)
Casualty reinsurance	$	52,266	41.5	%	$	63,292	46.7	%	$	183,085	43.2	%	$	206,532	47.8	%
Other specialty reinsurance	31,563		25.1	%	36,987		27.3	%	118,759		28.1	%	125,271		29.0	%
Property catastrophe reinsurance	3,617		2.9	%	2,481		1.8	%	9,707		2.3	%	7,443		1.7	%
Insurance programs and coinsurance	38,386		30.5	%	32,864		24.2	%	111,693		26.4	%	92,643		21.5	%
Total	$	125,832	100.0	%	$	135,624	100.0	%	$	423,244	100.0	%	$	431,889	100.0	%

Results for the three months ended September 30, 2019 versus 2018:

Net premiums earned were $125.8 million for the three months ended September 30, 2019 compared to $135.6 million for the three months ended September 30, 2018, a decrease of $9.8 million or 7.2%. The decrease in net premiums earned was primarily due to the reduction in one large client’s underlying exposure ceded at this year’s renewal, the continued impact of reduced participations over time on one cedent’s professional liability contracts, and the 2019 first quarter

non-renewal of one multi-line quota share contract. Reductions in earned premium were offset in part by premium growth of the WICE, WSIC and WIC platforms.

Results for the nine months ended September 30, 2019 versus 2018:

Net premiums earned were $423.2 million for the nine months ended September 30, 2019 compared to $431.9 million for the nine months ended September 30, 2018, a decrease of $8.6 million or 2.0%. The decrease in net premiums earned was primarily due to the reduction in one large client’s underlying exposure ceded at this year’s renewal, the continued impact of reduced participations over time on one cedent’s professional liability contracts, and the 2019 first quarter non-renewal of one multi-line quota share contract. Reductions in earned premium were offset in part by premium growth of the WICE, WSIC and WIC platforms.

Loss ratio

The following table shows the components of our loss and loss adjustment expenses for the three and nine months ended September 30, 2019 and 2018:



	Three Months Ended September 30,										Nine Months Ended September 30,
	2019					2018					2019					2018
	Loss and Loss Adjustment Expenses			% of Earned Premiums		Loss and Loss Adjustment Expenses			% of Earned Premiums		Loss and Loss Adjustment Expenses			% of Earned Premiums		Loss and Loss Adjustment Expenses			% of Earned Premiums
	($ in thousands)
Current year	$	96,417		76.6	%	$	99,215		73.2	%	$	318,812		75.3	%	$	314,381		72.8	%
Prior year development (favorable)/adverse	(203		)	(0.1	)%	(2,258		)	(1.7	)%	(332		)	(0.1	)%	(2,294		)	(0.5	)%
Loss and loss adjustment expenses	$	96,214		76.5	%	$	96,957		71.5	%	$	318,480		75.2	%	$	312,087		72.3	%

Results for the three months ended September 30, 2019 versus 2018:

Our loss ratio was 76.5% for the three months ended September 30, 2019, compared to 71.5% for the three months ended September 30, 2018, an increase of 5.0 points. The increase in the loss ratio partly reflected changes in the mix and type of business, which also resulted in a 3 point lower acquisition expense ratio versus the prior year quarter. In addition, the results for the nine months ended September 30, 2018 benefited from 1.7 points of net favorable loss reserve development, while loss reserve development in the 2019 third quarter was essentially flat.

Results for the nine months ended September 30, 2019 versus 2018:

Our loss ratio was 75.2% for the nine months ended September 30, 2019, compared to 72.3% for the nine months ended September 30, 2018, an increase of 2.9%. The increase in the loss ratio partly reflected changes in the mix and type of business, which also resulted in a 1.8 point lower acquisition expense ratio. In addition, the results for the first nine months of 2018 benefited from 0.5 points of net favorable loss reserve development, while loss reserve development for the first nine months of 2019 was essentially flat.

Refer to Note 5, “Reserve for losses and loss adjustment expenses” to our consolidated financial statements for more information about our prior year reserve development.

Acquisition expense ratio

Results for the three months ended September 30, 2019 versus 2018:

Our acquisition expense ratio was 21.9% for the three months ended September 30, 2019, a reduction of 3.0% from the three months ended September 30, 2018. The lower acquisition expense ratio was largely driven by an increased percentage of insurance net premiums earned and a

greater percentage of premiums earned on certain contracts with higher loss ratios and correspondingly lower acquisition expenses.

Results for the nine months ended September 30, 2019 versus 2018:

Our acquisition expense ratio was 22.9% for the nine months ended September 30, 2019, a reduction of 1.8% from the nine months ended September 30, 2018. The lower acquisition expense ratio was largely driven by an increased percentage of insurance net premiums earned and a greater percentage of premiums earned on certain contracts with higher loss ratios and correspondingly lower acquisition expenses.

General and administrative expense ratio

Results for the three months ended September 30, 2019 versus 2018:

Our general and administrative expense ratio was 5.6% for the three months ended September 30, 2019, compared to 4.3% for the three months ended September 30, 2018. The 1.3 point increase this quarter reflected ongoing public company corporate expenses.

Results for the nine months ended September 30, 2019 versus 2018:

Our general and administrative expense ratio was 5.7% for the nine months ended September 30, 2019, compared to 3.8% for the nine months ended September 30, 2018. The 1.9 point increase reflected both ongoing public company corporate expenses and the timing of certain one-time accelerated compensation expense incurred in the 2019 second quarter.

Combined ratio

Results for the three months ended September 30, 2019 versus 2018:

Our combined ratio was 104.0% for the three months ended September 30, 2019, compared to 100.7% for the three months ended September 30, 2018, an increase of 3.3%. In the 2019 third quarter, there was a 5.0 point increase in the loss expense ratio, a 1.3 point increase in the general and administrative expense ratio, offset in part by a 3.0 point decrease in acquisition expense ratio, versus the prior period, as described above.

Results for the nine months ended September 30, 2019 versus 2018:

Our combined ratio was 103.8% for the nine months ended September 30, 2019, compared to 100.8% for the nine months ended September 30, 2018, an increase of 3.0%. In the first nine months of 2019, there was a 2.9 point increase in the loss ratio, a 1.9 point increase in the general and administrative expense ratio, offset in part by a 1.8 point decrease in acquisition expense ratio, versus the prior period, as described above.

Investing results

The following table summarizes the components of total investment income:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2019			2018			2019			2018
	($ in thousands)
Interest income	$	41,376		$	38,704		$	123,113		$	109,830
Investment management fees - related parties	(4,606		)	(4,314		)	(13,585		)	(12,616		)
Borrowing and miscellaneous other investment expenses	(7,234		)	(6,993		)	(23,143		)	(19,636		)
Net interest income	29,536			27,397			86,385			77,578
Net realized gains (losses) on investments	645			4,004			2,716			(9,387		)
Net unrealized gains (losses) on investments	(15,291		)	(7,621		)	15,422			(6,850		)
Investment performance fees - related parties	(850		)	(2,407		)	(8,342		)	(6,606		)
Net investment income (loss)	$	14,040		$	21,373		$	96,181		$	54,735

Net interest income yield on average net assets (1)	1.4		%	1.3		%	4.1		%	3.9		%
Non-investment grade portfolio (1)	1.7		%	1.7		%	5.2		%	5.1		%
Investment grade portfolio (1)	0.6		%	0.5		%	1.8		%	1.4		%
Net investment income return on average net assets (1)	0.6		%	1.1		%	4.5		%	2.8		%
Non-investment grade portfolio (1)	0.6		%	1.4		%	5.1		%	4.2		%
Investment grade portfolio (1)	0.8		%	0.4		%	2.9		%	0.1		%
Net investment income return on average total investments (2)	0.5		%	0.8		%	3.5		%	2.1		%
Non-investment grade portfolio (2)	0.5		%	1.1		%	4.3		%	3.4		%
Investment grade portfolio (2)	0.8		%	0.4		%	2.9		%	0.1		%

Results for the three months ended September 30, 2019 versus 2018:

Net investment income was $14.0 million for the three months ended September 30, 2019 compared to net investment income of $21.4 million for the three months ended September 30, 2018, a decrease of $7.3 million. The 2019 third quarter net investment income return on average net assets was 0.6% as compared to 1.1% for the prior period.

The 2019 third quarter net investment return was driven by net interest income of $29.5 million, which increased 7.8% from the 2018 third quarter. The net interest income increase over the prior year quarter reflected the growth in average net invested assets. This increase was partially offset by net realized and unrealized losses of $14.6 million.

The 2019 third quarter non-investment grade portfolio net interest income yield was 1.7%, consistent with 1.7% in the third quarter of 2018. The net realized and unrealized losses reported in the 2019 third quarter were $16.4 million. The losses were reflective of a slight widening of credit spreads in the quarter.

The 2019 third quarter investment grade portfolio net interest income yield was 0.6%, consistent with 0.5% in the prior period. The slightly higher yield this quarter reflected higher interest rates in 2019. In addition, the investment grade portfolio recognized $1.8 million of net realized and unrealized gains in the quarter as compared to a loss of $0.6 million in the third quarter of 2018. The net realized and unrealized gains largely related to interest rate movements in 2019.

Results for the nine months ended September 30, 2019 versus 2018:

Net investment income was $96.2 million for the nine months ended September 30, 2019 compared to net investment income of $54.7 million in the prior period, an increase of $41.4 million. For the nine months ended September 30, 2019, the net investment income return on average net assets was 4.5% as compared to 2.8% for the prior period.

The net investment return for the nine months ended September 30, 2019 was driven by net interest income of $86.4 million, which increased 11.4% from the prior period. The net interest income increase over the prior period reflected the growth in average net invested assets. Additionally, net realized and unrealized gains of $18.1 million contributed to net investment income.

The non-investment grade portfolio net interest income yield for the nine months ended September 30, 2019 was 5.2%, remaining consistent with 5.1% in the prior period. Net realized and unrealized gains reported through the nine months ended September 30, 2019 totaled $7.8 million. The increase was primarily due to the narrowing of credit spreads through the first nine months of 2019.

The investment grade portfolio net interest income yield for the nine months ended September 30, 2019 was 1.8%, an increase from 1.4% in the prior period, reflecting higher interest rates in 2019. In addition, the investment grade portfolio recognized $10.3 million of net realized and unrealized gains, compared to a loss of $10.5 million in the prior period. The net realized and unrealized gains largely related to interest rate movements in the respective periods.

Growth in book value per diluted common share

Results for the three months ended September 30, 2019 versus 2018: Book value per diluted common share was $42.05 as of September 30, 2019, compared to $42.07 per share as of June 30, 2019. The decrease was driven by a $0.9 million other comprehensive loss.

Results for the nine months ended September 30, 2019 versus 2018: Book value per diluted common share was $42.05 as of September 30, 2019, compared to $39.22 per share as of December 31, 2018, an increase of $2.83 or 7.2%. The increase was driven by net investment income of $96.2 million, offset in part by an underwriting loss of $16.3 million.

Return on average equity

Results for the three months ended September 30, 2019 versus 2018: Our annualized return on average equity was 0.1% for the three months ended September 30, 2019, compared to 7.7% for the three months ended September 30, 2018. The decrease in return on average equity was driven

by reduced net investment income of $7.3 million, an increased underwriting loss of $4.1 million and one-time expenses related to the redemption of 76.34% of our preference shares.

Results for the nine months ended September 30, 2019 versus 2018: Our annualized return on average equity was 8.7% for the nine months ended September 30, 2019, compared to 5.6% for the nine months ended September 30, 2018. The increase in return on average equity was driven by net investment income of $96.2 million, offset in part by an underwriting loss of $16.3 million and one-time expenses related to the redemption of 76.34% of our preference shares.

Reconciliation of non-U.S. GAAP financial measures

Underwriting income (loss), adjusted underwriting income (loss), adjusted combined ratio and the non-investment grade portfolio and investment grade portfolio components of our investment returns (net interest income yield on average net assets, and net investment income return on average net assets and on average total investments, respectively) are non-U.S. GAAP financial measures. We use these measures, together with the GAAP financial statements, to provide information that assists with analyzing our performance. As a result, certain income and expense items are excluded from these measures in an effort to allow an effective analysis. With respect to expenses, we do not view certain operating expenses related to corporate activities, referred to as certain corporate expenses, as part of our underwriting activities. These expenses are generally comprised of non-recurring costs of the holding company, such as costs associated with the initial setup of subsidiaries, as well as costs associated with the ongoing operations of the holding company such as compensation of certain executives. The following are descriptions of each of the non-U.S. GAAP financial measures used by us.

Underwriting income (loss) is useful in evaluating our underwriting performance, without regard to other underwriting income (losses), net investment income (losses), interest expense, net foreign exchange gains (losses), income tax expenses and preference dividends.

Adjusted underwriting income (loss) is useful in evaluating our underwriting performance, without regard to net investment income (losses), interest expense, net foreign exchange gains (losses), income tax expenses, preference dividends and certain corporate expenses (which are described in more detail above). We define underwriting income (loss) as net premiums earned, less loss and loss adjustment expenses, acquisition expenses and general and administrative expenses, and we define adjusted underwriting income (loss) as underwriting income (loss) plus other underwriting income (loss) less certain corporate expenses. Our adjusted combined ratio is a key indicator of our profitability, without regard to certain corporate expenses. We calculate the adjusted combined ratio by dividing the sum of loss and loss adjustment expenses, acquisition expenses and general and administrative expenses less certain corporate expenses by the sum of net premiums earned and other underwriting income (loss).

The non-investment grade portfolio and investment grade portfolio components of our investment returns (net interest income yield on average net assets, and net investment income return on average net assets and on average total investments, respectively) are useful in evaluating our investment performance. The non-investment grade portfolio component of these investment returns reflect the performance of our investment strategy under HPS, which includes the use of leverage. The investment grade portfolio component of these investment returns reflect the performance of the investment portfolios that predominantly support our underwriting collateral.

We use underwriting income (loss), adjusted underwriting income (loss) and the adjusted combined ratio and the separate components of our returns (non-investment grade portfolio and investment grade portfolio) as internal performance measures in the management of our operations because we believe they give us and users of our financial information useful insight into our results of operations and our underlying business performance. Underwriting income (loss) and adjusted underwriting (income) loss should not be viewed as a substitute for net income (loss) calculated in accordance with U.S. GAAP, and our adjusted combined ratio should not be viewed as a substitute for our combined ratio. Furthermore, other companies may define these measures differently.

Reconciliation of underwriting income (loss) and adjusted underwriting income (loss)

Underwriting income (loss) reconciles to net income (loss) available to common shareholders, and adjusted underwriting income (loss) reconciles to underwriting income (loss) for the three and nine months ended September 30, 2019 and 2018 as follows:



	Three Months Ended September 30,						Nine Months Ended September 30,
	2019			2018			2019			2018
	($ in thousands)
Net income (loss) available to common shareholders	$	152		$	18,837		$	61,609		$	40,743
Preference dividends	2,608			4,909			12,423			14,724
Accelerated amortization of costs related to the redemption of preference shares	4,164			—			4,164			—
Net income (loss) before dividends and redemption costs	6,924			23,746			78,196			55,467
Income tax expense	—			—			20			27
Interest expense	2,841			—			2,841			—
Net foreign exchange (gains) losses	(167		)	(2,582		)	711			(1,847		)
Net investment (income) loss	(14,040		)	(21,373		)	(96,181		)	(54,735		)
Other underwriting (income) loss	(579		)	(703		)	(1,844		)	(2,092		)
Underwriting income (loss)	(5,021		)	(912		)	(16,257		)	(3,180		)
Certain corporate expenses	2,172			947			8,930			3,100
Other underwriting income (loss)	579			703			1,844			2,092
Adjusted underwriting income (loss)	$	(2,270	)	$	738		$	(5,483	)	$	2,012

Reconciliation of the adjusted combined ratio

The adjusted combined ratio reconciles to the combined ratio for the three and nine months ended September 30, 2019 and 2018 as follows:



	Three Months Ended September 30,
	2019									2018
	Amount			Adjustment			As Adjusted			Amount			Adjustment			As Adjusted
	($ in thousands)
Losses and loss adjustment expenses	$	96,214		$	—		$	96,214		$	96,957		$	—		$	96,957
Acquisition expenses	27,612			—			27,612			33,778			—			33,778
General & administrative expenses (1)	7,027			(2,172		)	4,855			5,801			(947		)	4,854
Net premiums earned (1)(2)	125,832			579			126,411			135,624			703			136,327

Loss ratio	76.5		%							71.5		%
Acquisition expense ratio	21.9		%							24.9		%
General & administrative expense ratio (1)	5.6		%							4.3		%
Combined ratio	104.0		%							100.7		%
Adjusted loss ratio							76.1		%							71.1		%
Adjusted acquisition expense ratio							21.8		%							24.8		%
Adjusted general & administrative expense ratio							3.9		%							3.6		%
Adjusted combined ratio							101.8		%							99.5		%

(1) Adjustments include certain corporate expenses, which are deducted from general and administrative expenses, and other underwriting income (loss), which is added to net premiums earned.

(2) The adjustment to net premiums earned relates to “other underwriting income” from underwriting contracts accounted for as derivatives.



	Nine Months Ended September 30,
	2019									2018
	Amount			Adjustment			As Adjusted			Amount			Adjustment			As Adjusted
	($ in thousands)
Losses and loss adjustment expenses	$	318,480		$	—		$	318,480		$	312,087		$	—		$	312,087
Acquisition expenses	97,003			—			97,003			106,708			—			106,708
General & administrative expenses (1)	24,018			(8,930		)	15,088			16,274			(3,100		)	13,174
Net premiums earned (1)(2)	423,244			1,844			425,088			431,889			2,092			433,981

Loss ratio	75.2		%							72.3		%
Acquisition expense ratio	22.9		%							24.7		%
General & administrative expense ratio (1)	5.7		%							3.8		%
Combined ratio	103.8		%							100.8		%
Adjusted loss ratio							74.9		%							71.9		%
Adjusted acquisition expense ratio							22.8		%							24.6		%
Adjusted general & administrative expense ratio							3.6		%							3.0		%
Adjusted combined ratio							101.3		%							99.5		%

(1) Adjustments include certain corporate expenses, which are deducted from general and administrative expenses, and other underwriting income (loss), which is added to net premiums earned.

(2) The adjustment to net premiums earned relates to “other underwriting income” from underwriting contracts accounted for as derivatives.

Reconciliation of the non-investment grade portfolio and investment grade portfolio components of our investment returns

The non-investment grade portfolio and the investment grade portfolio components of our investment returns for the three and nine months ended September 30, 2019 and 2018 are as follows:



	Three Months Ended September 30, 2019												Three Months Ended September 30, 2018
	Non-Investment Grade			Investment Grade			Cost of U/W Collateral (4)			Total			Non-Investment Grade			Investment Grade			Cost of U/W Collateral (4)			Total
	($ in thousands)
Interest income	$	35,014		$	6,362		$	—		$	41,376		$	34,338		$	4,366		$	—		$	38,704
Investment management fees - related parties	(4,204		)	(402		)	—			(4,606		)	(4,008		)	(306		)	—			(4,314		)
Borrowing and miscellaneous other investment expenses	(3,573		)	(225		)	(3,436		)	(7,234		)	(4,050		)	(80		)	(2,863		)	(6,993		)
Net interest income	27,237			5,735			(3,436		)	29,536			26,280			3,980			(2,863		)	27,397
Net realized gains (losses) on investments	(750		)	1,395			—			645			4,095			(91		)	—			4,004
Net unrealized gains (losses) on investments (1)	(15,668		)	377			—			(15,291		)	(7,129		)	(492		)	—			(7,621		)
Investment performance fees - related parties	(850		)	—			—			(850		)	(2,407		)	—			—			(2,407		)
Net investment income (loss)	$	9,969		$	7,507		$	(3,436	)	$	14,040		$	20,839		$	3,397		$	(2,863	)	$	21,373

Average total investments (2)	$1,854,911			$915,081			$	—		$2,769,992			$1,924,657			$827,085			$	—		$2,751,742
Average net assets (3)	$1,586,134			$915,632			$(328,751)			$2,173,015			$1,501,942			$827,058			$(295,647)			$2,033,353

Net interest income yield on average net assets (3)	1.7		%	0.6		%				1.4		%	1.7		%	0.5		%				1.3		%
Net investment income return on average total investments (2)	0.5		%	0.8		%				0.5		%	1.1		%	0.4		%				0.8		%
Net investment income return on average net assets (3)	0.6		%	0.8		%	(1.0		)%	0.6		%	1.4		%	0.4		%	(1.0		)%	1.1		%

(1) Net unrealized gains (losses) on investments excludes unrealized gains and losses from the available for sale portfolios, which are recorded in other comprehensive income.

(2) Net investment income return on average total investments is calculated by dividing net investment income by average total investments. For the three-month period, average total investments is calculated using the average of the beginning and ending balance of each quarterly period. However, for the investment grade portfolio component of these returns, the impact of revolving credit agreement borrowings is not subtracted from net investment income.

(3) Net interest income yield on average net assets and net investment income return on average net assets are calculated by dividing net interest income, and net investment income (loss), respectively, by average net assets. For the non-investment grade component of investment returns and total investment returns, net assets is calculated as the sum of total investments, accrued investment income and receivables for securities sold, less total revolving credit agreement borrowings, payable for securities purchased and payable for securities sold short. However, for the investment grade portfolio component of these returns, the impact of the revolving credit agreement borrowings is not subtracted from net interest income, net investment income (loss), or the net assets calculation.

(4) The cost of underwriting collateral is calculated as the revolving credit agreement expenses for the investment grade portfolios divided by the average total revolving credit agreement borrowings for the investment grade portfolios during the period.



	Nine Months Ended September 30, 2019												Nine Months Ended September 30, 2018
	Non-Investment Grade			Investment Grade			Cost of U/W Collateral (4)			Total			Non-Investment Grade			Investment Grade			Cost of U/W Collateral (4)			Total
	($ in thousands)
Interest income	$	104,845		$	18,268		$	—		$	123,113		$	97,594		$	12,236		$	—		$	109,830
Investment management fees - related parties	(12,446		)	(1,139		)	—			(13,585		)	(11,728		)	(888		)	—			(12,616		)
Borrowing and miscellaneous other investment expenses	(12,240		)	(667		)	(10,236		)	(23,143		)	(11,575		)	(274		)	(7,787		)	(19,636		)
Net interest income	80,159			16,462			(10,236		)	86,385			74,291			11,074			(7,787		)	77,578
Net realized gains (losses) on investments	392			2,324			—			2,716			(5,198		)	(4,189		)	—			(9,387		)
Net unrealized gains (losses) on investments (1)	7,446			7,976			—			15,422			(560		)	(6,290		)	—			(6,850		)
Investment performance fees - related parties	(8,342		)	—			—			(8,342		)	(6,606		)	—			—			(6,606		)
Net investment income (loss)	$	79,655		$	26,762		$	(10,236	)	$	96,181		$	61,927		$	595		$	(7,787	)	$	54,735

Average total investments (2)	$1,874,014			$910,784			$	—		$2,784,798			$1,833,711			$799,012			$	—		$2,632,723
Average net assets (3)	$1,546,871			$909,169			$(324,452)			$2,131,588			$1,465,589			$801,481			$(282,191)			$1,984,879

Net interest income yield on average net assets (3)	5.2		%	1.8		%				4.1		%	5.1		%	1.4		%				3.9		%
Net investment income return on average total investments (2)	4.3		%	2.9		%				3.5		%	3.4		%	0.1		%				2.1		%
Net investment income return on average net assets (3)	5.1		%	2.9		%	(3.2		)%	4.5		%	4.2		%	0.1		%	(2.8		)%	2.8		%

(1) Net unrealized gains (losses) on investments excludes unrealized gains and losses from the available for sale portfolios, which are recorded in other comprehensive income.

(2) Net investment income return on average total investments is calculated by dividing net investment income by average total investments. For the nine-month period, average total investments is calculated using the average of the beginning and ending balance of each quarterly period. However, for the investment grade portfolio component of these returns, the impact of revolving credit agreement borrowings is not subtracted from net investment income.



	As of September 30, 2019												As of September 30, 2018
	Non-Investment Grade			Investment Grade			Borrowings for U/W Collateral			Total			Non-Investment Grade			Investment Grade			Borrowings for U/W Collateral			Total
	($ in thousands)
Average total investments - QTD	$	1,854,911		$	915,081		$	—		$	2,769,992		$	1,924,657		$	827,085		$	—		$	2,751,742
Average total investments - YTD	1,874,014			910,784			—			2,784,798			1,833,711			799,012			—			2,632,723

Average net assets - QTD	1,586,134			915,632			(328,751		)	2,173,015			1,501,942			827,058			(295,647		)	2,033,353
Average net assets - YTD	1,546,871			909,169			(324,452		)	2,131,588			1,465,589			801,481			(282,191		)	1,984,879

Total investments	$	1,876,346		$	893,532		$	—		$	2,769,878		$	1,928,336		$	847,644		$	—		$	2,775,980
Accrued Investment Income	13,805			4,472			—			18,277			14,082			3,568			—			17,650
Receivable for Securities Sold	25,274			9			—			25,283			35,956			197			—			36,153
Less: Payable for Securities Purchased	36,870			3,716			—			40,586			127,708			7,982			—			135,690
Less: Payable for Securities Sold Short	65,736			—			—			65,736			9,288			—			—			9,288
Less: Revolving credit agreement borrowings	190,447			—			328,750			519,197			322,455			—			301,487			623,942
Net assets	$	1,622,372		$	894,297		$	(328,750	)	$	2,187,919		$	1,518,923		$	843,427		$	(301,487	)	$	2,060,863
Non-investment grade borrowing ratio (1)	11.7		%										21.2		%

Unrealized gains on investments	$	34,794		$	11,399		$	—		$	46,193		$	49,208		$	117		$	—		$	49,325
Unrealized losses on investments	(131,453		)	(9,534		)	—			(140,987		)	(49,227		)	(15,614		)	—			(64,841		)
Net unrealized gains (losses) on investments	$	(96,659	)	$	1,865		$	—		$	(94,794	)	$	(19	)	$	(15,497	)	$	—		$	(15,516	)

(1) The non-investment grade borrowing ratio is calculated as revolving credit agreement borrowings divided by net assets.

Critical accounting policies, estimates and recent accounting pronouncements

The preparation of consolidated financial statements in accordance with GAAP requires us to make many estimates and judgments that affect the reported amounts of assets, liabilities (including reserves), revenues and expenses, and related disclosures of contingent liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, insurance and other reserves, reinsurance recoverables and fair value measurements. We base our estimates on historical experience, where possible, and on various other assumptions that we believe to be reasonable under the circumstances, which form the basis for our judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Estimates and judgments for a relatively new company, like our company, are even more difficult to make than those made in a mature company since we have relatively limited historical information through September 30, 2019. Actual results will differ from these estimates and such differences may be material.

The critical accounting policies that we believe affect significant estimates used in the preparation of our consolidated financial statements, as well as certain recent accounting pronouncements, are discussed under the heading “Management’s discussion and analysis of financial condition and results of operations-Critical accounting policies, estimates and recent accounting pronouncements” beginning on page 119 of our prospectus dated March 26, 2019 related to the direct listing of our common shares on the Nasdaq Global Select Market. The information included under that heading has been updated, where applicable, in the notes accompanying our consolidated financial statements included elsewhere in this report, including Note 2, “Basis of presentation and significant accounting policies”. A copy of our prospectus, which was filed with the SEC in accordance with Rule 424(b) of the Securities Act of 1933, as amended, or the Securities Act, on March 28, 2019, is accessible on the SEC’s website at www.sec.gov.

Financial condition, liquidity and capital resources

General

We are a holding company whose assets primarily consist of the shares in our subsidiaries. Generally, we depend on our available cash resources, dividends or other distributions from subsidiaries to make payments, including the payment of dividends on our preference shares and operating expenses we may incur. During the nine months ended September 30, 2019 and the year ended December 31, 2018, we received dividends of $12.2 million and $19.3 million, respectively, from Watford Re, our Bermuda operating subsidiary.

The ability of our regulated operating subsidiaries to pay dividends or make distributions is dependent on their ability to meet applicable regulatory standards. Under Bermuda law, Watford Re is required to maintain an enhanced capital requirement, or ECR, which must equal or exceed its minimum solvency margin (in other words, the amount by which the value of its general business assets must exceed its general business liabilities). Watford Re is also required to maintain a minimum liquidity ratio whereby the value of its relevant assets is not less than 75% of the amount of its relevant liabilities for general business. Watford Re is prohibited from declaring or paying any dividends during any financial year if it is not in compliance with each of its ECR, minimum solvency margin and minimum liquidity ratio. In any financial year, Watford Re is prohibited from declaring or paying 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, or the BMA, an affidavit attesting that a dividend would not cause Watford Re to fail to meet its relevant margins. As of December 31, 2018, as determined under Bermuda law, Watford Re had a statutory capital and surplus of $1.1 billion and was in compliance with its ECR, minimum solvency margin and minimum liquidity ratio. Accordingly, Watford Re should be permitted to pay dividends of up to $278.7 million to us during 2019 without the requirement of filing such an affidavit with the BMA. In addition, Watford Re is

prohibited, without prior approval of the BMA, from reducing by 15% or more its total statutory capital, as set out in its previous year’s statutory financial statements.

Our U.S. and Gibraltar insurance subsidiaries are subject to similar insurance laws and regulations in the jurisdictions in which they operate. The ability of these insurance subsidiaries to pay dividends or make distributions is also dependent on their ability to meet applicable regulatory standards.

Furthermore, the ability of our operating subsidiaries to pay dividends to us and to intermediate subsidiaries owned by us 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 operating subsidiaries. We believe that we have sufficient cash resources and available dividend capacity to pay required dividends on our preference shares, service our indebtedness and satisfy other current outstanding obligations.

Financial condition

Shareholders’ equity

2019 versus 2018: Total shareholders’ equity was $960.8 million as of September 30, 2019, compared to $889.6 million as of December 31, 2018, an increase of $71.2 million or 8.0%.

The increase in shareholders’ equity was primarily driven by net investment income of $96.2 million, other comprehensive income of $7.0 million and other underwriting income of $1.8 million, offset in part by an underwriting loss of $16.3 million, preference dividends of $12.4 million, accelerated amortization of costs related to the redemption of preference shares of $4.2 million and an interest expense of $2.8 million.

Investment portfolios



	Credit Rating (1)
September 30, 2019	Fair Value		AAA		AA		A		BBB		BB		B		CCC		CC		D		Not Rated
	($ in thousands)
Term loan investments	$	1,040,983	$	—	$	—	$	—	$	—	$	16,766	$	683,504	$	274,946	$	2,502	$	—	$	63,265
Fixed maturities:
Corporate bonds	434,101		—		34,645		69,062		52,038		15,507		59,544		171,951		—		—		31,354
U.S. government and government agency bonds	298,447		—		298,447		—		—		—		—		—		—		—		—
Asset-backed securities	339,673		2,894		—		31,636		214,387		34,789		18,659		—		—		—		37,308
Mortgage-backed securities	31,318		—		—		—		22,505		1,123		—		—		—		2,800		4,890
Non-U.S. government and government agency bonds	135,579		2,498		133,081		—		—		—		—		—		—		—		—
Municipal government and government agency bonds	2,190		1,142		572		476		—		—		—		—		—		—		—
Total fixed income instruments	2,282,291		6,534		466,745		101,174		288,930		68,185		761,707		446,897		2,502		2,800		136,817
Short-term investments	357,611		15,300		187,484		36,413		109,865		—		—		3,037		—		—		5,512
Total fixed income instruments and short-term investments	2,639,902		21,834		654,229		137,587		398,795		68,185		761,707		449,934		2,502		2,800		142,329
Other Investments	29,583
Equities	100,393
Total	$	2,769,878	$	21,834	$	654,229	$	137,587	$	398,795	$	68,185	$	761,707	$	449,934	$	2,502	$	2,800	$	142,329



	Credit Rating (1)
December 31, 2018	Fair Value		AAA		AA		A		BBB		BB		B		CCC		CC		C		D		Not Rated
	($ in thousands)
Term loan investments	$	1,000,652	$	—	$	—	$	—	$	—	$	57,844	$	677,211	$	201,116	$	2,438	$	—	$	—	$	62,043
Fixed maturities:
Corporate bonds	654,607		3,961		58,185		100,590		63,791		15,246		174,867		203,505		—		2,200		—		32,262
U.S. government and government agency bonds	268,675		—		268,675		—		—		—		—		—		—		—		—		—
Asset-backed securities	225,983		4,532		4,973		10,278		113,075		36,643		20,818		—		—		—		—		35,664
Mortgage-backed securities	22,161		—		—		944		13,336		742		—		—		—		—		2,962		4,177
Non-U.S. government and government agency bonds	136,513		5,173		122,715		8,625		—		—		—		—		—		—		—		—
Municipal government and government agency bonds	8,231		6,490		715		1,026		—		—		—		—		—		—		—		—
Total fixed income instruments	2,316,822		20,156		455,263		121,463		190,202		110,475		872,896		404,621		2,438		2,200		2,962		134,146
Short-term investments	282,132		4,450		128,015		54,970		68,853		—		25,844		—		—		—		—		—
Total fixed income instruments and short-term investments	2,598,954		24,606		583,278		176,433		259,055		110,475		898,740		404,621		2,438		2,200		2,962		134,146
Other Investments	49,762
Equities	89,651
Total	$	2,738,367	$	24,606	$	583,278	$	176,433	$	259,055	$	110,475	$	898,740	$	404,621	$	2,438	$	2,200	$	2,962	$	134,146

The amortized cost and fair value of our term loans, fixed maturities and short-term investments summarized by contractual maturity as of September 30, 2019 and December 31, 2018 were as follows:



	Amortized Cost		Fair Value		% of Fair Value
	($ in thousands)
September 30, 2019
Due in one year or less	$	344,191	$	341,747	12.9	%
Due after one year through five years	1,199,926		1,154,443		43.7	%
Due after five years through ten years	735,861		703,797		26.7	%
Due after ten years	70,275		68,924		2.6	%
Asset-backed securities	347,881		339,673		12.9	%
Mortgage-backed securities	30,168		31,318		1.2	%
Total	$	2,728,302	$	2,639,902	100.0	%

December 31, 2018
Due in one year or less	$	300,554	$	300,519	11.6	%
Due after one year through five years	1,322,982		1,269,540		48.8	%
Due after five years through ten years	823,643		776,937		29.9	%
Due after ten years	3,925		3,814		0.1	%
Asset-backed securities	233,215		225,983		8.7	%
Mortgage-backed securities	23,466		22,161		0.9	%
Total	$	2,707,785	$	2,598,954	100.0	%

Actual maturities may differ from contractual maturities because some borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

The following chart shows the composition of our non-investment grade and investment grade portfolios as of September 30, 2019:

Total: $1,876.3 million

Total: $893.5 million

Liquidity and capital resources

Cash flows

Liquidity is a measure of our ability to access sufficient cash flows to meet the short-term and long-term cash requirements of our business operations. Our most significant source of operating cash flow is from premiums received from our insureds and reinsureds. Our underwriting operations provide liquidity in that premiums are received in advance, sometimes substantially in advance, of the time losses are paid. The period of time from the occurrence of a claim through the settlement of the resulting liability may extend many years into the future. We expect that our liquidity needs, including our anticipated insurance and reinsurance obligations and operating and capital expenditure needs, for at least the next twelve months, will be met by funds generated from underwriting activities and investment income, as well as by our balance of cash, short-term investments, proceeds on the sale or maturity of our investments, and our credit facilities.

Our most significant operating cash outflow is for claim payments. Because the payment of claims occurs after the receipt of the premium, often years later, we invest the cash in various fixed income investments that earn interest. We also use cash to pay commissions to brokers, as well as to pay for ongoing operating expenses such as salaries, rent and taxes, interest expense on our senior notes and dividends on our preference shares. We have reinsurance agreements with Arch and others through which we cede a portion of our business. In purchasing reinsurance, we pay part of our premiums to reinsurers and collect cash back when our reinsurers reimburse us for losses subject to our reinsurance coverage.

The timing of our cash flows from operating activities can vary among periods due to the timing by which payments are made or received. Some of our payments and receipts, including loss settlements and subsequent reinsurance receipts, can be significant, so their timing can influence cash flows from operating activities in any given period.

Sources of liquidity include cash flows from operations, financing arrangements, or routine sales of investments. The following table summarizes our cash flows from operating, investing and financing activities for the nine months ended September 30, 2019 and 2018:



	Nine Months Ended September 30,
	2019			2018
	($ in thousands)
Cash and cash equivalents provided by (used for):
Operating activities	$	177,182		$	174,287
Investing activities	28,485			(224,266		)
Financing activities	(187,453		)	61,917
Effects of exchange rate changes on foreign currency	(1,353		)	(1,757		)
Change in cash and cash equivalents	$	16,861		$	10,181

Results for the nine months ended September 30, 2019:


•	Cash provided by operating activities for the nine months ended September 30, 2019 increased from the same period in 2018. We continued to generate significant operating cash inflows, primarily driven by our premium receipts exceeding the level of our paid claims and interest income received.


•	Cash provided by investing activities for the nine months ended September 30, 2019 was higher than the comparative period in the 2018 period when cash was used for investing activities, due to an increase in sales, redemptions and maturities of investments in the 2019 period, rather than higher net purchases in the 2018 period.

•

Cash used for financing activities for the nine months ended September 30, 2019 was due to higher borrowing repayments during the 2019 period and lower withdrawals of borrowings, rather than cash provided by higher net proceeds from borrowings in the same period for 2018. The cash proceeds from the issuance of our senior notes were used to repurchase a portion of our preference shares, resulting in a net impact that was immaterial to our cash flows.

Our investments in certain securities may be illiquid due to contractual provisions or investment market conditions. Changes in general economic conditions could have a material adverse effect on the value and liquidity of securities in our investment portfolios. If we require significant amounts of cash on short notice in excess of anticipated cash requirements, we may have difficulty selling these investments in a timely manner or may be forced to sell or otherwise liquidate them at unfavorable values.

The primary goals of our asset liability management process are to satisfy insurance liabilities and maintain sufficient liquidity to cover fluctuations in projected liability cash flows, including payment of dividends on our preference shares and other debt service obligations. We do not explicitly implement an exact cash flow match in each period. However the substantial degree by which the fair value of our investment portfolios exceeds the expected present value of the net underwriting liabilities, as well as the ongoing cash flow from premiums and contractual principal and interest payments received from our investment portfolios, provide assurance of our ability to fund the payment of claims and to service our other outstanding obligations without having to sell securities at distressed prices. We believe that, generally, the combination of premium receipts and the expected principal and interest payments produced by our predominantly fixed income investment portfolios will adequately fund future claim payments and other liabilities when due.

Capital resources

In addition to the common shares and preference shares we issued in our initial funding, we have entered into credit facilities to support our business operations. Further, in July 2019, we issued our

senior notes and used the net proceeds from the issuance to redeem 76.34% of our then outstanding preference shares, as described in more detail below. We believe that we hold sufficient capital to allow us to take advantage of market opportunities and to maintain our financial strength ratings, as well as to comply with all applicable statutory regulations.

We monitor our capital adequacy on a regular basis and will seek to adjust our capital base (up or down) according to the needs of our business. As part of our capital management program, we may seek to raise additional capital or may seek to return capital to our shareholders through share repurchases, cash dividends or other methods (or a combination of such methods). Any such determination will be at the discretion of our board of directors and will be dependent upon our profits, financial requirements and other factors, including legal restrictions, rating agency requirements and such other factors as our board of directors deems relevant. Our board of directors has authorized a share repurchase program under which we may repurchase up to $75 million of our outstanding common shares from time to time. Any such repurchases will be in accordance with applicable laws, our organizational documents and the applicable terms of our outstanding securities. We commenced repurchasing common shares under this program on September 30, 2019. Other than pursuant to this share repurchase program, at the present time, we do not expect to repurchase common shares, declare or pay dividends on our common shares or otherwise return capital to our common shareholders for the foreseeable future.

The following table summarizes our consolidated capital position:



	September 30, 2019				December 31, 2018
	Amount		% of Total Capital		Amount		% of Total Capital
	($ in thousands)
Debt:
Senior notes	$	172,350	14.5	%	$	—	—	%
Shareholders’ equity:
Preference shares	52,281		4.4	%	220,992		19.9	%
Shareholders’ equity	960,773		81.1	%	889,608		80.1	%
Total	1,013,054		85.5	%	1,110,600		100.0	%
Total capital available to Watford	$	1,185,404	100.0	%	$	1,110,600	100.0	%

The future capital requirements of our business will depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses. Our ability to underwrite is largely dependent upon the quality of our claims paying and financial strength ratings as evaluated by independent rating agencies. In particular, we require (1) sufficient capital to maintain our financial strength ratings, as issued by ratings agencies, at a level considered necessary by management to enable our key operating subsidiaries to compete; (2) sufficient capital to enable our underwriting subsidiaries to meet the capital adequacy tests mandated by regulatory agencies in Bermuda, the United States and other key markets; and (3) sufficient letter of credit and other credit facilities to enable Watford Re to post regulatory and commercially required letters of credit and other forms of collateral that are necessary for it to write business.

To the extent that our existing capital is insufficient to fund our future operating requirements or maintain such ratings, we may need to raise additional funds through financings or limit our growth. However, we can provide no assurance that, if needed, we would be able to obtain additional funds through financing on satisfactory terms or at all. Adverse developments in the financial markets, such as disruptions, uncertainty or volatility in the capital and credit markets may result in realized and unrealized capital losses that could have a material adverse effect on our

results of operations, financial position and our businesses, and may also limit our access to capital required to operate our business.

If we are not able to obtain adequate capital, our business, results of operations and financial condition could be adversely affected, which could include, among other things, the following possible outcomes: (1) potential downgrades in the financial strength ratings assigned by ratings agencies to our operating subsidiaries, which could place those operating subsidiaries at a competitive disadvantage compared to higher-rated competitors; (2) reductions in the amount of business that our operating subsidiaries are able to write in order to meet capital adequacy-based tests enforced by regulatory agencies; and (3) any resultant ratings downgrades could, among other things, affect our ability to write business and increase the cost of bank credit and letters of credit. In addition, under certain of the reinsurance agreements assumed by our reinsurance operations, upon the occurrence of a ratings downgrade or other specified triggering event with respect to our reinsurance operations, such as a reduction in surplus by specified amounts during specified periods, our ceding company clients may be provided with certain rights, including, among other things, the right to terminate the subject reinsurance agreement and/or to require that our reinsurance operations post additional collateral.

Prior to August 1, 2019, we had a total of 9,065,200 preference shares that were issued and outstanding and, on August 1, 2019 we redeemed 76.34% of these preference shares as described below. The holders of our remaining preference shares have the option, at any time on or after June 30, 2034, to redeem their preference shares at the liquidation price of $25.00 per share. We have the right to redeem any or all of our remaining preference shares at the original purchase price of $25.00 per share. On June 28, 2019, we completed a direct listing of our preference shares on the Nasdaq Global Select Market. Prior to June 30, 2019, dividends on our preference shares accrued at a fixed rate of 8½% per annum. On June 30, 2019, dividends on our preference shares began accruing at a floating rate. As noted above, on August 1, 2019, we redeemed 6,919,998 of our then outstanding preference shares. The preference shares were redeemed at a total redemption price of $25.19748 per share, inclusive of all declared and unpaid dividends, with accumulation of any undeclared dividends on or after June 30, 2019.

In relation to the partial redemption of the preference shares, an accelerated expense for the unamortized original issue discount and underwriting fees of approximately $4.2 million was recognized in the 2019 third quarter.

On July 2, 2019, we completed a private offering of $175.0 million in aggregate principal amount of our 6.5% senior notes due July 2, 2029. Interest on our senior notes will be paid semi-annually in arrears on each January 2 and July 2, commencing January 2, 2020. Affiliates of Arch Capital Group Ltd. purchased $35.0 million in aggregate principal amount of our senior notes. The $172.3 million net proceeds from the offering were used to redeem a portion of our outstanding preference shares, as described above.

As a result of the issuance of our senior notes and the redemption of our preference shares, we expect to incur interest expenses and a reduction of preference dividends in future periods, with the cumulative effect resulting in substantial savings in our combined interest and preference dividend expense.

In addition to the capital provided by the sale of our common shares, preference shares and senior notes, we may depend on external sources of finance to support our underwriting activities, such as bank credit facilities providing loans and/or letters of credit, as well as additional note issuances. As noted above, additional equity or debt financing, if available at all, may be on terms that are unfavorable to us. In the case of equity financings, dilution to our shareholders could result, and, in any case, such securities might have rights, preferences and privileges that are senior to those of our outstanding securities.

Ratings

Our operating subsidiaries, Watford Re, WICE, WIC and WSIC, each carry a financial strength rating of “A-” (Excellent) from A.M. Best Company, or A.M. Best. A.M. Best assigns 16 ratings to insurance companies, which currently range from “A++” (Superior) to “F” (In Liquidation). “A-” (Excellent) is the fourth highest rating issued by A.M. Best. The “A-” (Excellent) rating is assigned to insurers that have, in A.M. Best’s opinion, an excellent ability to meet their ongoing obligations to policyholders. Each of our operating subsidiaries also carries a financial strength rating of “A” from KBRA. KBRA assigns 22 ratings to insurance companies, which currently range from “AAA” to “D”. The “A” rating, KBRA’s sixth highest rating category, is assigned to insurers for which, in KBRA’s opinion, the insurer’s financial condition is sound and the entity is likely to meet its policyholder obligations under difficult economic, financial and business conditions. These respective ratings are intended to provide an independent opinion of an insurer’s ability to meet its obligation to policyholders and neither is an evaluation directed at investors.

The financial strength ratings assigned by A.M. Best and KBRA, respectively, have an impact on the ability of Watford Re to attract reinsurance clients, and also on the ability of our insurance subsidiaries to attract and retain program administrators, agents, brokers and insureds. The A.M. Best “A-” (Excellent) rating and KBRA “A” rating obtained by Watford Re, WICE, WIC, and WSIC are each consistent with our business plan and allow us to actively pursue relationships with the types of cedents, program administrators, agents, brokers and insureds targeted in our marketing plan.

Underwriting, natural and man-made catastrophic events

The broader P&C insurance and reinsurance market in which we operate has long been subject to market cycles. “Soft” markets occur when the supply of insurance capital in a given market or territory is greater than the amount of insurance capital necessary to meet the coverage needs of the insureds in that market. When this occurs, insurance prices tend to decline and policy terms and conditions become more favorable to the insured. Conversely, there are periods when there is not enough insurance capital in the market to meet insureds’ needs, leading to a “hard” market during which insurance prices generally rise and policy terms and conditions become more favorable to the insurer.

The current insurance and reinsurance market environment is extremely competitive and reflects a prolonged period of low prices and continued pressure to broaden terms and conditions, although the 2017 and 2018 global catastrophe events seem to have partially dampened this downward pricing pressure. While the insurance and reinsurance market historically has been subject to pricing and capacity cycles, the overall market has not experienced true cyclicality in the period since the inception of our operations in 2014. Over the past several years, the industry has witnessed a gradual rate softening in response to a surplus of industry capital and a number of years of benign catastrophe activity; this market dynamic has led to reduced underwriting profitability. However, due to the hurricane, wildfire and earthquake activity over the past two years, pricing on certain product lines appears to be firming and becoming more attractive on a risk-adjusted basis.

There have recently, however, been certain product lines that have experienced a favorable hardening, such as European motor insurance. The rates for these particular lines have been rising as a result of several years of higher than expected losses, as well as regulatory changes impacting loss costs. As rates and commensurate risk-adjusted returns have risen, we have increased our writings in those lines.

Since the formation of WICE, we have grown our European motor insurance business. Gross premiums written generated by WICE for the three months ended September 30, 2019 and 2018 were $51.2 million and $46.4 million, respectively. Gross premiums written generated by WICE for the nine months ended September 30, 2019 and 2018 were $162.1 million and $137.2 million, respectively. The majority of such premiums relate to European motor insurance.

In addition, certain “new” product lines, such as mortgage reinsurance (having historically been written by captive insurers allied with primary mortgage insurers or mortgage lenders), are now more widely available due to risk transfer programs initiated over the past few years by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. We believe the pricing for mortgage reinsurance is attractive on a risk-adjusted basis and have increased our writings as a result.

We target a medium- to long-term, lower volatility underwriting portfolio with tightly managed natural catastrophe exposure in order to reduce the likelihood that our capital and/or liquidity position would be adversely affected by a catastrophe event. We seek to limit our modeled net probable maximum loss, or PML, for property catastrophe exposures for each peak peril and peak zone from a modeled 1-in-250 year occurrence to no more than 10% of our total capital, which is less than most of our principal reinsurance competitors. As of September 30, 2019, our largest modeled peak peril and zone net occurrence PML was 3.2%, respectively, of our total capital. Our conscious effort to limit our catastrophe exposure is designed to lower the volatility of our overall underwriting portfolio and to provide greater certainty as to future claims-related payout patterns and timing. Our casualty-focused underwriting portfolio’s payout pattern is slower than that of most competitors due to the longer tail lines of business we write, and that slower payout pattern provides us with the potential for greater investment income on those premiums.

While we seek to limit our exposure to catastrophic events to a level we believe is acceptable, given the liquidity profile of our underwriting portfolio and investment portfolios, we do assume meaningful aggregate exposures to natural and man-made catastrophic events. Catastrophes can be caused by various events, including hurricanes, floods, windstorms, earthquakes, hailstorms, tornadoes, explosions, severe winter weather, fires, droughts and other natural disasters. Catastrophes can also cause losses in non-property business such as workers’ compensation or general liability. In addition to the general nature of the risks inherent in writing property business, we believe that economic and geographic trends affecting insured property, including inflation, property value appreciation and geographic concentration, tend to generally increase the size of losses from catastrophic events over time.

We monitor our exposure to catastrophic events, including earthquake and wind and periodically reevaluate the estimated PML for such exposures. Our estimated PML is determined through the use of modeling techniques, but such estimate does not represent our total potential loss for such exposures. Net PML estimates are net of expected reinsurance recoveries, before income tax and before excess reinsurance reinstatement premiums. Such modeled loss estimates are reflective of the zone indicated and not the entire portfolio. Since hurricanes and windstorms can affect more than one zone and make multiple landfalls, our loss estimates include clash estimates from other zones. Our loss estimates do not represent our maximum exposures and it is highly likely that our actual incurred losses would vary materially from the modeled estimates. There can be no assurances that we will not suffer pre-tax losses greater than 10% of total capital from one or more catastrophic events due to several factors, including the inherent uncertainties in estimating the frequency and severity of such events and the margin of error in making such determinations resulting from potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques and the application of such techniques or as a result of a decision to change the percentage of shareholders’ equity exposed to a single catastrophic event. In addition, our actual losses may increase if our reinsurers fail to meet their obligations to us or the reinsurance protections purchased by us are exhausted or are otherwise unavailable. Depending on business opportunities and the mix of business that may comprise our underwriting portfolio, we may seek to adjust our self-imposed limitations on PML for catastrophe-exposed business.

Contractual obligations and commitments

Lloyds letter of credit facility

On May 14, 2019, Watford Re renewed its letter of credit facility with Lloyds Bank Corporate Markets Plc, New York Branch (the “Lloyds Facility”). The Lloyds Facility amount is $100.0 million and was renewed through to May 16, 2020. Under the renewed Lloyds Facility, we may request an increase in the facility amount, up to an aggregate of $50.0 million. The principal purpose of the Lloyds 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 to ensure that such counterparties are permitted to take credit for reinsurance obtained from us as required under insurance regulations in the United States. The amount of letters of credit issued is driven by, among other things, the timing and payment of catastrophe losses, loss development of existing reserves, the payment pattern of such reserves, the further expansion of our business and the loss experience of such business. When issued, the letters of credit are secured by certificates of deposit or cash. In addition, the Lloyds Facility also requires the maintenance of certain covenants, with which we were in compliance as of September 30, 2019 and December 31, 2018. At such dates, we had approximately $51.0 million and $68.9 million, respectively, in outstanding letters of credit issued from the Lloyds Facility, which were secured by certificates of deposit. These collateral amounts are reflected as short-term investments in our consolidated balance sheets.

Unsecured letter of credit facility

On September 20, 2019, Watford Re signed a 364-day letter of credit agreement with Lloyds Bank Corporate Markets Plc and BMO Capital Markets Corp., (the “Unsecured Facility”). The Unsecured Facility amount is $100.0 million, and will be automatically extended for a period of one year unless canceled or not renewed by either counterparty prior to expiration. The principal purpose of the Unsecured 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 to ensure that such counterparties are permitted to take credit for reinsurance obtained from us as required under insurance regulations in the United States. The amount of letters of credit issued is driven by, among other things, the timing and payment of catastrophe losses, loss development of existing reserves, the payment pattern of such reserves, the further expansion of our business and the loss experience of such business. When issued, the letters of credit are secured by certificates of deposit or cash. The Unsecured Facility also requires the maintenance of certain covenants, which we were in compliance with at September 30, 2019. In the Unsecured Facility, we make representations, warranties and covenants that are customary for facilities of this type, which we were in compliance with at September 30, 2019.

Bank of America secured credit facility

On November 30, 2017, Watford Re amended and restated its $800.0 million secured credit facility (the “Secured Facility”) with Bank of America, N.A. through Watford Trust, which had originally been entered into in June 2015. Watford Re owns all of the beneficial interests of Watford Trust. The facility expires on November 30, 2021 and is backed by a portion of Watford Re’s non-investment grade portfolio which has been transferred to Watford Trust and which continues to be managed by HPS pursuant to an investment management agreement between HPS and Watford Trust. The purpose of the facility is to provide borrowing capacity, including for the purchase of loans, securities and other assets and to distribute cash or any such loans, securities or other assets to Watford Re. Pursuant to this credit agreement, the bank assigns borrowing or letter of credit capacity (or “advance rate”) for each eligible asset type held in the trust. Under our credit agreement, advance rates range from 100% for cash and 80% for certain first-lien loans to 40% for certain small-issue unsecured bonds.

Borrowings on the facility may be made at LIBOR or an alternative base rate at our option, in either case plus an applicable margin. The applicable margin varies based on the applicable base rate and,

in the case of LIBOR rate borrowings, the currency in which the borrowing is denominated. In addition, the facility allows for us to issue up to $400.0 million in evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which we have entered into reinsurance arrangements. We pay a fee on each letter of credit equal to the amount available to be drawn under such letter of credit multiplied by an applicable percentage. The applicable percentage varies based on the currency in which the letter of credit is denominated.

The borrowings and outstanding letters of credit from the Secured Facility were as follows:



	September 30,		December 31,
	2019		2018
	($ in thousands)
Borrowings to purchase investments	$	161,969	$	148,194
Borrowings to purchase collateral	328,750		307,487
Total secured credit facility borrowings	490,719		455,681
Outstanding letters of credit	52,533		52,533

The Secured Facility contains various affirmative and negative covenants. As of September 30, 2019 and December 31, 2018, Watford Re was in compliance with all covenants contained in the Secured Facility.

Custodian bank facility

As of September 30, 2019 and December 31, 2018, we had borrowings of $28.5 million and $238.2 million, respectively, from our custodian bank to purchase USD denominated securities. As of December 31, 2018, the total borrowed amount of $238.2 million included 2.0 million Swiss Francs, or CHF (U.S. dollar equivalent of $2.0 million), to purchase CHF-denominated securities. We pay interest based on 3-month LIBOR plus a margin and the borrowed amount is payable upon demand. The foreign exchange gain or loss on revaluation on the borrowed Euro denominated funds is included as a component of foreign exchange gains (losses) included in the consolidated statements of net income (loss).

The custodian bank requires us to hold cash and investments on deposit or in an investment account with respect to the borrowed funds. As at September 30, 2019 and December 31, 2018, we were required to hold $40.6 million and $339.1 million, respectively, in such deposits and investment accounts.

Senior notes

On July 2, 2019, we completed a private offering of $175.0 million in aggregate principal amount of our 6.5% senior notes, due July 2, 2029. Interest on the senior notes will be paid semi-annually in arrears on each January 2 and July 2, commencing January 2, 2020. The senior notes are Watford Holding’s senior unsecured and unsubordinated obligations and rank equally with all of the other existing and future obligations of Watford Holdings that are unsecured and unsubordinated. We may redeem the senior notes at any time, in whole or in part, prior to July 2, 2024, at “make-whole” redemption price, subject to BMA requirements. The senior notes are redeemable, in whole or in part, at a redemption price equal to 100% of the principal amount, subject to BMA requirements, at any time after July 2, 2024. As at September 30, 2019, the carrying amount of the senior notes was $172.3 million, presented net of unamortized debt issuance costs of $2.7 million.

Master confirmation of total return swap transactions

On August 13, 2018, Watford Re executed a Master Confirmation of Total Return Swap Transactions, or the Master TRS, with Credit Suisse International, or CSI, under the ISDA Master Agreement between Watford Re and CSI dated as of April 24, 2014. Under the Master TRS, we can from time to

time execute total return swap transactions referencing loan obligations. The purpose of the Master TRS is to allow us to obtain leveraged exposure to loan obligations in a cash efficient manner. Since each transaction will be confirmed separately, the Master TRS is uncommitted and does not have a maximum facility size. Each confirmed transaction executed under the Master TRS will expire on the earlier of (i) the repayment date of the underlying reference loan or (ii) the date specified in the confirmation, which cannot be later than 360 days after the date of the confirmation, provided that each transaction will automatically extend for a further 360 days unless certain events have occurred. Under the terms of the Master TRS, we are required to post collateral to CSI under our ISDA Credit Support Annex with CSI to support our obligations under each transaction. The collateral will comprise an initial amount, determined on a transaction-by-transaction basis, plus an amount calculated on the basis of the daily mark-to-market value of the transaction. Under each transaction, CSI will pay to us an amount equal to the amounts received by a lender of the specified principal amount under the relevant reference loan and, if the transaction is terminated before the loan is repaid, an amount based on the change in market value of the loan. We have the option to terminate any transaction at will, subject to paying a break fee, and CSI can terminate transactions if certain events occur, including the unavailability of market prices for the relevant loan, CSI being unable to hedge the relevant transaction or certain changes of law or regulation.

Pledged and restricted assets

For the benefit of certain Arch entities and other third parties that cede business to us, we are required to post and maintain collateral to support our potential obligations under reinsurance contracts that we write. This collateral can be in the form of either investment assets held in collateral trust accounts or letters of credit. Under our credit facilities, in order for us to have the bank issue a letter of credit to our reinsurance contract counterparty, we must post investment assets or cash as collateral to the bank. In either case, the amounts remain restricted for the duration of the term of the trust or letter of credit, as applicable. See Note 13, “Commitments and contingencies” in our consolidated financial statements included elsewhere in this report for further details.

As of September 30, 2019 and December 31, 2018, we held $2.2 billion and $2.4 billion, respectively, in pledged assets in support of insurance and reinsurance liabilities as well as to collateralize our credit facilities. Included within total pledged assets, we held $6.4 million and $5.5 million, respectively, in deposits with U.S. regulatory authorities.

The following table summarizes our assets pledged as collateral for credit and letter of credit facilities and total return swap transactions, assets held in trust for underwriting transactions and regulatory deposits as of September 30, 2019 and December 31, 2018:



	September 30,		December 31,
	2019		2018
	($ in thousands)
Total investments held in trust as collateral for underwriting transactions and regulatory deposits	$	1,109,336	$	988,872
Total investments pledged for Secured Facility	962,314		917,837
Total investments pledged for custodian bank	40,562		339,139
Total investments pledged for Lloyds Facility	51,047		68,853
Total investments pledged for Master TRS	58,817		36,336

Contractual obligations and commitments

The following table illustrates our contractual obligations and commitments by due date as of September 30, 2019 and December 31, 2018:



	Payments Due by Period
	Total		Less Than One Year		One Year to Less Than Three Years		Three Years to Less Than Five Years		More Than Five Years
	($ in thousands)
September 30, 2019
Estimated gross payments for losses and loss adjustment expenses (1)	$	1,164,945	$	294,978	$	380,632	$	205,890	$	283,445
Interest payments on senior notes (2)	110,938		11,375		22,750		22,750		54,063
Senior notes (2)	175,000		—		—		—		175,000
Revolving credit agreement borrowings (3)	519,197		519,197		—		—		—
Operating lease obligations	1,109		283		566		260		—
Total	$	1,971,189	$	825,833	$	403,948	$	228,900	$	512,508
December 31, 2018
Estimated gross payments for losses and loss adjustment expenses (1)	$	1,032,760	$	238,291	$	316,166	$	172,955	$	305,348
Revolving credit agreement borrowings (2)	693,917		693,917		—		—		—
Operating lease obligations	1,321		283		566		472		—
Total	$	1,727,998	$	932,491	$	316,732	$	173,427	$	305,348

(1) The estimated expected contractual commitments related to the reserves for loss and loss adjustment expenses are presented on a gross basis (not reflecting any corresponding reinsurance recoverable amounts that would be due to us).

(2) On July 2, 2019 we completed a private offering of $175.0 million aggregate principal amount of our 6.5% senior notes due July 2, 2029. Interest on the senior notes will be paid semi-annually in arrears on each January 2 and July 2, commencing January 2, 2020.

(3) Revolving credit agreement borrowings include borrowings from our custodian bank to purchase securities, which is payable on demand. Therefore we have assumed that these payments will be made within one year, but payment may occur over a longer period of time.

Reserves for losses and loss adjustment expenses represent our best estimate of the ultimate cost of settling reported and unreported claims and related expenses. As discussed previously, the estimation of loss and loss expense reserves is based on various complex and subjective judgments. Actual losses and settlement expenses we are ultimately required to pay may deviate, perhaps substantially, from the reserve estimates reflected in our financial statements. Similarly, the timing for payment of our estimated losses is not fixed and is not determinable on an individual or aggregate basis. The assumptions used in estimating the payments due by period are based on industry and peer-group claims payment experience. Due to the uncertainty inherent in the process of estimating the timing of such payments, there is a risk that the amounts paid in any period can be significantly different than the amounts discussed above. Amounts discussed above are gross of anticipated amounts recoverable from reinsurers. Reinsurance balances recoverable on reserves for losses and loss adjustment expenses are reported separately as assets, instead of being netted with the related liabilities, since having purchased reinsurance does not discharge us of our liability to policyholders. Reinsurance balances recoverable on reserves for paid and unpaid losses and loss adjustment expenses as of September 30, 2019 and December 31, 2018 totaled $144.4 million and $86.4 million, respectively.

Regulatory Update

On July 10, 2019, the United States Treasury issued proposed regulations that included new proposed rules for determining if a non-U.S. company engaged in an insurance business would be classified by Treasury as a PFIC (the “2019 Proposed Regulations”). If finalized in their current form, the 2019 Proposed Regulations would impose additional requirements for us to continue to qualify for the insurance company exception to PFIC status and could adversely impact our ability to avoid becoming classified as a PFIC in the future. The Treasury Department requested comments on various aspects of the 2019 Proposed Regulations, which are generally proposed to be effective for taxable years of shareholders beginning after the regulations are finalized. Although we believe the 2019 Proposed Regulations may be modified in response to comments and are likely to further develop, it is not possible to predict if, when, or in what form the 2019 Proposed Regulations might be finalized. As a result, no assurance can be provided that we would not become classified as a PFIC under such final regulations issued by the Treasury in the future or any other future guidance or legislation.

Direct or indirect holders of our shares that are treated as U.S. persons for U.S. federal income tax purposes could be subject to adverse U.S. federal income consequences if we were to become classified as a PFIC. For more information regarding the risks associated with Watford Holdings or Watford Re being treated as PFICs, see “Risk factors-Risks related to taxation-U.S. Holders may be subject to certain adverse tax consequences based on the application of rules regarding passive foreign investment companies, or PFICs” and “-Changes in U.S. federal tax laws, which may be retroactive, including the finalization of proposed Treasury Regulations, could occur after the initial listing of our common shares on the Nasdaq Global Select Market and could subject Watford Holdings, Watford Re or U.S. Holders to U.S. federal income taxation on the earnings of Watford Holdings, Watford Re or our subsidiaries or could otherwise adversely impact Watford Holdings and its subsidiaries or shareholders”, in our prospectus dated March 26, 2019 related to the direct listing of our common shares on the Nasdaq Global Select Market, filed with the SEC in accordance with Rule 424(b) of the Securities Act on March 28, 2019, which prospectus is accessible on the SEC’s website at www.sec.gov and which risk factors are incorporated by reference herein.

Inflation

The effects of inflation are considered implicitly in pricing our contracts and policies through the modeled components such as demand surge. Loss reserves are established to recognize likely loss settlements at the date payment is made. Those reserves inherently recognize the effects of inflation. The actual effects of inflation on our results cannot be accurately known, however, until claims are ultimately resolved.

Off-balance sheet arrangements

We are not party to any transaction, agreement or other contractual arrangement to which an entity unconsolidated with us is a party that management believes is reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.

Item 3. Quantitative and qualitative disclosures about market risk

We believe we are principally exposed to the following types of market risk:


•	foreign currency risk;


•	interest rate risk;


•	credit spread risk;


•	credit risk;


•	liquidity risk; and


•	political risk.

Foreign currency risk

Underwriting contracts and policies

Foreign currency rate risk is the potential change in value, income and cash flow arising from adverse changes in foreign currency exchange rates. We have foreign currency exposure related to non-U.S. dollar denominated contracts and policies. Of our gross premiums written from inception, $1.3 billion, or 39.2%, were written in currencies other than the U.S. dollar. For these contracts, non-U.S. dollar assets generally offset liabilities in the same non-U.S. dollar currencies resulting in minimal net exposure. As of September 30, 2019 and December 31, 2018, net loss and loss adjustment expense reserves included $378.7 million and $310.2 million, respectively, in foreign currencies.

Investments

We are exposed to foreign currency risk through cash and investments in loans and securities denominated in foreign currencies. Foreign currency exchange rate risk is the potential for adverse changes in the U.S. dollar value of investments (long and short) and foreign currency derivative instruments, which we may employ from a risk management perspective, due to a change in the exchange rate of the foreign currency in which cash and financial instruments are denominated. As of September 30, 2019 and December 31, 2018, our total net long exposure to foreign denominated investments represented 10.8% and 9.5% of our total investment portfolios of $2.8 billion and $2.7 billion, respectively.

The following table summarizes the net impact that a 10% increase and decrease in the value of the U.S. dollar against select foreign currencies in which we have written contracts and policies would have had on the value of our shareholders’ equity as of September 30, 2019 and December 31, 2018:



	September 30,			December 31,
	2019			2018
(U.S. dollars in thousands, except per share data)
Assets, net of insurance liabilities, denominated in foreign currencies, excluding shareholders’ equity and derivatives	$	72,179		$	65,674
Shareholders’ equity denominated in foreign currencies (1)	(21,727		)	(23,501		)
Net assets denominated in foreign currencies	$	50,452		$	42,173
Pre-tax impact of a hypothetical 10% appreciation of the U.S. dollar against foreign currencies:
Shareholders’ equity	$	(5,045	)	$	(4,217	)
Book value per diluted common share	$	(0.22	)	$	(0.19	)
Pre-tax impact of a hypothetical 10% decline of the U.S. dollar against foreign currencies:
Shareholders’ equity	$	5,045		$	4,217
Book value per diluted common share	$	0.22		$	0.19

(1) Represents capital contributions held in the foreign currency of WICE.

Although we generally attempt to match the currency of our projected liabilities with investments in the same currencies, from time to time we may elect to over or underweight one or more currencies, which could increase our exposure to foreign currency fluctuations and increase the volatility of our shareholders’ equity. Historical observations indicate a low probability that all foreign currency exchange rates would shift against the U.S. dollar in the same direction and at the same time and, accordingly, the actual effect of foreign currency rate movements may differ materially from the amounts set forth above.

Interest rate risk

Our investment portfolios include interest rate sensitive securities, such as corporate and sovereign debt instruments and asset-backed securities. One key market risk exposure for any debt instrument is interest rate risk. As interest rates rise, the market value of our fixed income portfolio may fall, and the opposite is generally true when interest rates fall. Based on historical observations, there is a low probability that all interest rate yield curves would shift in the same direction at the same time. Furthermore, at times interest rate movements in certain credit sectors exhibit a much lower correlation to changes in U.S. Treasury yields. Accordingly, the actual effect of interest rate movements may differ materially from the amounts set forth in the following tables.

The following table estimates the impact that a 50 basis point and 100 basis point increase or decrease in interest rates would have on the value of our investment portfolios as of September 30, 2019 and December 31, 2018:



	Interest Rate Shift in Basis Points
(U.S. dollars in millions)	-100			-50			0			+50			+100
September 30, 2019
Total fair value	$	2,798		$	2,785		$	2,770		$	2,754		$	2,740
Change from base	1.0		%	0.5		%	—		%	(0.6		)%	(1.1		)%
Change in unrealized value	$	28		$	15		$	—		$	(16	)	$	(30	)

December 31, 2018
Total fair value	$	2,778		$	2,758		$	2,738		$	2,719		$	2,700
Change from base	1.5		%	0.7		%	—		%	(0.7		)%	(1.4		)%
Change in unrealized value	$	40		$	20		$	—		$	(19	)	$	(38	)

Credit spread risk

We invest in credit spread sensitive assets, primarily debt assets. We consider the effect of credit spread movements on the market value of our fixed maturity investments, short-term investments, and certain of our other investments and the corresponding change in market value. As credit spreads widen, the fair value of our fixed income investments falls, and the converse is also true. Based upon historical observations, there is a low probability that credit spreads would change in the same magnitude across asset classes, industries, credit ratings, jurisdictions, and individual instruments. Accordingly, the actual effect of credit spread movements may differ materially from the amounts set forth in the following tables.

The following table summarizes the effect that an immediate, parallel shift in credit spreads in a static interest rate environment would have had on our portfolios as of September 30, 2019 and December 31, 2018:



	Percentage Shift in Credit Spreads
(U.S. dollars in millions)	-50%			-10%			0			+10%			+50%
September 30, 2019
Total fair value	$	2,921		$	2,801		$	2,770		$	2,738		$	2,607
Change from base	5.5		%	1.1		%	—		%	(1.2		)%	(5.9		)%
Change in unrealized value	$	151		$	31		$	—		$	(32	)	$	(163	)

December 31, 2018
Total fair value	$	2,930		$	2,778		$	2,738		$	2,698		$	2,539
Change from base	6.6		%	1.4		%	—		%	(1.5		)%	(7.8		)%
Change in unrealized value	$	192		$	40		$	—		$	(40	)	$	(199	)

Credit risk

Underwriting contracts and policies

We are exposed to credit risk from our clients relating to premiums receivable under our contracts and policies, and the possibility that counterparties may default on their obligations to us. The risk of counterparty default is partially mitigated by the fact that any amount owed to us from an

insurance or reinsurance counterparty would be netted against any losses we would pay in the future. We monitor the collectability of these premiums on a regular basis.

Investments

Our investment strategy is to invest primarily in the debt obligations of non-investment grade corporate issuers. We rely upon our Investment Managers to invest our funds in debt instruments that provide an attractive risk-adjusted return, but the value we ultimately receive from these debt instruments is dependent upon the performance of the issuers of such obligations. In addition, the securities and cash in our investment portfolios are held with several custodians and prime brokers, subjecting us to the related credit risk from the possibility that one or more of them may default on their obligations to us. Our Investment Managers regularly monitor the concentration of credit risk with each broker and if necessary, transfer cash or securities among brokers to diversify and mitigate our credit risk.

Liquidity risk

Certain of our investments are, or may become, illiquid. Disruptions in the credit markets may materially affect the liquidity of certain investments including our Level 3 (non-quoted) assets, which, as of September 30, 2019 and December 31, 2018, represented 5.7% and 6.0% of our total investments, respectively. If we require significant amounts of cash on short notice in excess of normal cash requirements, which could include the payment of claims expenses or to satisfy a requirement of rating agencies in a period of market illiquidity, certain of our investments may be difficult to sell in a timely manner and may have to be sold or otherwise liquidated for less than what may otherwise have been possible under normal market conditions.

Political risk

We are exposed to political risk to the extent that we underwrite business from entities located in foreign markets; we operate through subsidiaries located in Bermuda, the United States and Gibraltar, and to the extent that HPS or AIM trade securities or assets that are originated, listed or traded in various U.S. and foreign markets. The governments in any of these jurisdictions could impose restrictions, regulations or other measures which may have a material impact on our investment strategy, the value of our investments and our underwriting operations.

We do not currently write political risk coverage in our insurance or reinsurance contracts; however, changes in government law and regulation may impact our underwriting operations.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports we file under the Securities Exchange Act of 1934, as amended, or the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required financial disclosure.

As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures defined under Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based upon this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective.

Changes in Internal Controls over Financial Reporting

There were no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarter ended September 30, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Inherent Limitations on Effectiveness of Controls

The effectiveness of any system of controls and procedures is subject to certain limitations, and, as a result, there can be no assurance that our controls and procedures will detect all errors or fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system will be attained.

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 September 30, 2019, we were not a party to any litigation or arbitration which is expected by management to have a material adverse effect on our results of operations and financial condition and liquidity.

Item 1A. Risk factors

Investing in our common shares involves risks. For a discussion of these potential risks and uncertainties, see the information under the heading “Risk factors” (or the Risk Factor Section) beginning on page 22 of our prospectus dated March 26, 2019 related to the direct listing of our common shares on the Nasdaq Global Select Market, filed with the SEC in accordance with Rule 424(b) of the Securities Act on March 28, 2019, which prospectus is accessible on the SEC’s website at www.sec.gov and which Risk Factor Section is incorporated by reference herein.

Other than as noted below, there have been no material changes to the risk factors included in the Risk Factor Section.

The failure to maintain our credit facilities and letter of credit facilities or to have adequate available collateral in connection with reinsurance contracts may negatively affect our ability to successfully implement our business strategy.

We currently have access to an $800 million secured credit facility that provides for borrowings as well as two separate $100 million letter of credit facilities, one of which is secured by collateral assets and one which is unsecured, that provide for the issuance of letters of credit. These facilities allow us to borrow for investment and general purposes and also to provide collateral to counterparties in the form of letters of credit. If such facilities were to become unavailable, we may be required to liquidate investment assets at inopportune times, forcing us to realize investment losses. Additionally, the unavailability of such facilities may limit our ability to borrow funds for investment purposes, thereby reducing our investment income, or prevent us from writing certain classes of business where collateral in the form of letters of credit is required.

In particular, our primary reinsurance operating subsidiary, Watford Re, is neither licensed nor admitted as a reinsurer in any jurisdiction other than Bermuda nor is it licensed or admitted as an insurer in any jurisdiction in the United States. Certain jurisdictions, including the United States, may not permit our insurance company clients to take full statutory credit for reinsurance obtained from unlicensed or non-admitted insurers unless appropriate collateral is provided. In addition, ceding companies, including Arch, may require additional collateral to mitigate counterparty risk irrespective of regulatory requirements. As a result, we are generally required either to post collateral or to provide a letter of credit in connection with this portion of our business. We have, and intend to maintain, letter of credit facilities and/or trust arrangements to meet these collateral requirements.

An event of default under our credit facilities or our letter of credit facilities (including as a result of events that are beyond our control) may require us to liquidate assets held in our credit facilities, have an adverse effect on our liquidity position to the extent the facilities have a security interest in any collateral posted, or require us to take other material actions. Any such forced sale of these investment assets could negatively affect our return on our investment portfolios, which could negatively affect the types and amount of business we choose to underwrite. A default under our credit facilities or our letter of credit facilities may cause our counterparties to exercise control over

the collateral posted, negatively affecting our ability to earn investment income or to pay claims or other operating expenses. Additionally, a default under any of these facilities may have a negative impact on our relationships with regulators, rating agencies and banking counterparties.

Our failure to comply with covenants contained in our credit and letter of credit facilities or in the indenture governing our senior notes could trigger prepayment obligations, which could adversely affect our results of operations and financial condition.

We and our subsidiaries currently have several outstanding credit and letter of credit facilities and we have outstanding senior notes. We depend on access to these funds in operating our business. The credit and letter of credit facilities and the indenture governing our senior notes contain various business and financial covenants that impose restrictions on us and certain of our subsidiaries with respect to, among other things, limitations on mergers and consolidations, sales of substantially all assets and indebtedness, restrictions as to dividends and stock repurchases, investment constraints and limitations on liens on the capital stock of certain subsidiaries. We may also enter into future debt arrangements containing similar or different restrictive covenants. Our failure to comply with these covenants could result in an event of default under the credit or letter of credit facilities or the indenture governing our senior notes, which could result in us being required to repay the amounts outstanding under these facilities or our senior notes prior to maturity. These prepayment obligations could have an adverse effect on our results of operations and financial condition.

In addition, complying with these covenants could limit our financial and operational flexibility. Our credit and letter of credit facilities and our senior notes are described in more detail in “Item 2. Management’s discussion and analysis of financial condition and results of operations - Contractual obligations and commitments.”

Item 2. Unregistered sales of equity securities and use of proceeds

None.

Item 3. Defaults upon senior securities

None.

Item 4. Mine safety disclosures

None.

Item 5. Other information

None.

Item 6. Exhibit index



		Incorporated by Reference
Exhibit Number	Exhibit Description	Form	Original Exhibit Number	Date Filed	Filed Herewith
4.1	Indenture, dated as of July 2, 2019, between the Company and The Bank of New York Mellon, as trustee	8-K	4.1	July 2, 2019
4.2	Form of 6.500% Senior Notes due 2029 (included in Exhibit 4.1)	8-K	4.2	July 2, 2019
10.1	364-Day Letter of Credit Agreement, dated as of September 20, 2019, among, inter alios, Watford Holdings Ltd., as parent guarantor, Watford Re Ltd., as account party, Lloyds Bank Corporate Markets Plc and BMO Capital Markets Corp., as joint lead arrangers and joint bookrunners, Lloyds Bank Corporate Markets Plc, as administrative agent and L/C agent, and the lenders party thereto, as issuing lenders	8-K	10.1	September 25, 2019
31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002				X
31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002				X
32.1	Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002				X
32.2	Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002				X
101	The following financial information from Watford Holdings Ltd.’s Quarterly Report for the quarter ended September 30, 2019 formatted in XBRL: (i) Consolidated Balance Sheets at September 30, 2019 and December 31, 2018; (ii) Consolidated Statements of Income for the three and nine months ended September 30, 2019 and 2018; (iii) Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2019 and 2018; (iv) Consolidated Statements of Changes in Shareholders’ Equity for the three and nine months ended September 30, 2019 and 2018; (v) Consolidated Statements of Cash Flows for the three and nine months ended September 30, 2019 and 2018; and (vi) Notes to Consolidated Financial Statements.

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.



		WATFORD HOLDINGS LTD.
		(REGISTRANT)

		/s/ John F. Rathgeber
Date:	November 8, 2019	John F. Rathgeber, Chief Executive Officer

Date:	November 8, 2019	/s/ Robert L. Hawley
		Robert L. Hawley, Chief Financial Officer

100