Watford Holdings Ltd. - Quarter Report: 2020 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, 2020

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

Commission file number: 001-38788

Watford Holdings Ltd.


Bermuda						98-1155442
(State or other jurisdiction of incorporation or organization)						(I.R.S. Employer Identification Number)

Waterloo House, 1st Floor

(441)

278-3455

100 Pitts Bay Road,

Pembroke

HM 08,

Bermuda

(Registrant’s telephone number, including area code)

(Address of principal executive offices)

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 10, 2020, there were 19,886,979 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	4
Item 1.	Consolidated financial statements	6
Item 2.	Management’s discussion and analysis of financial condition and results of operations	54
Item 3.	Quantitative and qualitative disclosures about market risk	102
Item 4.	Controls and procedures	106

Part II.	Other information	107
Item 1.	Legal proceedings	107
Item 1A.	Risk factors	107
Item 2.	Unregistered sales of equity securities and use of proceeds	114
Item 3.	Defaults upon senior securities	114
Item 4.	Mine safety disclosures	114
Item 5.	Other information	114
Item 6.	Exhibits	116
	Signatures	117

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 12.6% of our outstanding common shares as of September 30, 2020;

•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.

In addition, unless the context suggests otherwise, any reference in this report to:

•“HoldCo” refers to Greysbridge Holdings Ltd., a newly formed entity of which ACGL will own approximately 40%, and funds managed by Warburg Pincus LLC and Kelso & Company will each own approximately 30%;

•“Merger” refers to the merger of Merger Sub with and into Watford pursuant to the Merger Agreement, with Watford surviving as a wholly-owned subsidiary of HoldCo;

•“Merger Agreement” refers to the Agreement and Plan of Merger, dated as of October 9, 2020, among Watford, ACGL and Merger Sub, as amended by Amendment No. 1 to Agreement and Plan of Merger, dated as of November 2, 2020, among Watford, ACGL and Merger Sub; and

•“Merger Sub” refers to Greysbridge Ltd., a wholly-owned subsidiary of HoldCo.

Explanatory note - Proposed merger

On October 9, 2020, we announced that we had entered into a definitive agreement to be acquired by ACGL. Further, on November 2, 2020, ACGL assigned its interests and obligations in connection with this acquisition to Greysbridge Holdings Ltd., a newly formed entity of which ACGL will own approximately 40%, and funds managed by Warburg Pincus LLC and Kelso & Company will each own approximately 30%. Unless stated otherwise, all forward-looking information contained in this report on Form 10-Q does not take into account or give any effect to the impact of the Merger (as defined herein). For additional details regarding the Merger, see Part II Item 1A “Risk factors” and Part I Item 2 “Management’s discussion and analysis of financial condition and results of operations” of this Quarterly Report on Form 10-Q, and Note 19 to our consolidated financial statements contained in Part I Item 1 of this Quarterly Report on Form 10-Q.

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, including the recent announcements by A.M. Best Company, or A.M. Best, that it has placed under review with negative implications our financial strength and credit ratings and Kroll Bond Rating Agency, or KBRA, that it has revised the outlook of our financial strength and credit ratings to negative and placed such ratings on “watch developing” status;

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

◦our dependence on letter of credit facilities and borrowing 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;

◦our ability to complete acquisitions and integrate businesses successfully;

◦adverse general, societal, economic and market conditions, including those caused by pandemics, including the current global pandemic related to the novel coronavirus, or COVID-19, and government actions in response thereto;

◦one or more closing conditions to the Merger, including certain regulatory approvals, may not be satisfied or waived, on a timely basis or otherwise, including that a governmental entity may prohibit, delay or refuse to grant approval for the consummation of the Merger, or that the required approval of the Merger Agreement by our shareholders may not be obtained;

◦our business may suffer as a result of uncertainty surrounding the Merger and there may be challenges with employee retention as a result of the Merger;

◦the Merger may involve unexpected costs, liabilities or delays;

◦legal proceedings may be initiated related to the Merger;

◦an event, change or other circumstance may occur that could give rise to the termination of the Merger Agreement (including circumstances requiring us to pay HoldCo a termination fee pursuant to the Merger Agreement); and

◦the other matters set forth under Item 1A “Risk factors,” Item 7 “Management’s discussion and analysis of financial condition and results of operations,” and other sections of the Company’s Annual Report on Form 10-K for the year ended December 31, 2019, Part II Item 1A “Risk factors” and Part I Item 2 “Management’s discussion and analysis of financial condition and results of operations” of this Quarterly Report on Form 10-Q as well as the other factors set forth in the Company’s other documents on file with the SEC, and management’s response to any of the aforementioned factors.

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, 2020 (unaudited) and December 31, 2019			7

Consolidated Statements of Income (Loss)
For the three and nine months ended September 30, 2020 and 2019 (unaudited)			8

Consolidated Statements of Comprehensive Income (Loss)
For the three and nine months ended September 30, 2020 and 2019 (unaudited)			9

Consolidated Statements of Changes in Shareholders’ Equity
For the three and nine months ended September 30, 2020 and 2019 (unaudited)			10

Consolidated Statements of Cash Flows
For the nine months ended September 30, 2020 and 2019 (unaudited)			11

Notes to the Consolidated Financial Statements (unaudited)
Note 1 - Organization			12
Note 2 - Basis of Presentation and Significant Accounting Policies			13
Note 3 - Segment Information			16
Note 4 - Reinsurance			17
Note 5 - Reserves for Losses and Loss Adjustment Expenses			18
Note 6 - Allowance for Expected Credit Losses			19
Note 7 - Investment Information			19
Note 8 - Fair Value			30
Note 9 - Derivative Instruments			39
Note 10 - Earnings Per Common Share			41
Note 11 - Income Taxes			41
Note 12 - Transactions With Related Parties			42
Note 13 - Commitments and Contingencies			47
Note 14 - Leases			50
Note 15 - Senior Notes			50
Note 16 - Contingently Redeemable Preference Shares			51
Note 17 - Share Transactions			52
Note 18 - Legal Proceedings			53
Note 19 - Subsequent Events			53

WATFORD HOLDINGS LTD.

CONSOLIDATED BALANCE SHEETS

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


	(Unaudited)
	September 30,		December 31,
	2020		2019
Assets
Investments:
Term loans, fair value option (Amortized cost: $969,929 and $1,113,212)	$	893,030	$	1,061,934
Fixed maturities, fair value option (Amortized cost: $677,977 and $432,576)	632,664		416,594
Short-term investments, fair value option (Cost: $348,479 and $325,542)	350,391		329,303
Equity securities, fair value option	60,951		59,799
Other investments, fair value option (1)	—		30,461
Investments, fair value option	1,937,036		1,898,091
Fixed maturities, available for sale (Amortized cost: $645,663 and $739,456)	649,781		745,708
Equity securities, fair value through net income	52,829		65,338
Total investments (1)	2,639,646		2,709,137
Cash and cash equivalents	195,333		102,437
Accrued investment income	16,234		14,025
Premiums receivable (1)	263,748		273,657
Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses (1)	263,293		170,974
Prepaid reinsurance premiums (1)	131,885		132,577
Deferred acquisition costs, net (1)	58,583		64,044
Receivable for securities sold	1,730		16,288
Intangible assets	7,650		7,650
Funds held by reinsurers (1)	46,787		42,505
Other assets	28,331		17,562
Total assets	$	3,653,220	$	3,550,856
Liabilities
Reserve for losses and loss adjustment expenses (1)	$	1,429,656	$	1,263,628
Unearned premiums (1)	459,476		438,907
Losses payable (1)	78,537		61,314
Reinsurance balances payable (1)	68,339		77,066
Payable for securities purchased	67,602		18,180
Payable for securities sold short	24,909		66,257
Revolving credit agreement borrowings	390,195		484,287
Senior notes (1)	172,621		172,418
Amounts due to affiliates (1)	5,060		4,467
Investment management and performance fees payable (1)	7,539		17,762
Other liabilities (1)	30,012		21,912
Total liabilities	$	2,733,946	$	2,626,198
Commitments and contingencies
Contingently redeemable preference shares (1)	52,375		52,305
Shareholders’ equity
Common shares ($0.01 par; shares authorized: 120 million; shares issued: 22,804,128 and 22,692,300)	228		227
Additional paid-in capital	899,213		898,083
Retained earnings (deficit)	42,184		43,470
Accumulated other comprehensive income (loss)	3,197		5,629
Common shares held in treasury, at cost (shares: 2,917,149 and 2,789,405)	(77,923)		(75,056)
Total shareholders’ equity	866,899		872,353
Total liabilities, contingently redeemable preference shares and shareholders’ equity	$	3,653,220	$	3,550,856

(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 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,
	2020		2019		2020		2019
Revenues
Gross premiums written (1)	$	197,480	$	249,960	$	590,309	$	598,627
Gross premiums ceded (1)	(50,164)		(94,208)		(150,437)		(178,118)
Net premiums written	147,316		155,752		439,872		420,509
Change in unearned premiums (1)	(1,285)		(29,920)		(22,267)		2,735
Net premiums earned (1)	146,031		125,832		417,605		423,244
Other underwriting income (loss)	546		579		1,547		1,844
Interest income	34,553		41,376		108,830		123,113
Investment management fees - related parties (1)	(4,380)		(4,606)		(12,994)		(13,585)
Borrowing and miscellaneous other investment expenses	(3,657)		(7,234)		(14,089)		(23,143)
Net interest income	26,516		29,536		81,747		86,385
Realized and unrealized gains (losses) on investments	67,995		(14,646)		(50,444)		18,138
Investment performance fees - related parties (1)	(1,758)		(850)		(1,758)		(8,342)
Net investment income (loss)	92,753		14,040		29,545		96,181
Total revenues	239,330		140,451		448,697		521,269

Expenses
Loss and loss adjustment expenses (1)	(115,813)		(96,214)		(331,275)		(318,480)
Acquisition expenses (1)	(31,110)		(27,612)		(88,963)		(97,003)
General and administrative expenses (1)	(7,346)		(7,027)		(22,326)		(24,018)
Interest expense (1)	(2,912)		(2,841)		(8,735)		(2,841)
Net foreign exchange gains (losses)	(2,926)		167		4,752		(711)
Total expenses	(160,107)		(133,527)		(446,547)		(443,053)
Income (loss) before income taxes	79,223		6,924		2,150		78,216
Income tax benefit (expense)	(69)		—		333		(20)
Net income (loss) before preference dividends and redemption costs	79,154		6,924		2,483		78,196
Preference dividends (1)	(1,061)		(2,608)		(3,341)		(12,423)
Accelerated amortization of costs related to the redemption of preference shares (1)	—		(4,164)		—		(4,164)
Net income (loss) available to common shareholders	$	78,093	$	152	$	(858)	$	61,609

Earnings (loss) per common share:
Basic	$	3.93	$	0.01	$	(0.04)	$	2.71
Diluted	$	3.92	$	0.01	$	(0.04)	$	2.71
Weighted average number of common shares used in the determination of earnings (loss) per share:
Basic	19,890,784		22,765,802		19,901,921		22,729,848
Diluted	19,904,051		22,776,204		19,901,921		22,734,464

(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,
	2020		2019		2020		2019
Comprehensive income (loss)
Net income (loss) available to common shareholders	$	78,093	$	152	$	(858)	$	61,609
Other comprehensive income (loss) net of income tax:
Available for sale investments:
Unrealized holding gains (losses) arising during the period	6,631		3,785		9,440		14,398
Unrealized foreign currency gains (losses) arising during the period	5,729		(3,676)		(1,691)		(4,224)
Credit loss recognized in net income (loss)	59		—		410		—
Reclassification of net realized (gains) losses, included in net income (loss)	368		(1,254)		(10,368)		(3,465)
Unrealized holding gains (losses) of available for sale investments	12,787		(1,145)		(2,209)		6,709
Foreign currency translation adjustments	(411)		286		(223)		333
Other comprehensive income (loss) net of income tax	12,376		(859)		(2,432)		7,042
Comprehensive income (loss)	$	90,469	$	(707)	$	(3,290)	$	68,651

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,
	2020		2019		2020		2019
Common shares
Balance at beginning of period	$	228	$	227	$	227	$	227
Common shares issued	—		—		1		—
Balance at end of period	228		227		228		227

Additional paid-in capital
Balance at beginning of period	898,935		897,716		898,083		895,386
Common shares issued under share plans	—		—		490		250
Share-based compensation	278		184		640		2,264
Balance at end of period	899,213		897,900		899,213		897,900

Accumulated other comprehensive income (loss)
Balance at beginning of period	(9,179)		3,171		5,629		(4,730)
Unrealized holding gains (losses) of available for sale investments:
Balance at beginning of period	(8,744)		3,696		6,252		(4,158)
Unrealized holding gains (losses) of available for sale investments, net of reclassification adjustments	12,787		(1,145)		(2,209)		6,709
Balance at end of period	4,043		2,551		4,043		2,551
Currency translation adjustment:
Balance at beginning of period	(435)		(525)		(623)		(572)
Currency translation adjustment	(411)		286		(223)		333
Balance at end of period	(846)		(239)		(846)		(239)
Balance at end of period	3,197		2,312		3,197		2,312

Common shares held in treasury, at cost
Balance at beginning of period	(77,923)		—		(75,056)		—
Shares repurchased for treasury	—		—		(2,867)		—
Balance at end of period	(77,923)		—		(77,923)		—

Retained earnings (deficit)
Balance at beginning of period	(35,909)		60,182		43,470		(1,275)
Cumulative effect of adoption of updated accounting guidance for credit losses at January 1, 2020	—		—		(428)		—
Net income (loss) before preference dividends and redemption costs	79,154		6,924		2,483		78,196
Preference share dividends paid and accrued	(1,061)		(2,608)		(3,341)		(12,423)
Accelerated amortization of costs related to the redemption of preference shares	—		(4,164)		—		(4,164)
Balance at end of period	42,184		60,334		42,184		60,334
Total shareholders’ equity	$	866,899	$	960,773	$	866,899	$	960,773

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,
	2020		2019
Operating Activities
Net income (loss) before preference dividends	$	2,483	$	78,196
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Net realized and unrealized (gains) losses on investments	50,444		(18,138)
Amortization of fixed assets	5		84
Share-based compensation	1,130		2,514
Changes in:
Accrued investment income	(2,209)		1,179
Premiums receivable	6,878		(74,695)
Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses	(88,767)		(56,418)
Prepaid reinsurance premiums	692		(68,322)
Deferred acquisition costs, net	3,369		15,635
Reserve for losses and loss adjustment expenses	171,880		141,325
Unearned premiums	21,576		65,587
Reinsurance balances payable	(10,872)		58,945
Funds held with reinsurers	(4,956)		(8,322)
Other liabilities	5,364		40,818
Other items	(14,423)		(1,206)
Net Cash Provided By Operating Activities	142,594		177,182
Investing Activities
Purchase of term loans	(227,981)		(343,110)
Purchase of fixed maturity investments	(1,092,529)		(957,250)
Purchase of short-term investments with maturities over three months	(16,013)		(8,712)
Proceeds from sale, redemptions and maturity of term loans	375,829		283,126
Proceeds from sales, redemptions and maturities of fixed maturity investments	966,052		1,116,398
Proceeds from sales, redemptions and maturities of other investments	34,194		47,288
Proceeds from sales, redemptions and maturities of short-term investments with maturities over three months	14,963		28,791
Net (purchases) sales of short-term investments with maturities less than three months	(14,977)		(98,835)
Purchases of equity securities	(10,222)		(66,593)
Proceeds from sales of equity securities	23,216		25,894
Net settlements of derivative instruments	973		1,488
Purchases of furniture, equipment and other assets	(3)		—
Net Cash Provided by (Used For) Investing Activities	53,502		28,485
Financing Activities
Dividends paid on redeemable preference shares	(3,271)		(12,216)
Repayments on borrowings	(304,000)		(237,239)
Proceeds from borrowings	209,907		62,800
Purchases of common shares under share repurchase program	(2,867)		—
Repurchase of preference shares	—		(173,081)
Net proceeds from issuance of senior notes	—		172,283
Net Cash Provided By (Used For) Financing Activities	(100,231)		(187,453)
Effects of exchange rate changes on foreign currency cash	(2,969)		(1,353)
Increase (decrease) in cash	92,896		16,861
Cash and cash equivalents, beginning of period	102,437		63,529
Cash and cash equivalents, end of period	$	195,333	$	80,390
Supplementary information
Income taxes paid	$	297	$	20
Interest paid	$	18,704	$	21,998
Non-cash exchange of investments	$	75,026	$	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.

In May 2018, WICE formed a branch in Romania and commenced underwriting operations in June 2018. WICE is a wholly-owned subsidiary of Watford Re. The Romanian branch ceased accepting new business from September 1, 2020.

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, 2020 are not necessarily indicative of the results expected for the full calendar year, especially when considering the risks and uncertainties associated with the COVID-19 global pandemic and the impact it may have on our business, results of operations and financial condition.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

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, 2019 and 2018 and for each of the years in the periods ended December 31, 2019, 2018 and 2017, except as noted below.

(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. These unaudited interim financial statements should be read in conjunction with the Company’s audited consolidated financial statements and the accompanying notes for the years ended December 31, 2019, 2018 and 2017.

To facilitate comparison of information across periods, certain reclassifications have been made to prior period amounts to conform to the current period’s presentation.

(b) Recent accounting pronouncements

Issued and effective as of September 30, 2020 - Credit Losses

Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments

The Company adopted ASU 2016-13, Financial Instruments - Credit Losses (Topic 326) (“ASU 2016-13”) which was issued in June 2016. This ASU applies a new credit loss model (current expected credit losses, or “CECL”) for determining credit-related impairments for financial instruments measured at amortized cost (including reinsurance recoverables) and requires an entity to estimate the credit losses expected over the life of an exposure or pool of exposures. The estimate of expected credit losses should consider historical information, current information, as well as reasonable and supportable forecasts, including estimates of prepayments. The expected credit losses, and subsequent adjustments to such losses, are recorded through an allowance account that is deducted from the amortized cost basis of the financial asset, with the net carrying value of the financial asset presented on the Company’s consolidated balance sheet.

This ASU also amends the previous other-than-temporary impairment model for available for sale debt securities by requiring the recognition of impairments relating to credit losses through an allowance account and limiting the amount of credit loss to the difference between a security’s amortized cost basis and its fair value. In addition, the length of time a security has been in an unrealized loss position will no longer impact the determination of whether a credit loss exists.

The Company adopted this ASU as of January 1, 2020. For available for sale debt securities, the updated guidance was applied prospectively. For financial instruments measured at amortized cost,

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

the updated guidance was applied by recognizing a cumulative effect adjustment of $0.4 million, net of tax, to the opening balance of retained earnings as of January 1, 2020, the beginning of the period of adoption. This adjustment is associated with “premiums receivable” and “reinsurance recoverables on unpaid and paid losses and loss adjustment expenses” in the Company’s consolidated balance sheets. The cumulative effect of the adjustment decreased retained earnings as of January 1, 2020 and increased the allowance for estimated uncollectible reinsurance.

The following accounting policies have been updated to reflect the Company’s adoption of ASU 2016-13, as described above. Results for the reporting periods beginning January 1, 2020 and thereafter are presented under ASC 326, while prior period amounts continue to be reported in accordance with previous applicable GAAP.

Investment Impairments

The Company conducts a periodic review to identify and evaluate invested assets that may have credit impairments.

Credit Impairments of Available For Sale Fixed Maturities

The Company derives estimated credit losses for fixed maturities by comparing expected future cash flows to be collected to the amortized cost of the security. Estimates of expected future cash flows consider among other things, macroeconomic conditions as well as the financial condition of the issuer, near-term and long-term prospects for the issuer, and the likelihood of the recoverability of principal and interest.

Beginning on January 1, 2020, credit losses are recognized through an allowance account subject to reversal, rather than a reduction in amortized cost. Declines in value attributable to factors other than credit are reported in other comprehensive income while the allowance for credit loss is charged to “realized and unrealized gains (losses) on investments” in the Company’s consolidated statements of income (loss).

For fixed maturity investments the Company intends to sell or for which it is more likely than not that the Company will be required to sell before an anticipated recovery in value, the full amount of the impairment is included in “realized and unrealized gains (losses) on investments” on the Company’s consolidated statements of income (loss). The new cost basis of the investment is the previous amortized cost basis less the impairment recognized in “realized and unrealized gains (losses) on investments.” The new cost basis is not adjusted for any subsequent recoveries in fair value.

The Company reports accrued investment income separately from available for sale fixed maturities, and has elected not to measure an allowance for credit losses for accrued investment income. Uncollectible accrued interest is written off when the Company determines that no additional interest payments will be received.

Reinsurance Recoverables

In the normal course of business, the Company’s subsidiaries cede a portion of their premium and losses through pro rata and excess of loss reinsurance agreements on a treaty or facultative basis. Reinsurance recoverables are recorded as assets, predicated on the reinsurers’ ability to meet their obligations under the reinsurance agreements. In certain instances, the Company obtains collateral, including letters of credit and trust accounts, to further reduce the credit exposure on its reinsurance recoverables. The Company reports its reinsurance recoverables net of an allowance for expected credit loss in the Company’s consolidated balance sheets. The allowance is based upon the Company’s ongoing review of amounts outstanding, the financial condition of its reinsurers, amounts and form of collateral obtained and other relevant factors. A ratings based probability-of-default and loss-given-default methodology is used to estimate the allowance for expected credit loss. Any allowance for credit losses is charged to the Company’s consolidated statements of income

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

(loss) in the period the recoverable is recorded and revised in subsequent periods to reflect changes in the Company’s estimate of expected credit losses.

Premiums receivable and unearned premium reserves

Premiums are recognized as revenues pro rata over the policy period. Unearned premium reserves represent the unexpired portion of policy premiums. Accrued retrospective premiums are included in premiums receivable balances. Premiums receivable balances are reported net of an allowance for expected credit losses. The Company monitors credit risk associated with premiums receivable through its ongoing review of amounts outstanding, aging of the receivable, historical loss data and counterparty financial strength measures. The allowance also includes estimated uncollectible amounts related to dispute risk. Amounts deemed to be uncollectible, are written off against the allowance. In certain instances, credit risk may be reduced by the Company’s right to offset loss obligations or unearned premiums against premiums receivable. Any allowance for credit losses is charged to the Company’s consolidated statements of income (loss) in the period the receivable is recorded and revised in subsequent periods to reflect changes in the Company’s estimate of expected credit losses.

Issued and effective as of September 30, 2020

In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820), Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurements (“ASU 2018-13”). ASU 2018-13 modifies the disclosure requirements on fair value measurements. This ASU was adopted on January 1, 2020, and the Company considers the impact to be immaterial to the Company’s consolidated financial statements and disclosures.

In March 2020, the FASB issued ASU 2020-03, Codification Improvements (“ASU 2020-03”), which provides updates to a wide variety of Topics in the Codification. For public business entities, this ASU was effective upon issuance. This ASU was adopted upon issuance, and did not have a material impact on the Company’s consolidated financial statements.

In April 2019, the FASB issued ASU 2019-04, which identified and clarified issues relevant to ASU 2017-12, Derivatives and Hedging (Topic 815), Targeted Improvements to Accounting for Hedging Activities (“ASU 2017-12”). 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. This ASU was adopted on January 1, 2020 and did not have a material impact on the Company’s consolidated financial statements.

Recently issued accounting standards not yet adopted

In March 2020, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848) (“ASU 2020-04”). This ASU provides practical expedients and exceptions for applying GAAP to contracts and transactions affected by reference rate reform if such contracts or transactions reference LIBOR or another reference rate expected to be discontinued. Amendments in this ASU for contract modifications may be applied as of March 12, 2020 through December 31, 2022. Once adopted, this ASU must be applied prospectively for all eligible contract modifications. The Company is currently assessing the impact the implementation of this ASU will have on its consolidated financial statements and disclosures, but does not believe that such impact will be material.

For additional information regarding accounting standards that the Company has not yet adopted, see Note 2, “Basis of presentation and significant accounting policies” in the Company’s audited consolidated financial statements in Part II, Item 8 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2019.

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 (on its 6.5% senior notes due July 2, 2029), net foreign exchange gains (losses), income tax expense and items related to the Company’s 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,
	2020		2019		2020		2019
	($ in thousands)
Gross premiums written:
Casualty reinsurance	$	64,860	$	145,129	$	173,803	$	253,287
Other specialty reinsurance	31,549		22,453		89,509		84,587
Property catastrophe reinsurance	4,680		3,461		25,765		15,382
Insurance programs and coinsurance	96,391		78,917		301,232		245,371
Total	$	197,480	$	249,960	$	590,309	$	598,627

Net premiums written:
Casualty reinsurance	$	63,247	$	92,084	$	171,688	$	199,226
Other specialty reinsurance	30,157		22,093		85,484		81,798
Property catastrophe reinsurance	4,680		3,040		25,018		14,643
Insurance programs and coinsurance	49,232		38,535		157,682		124,842
Total	$	147,316	$	155,752	$	439,872	$	420,509

Net premiums earned:
Casualty reinsurance	$	54,566	$	52,266	$	155,477	$	183,085
Other specialty reinsurance	32,833		31,563		98,073		118,759
Property catastrophe reinsurance	6,589		3,617		17,297		9,707
Insurance programs and coinsurance	52,043		38,386		146,758		111,693
Total	$	146,031	$	125,832	$	417,605	$	423,244

Net premiums written by underwriting location:
United States	$	24,236	$	20,649	$	88,337	$	61,436
Europe	24,987		18,412		69,111		65,597
Bermuda	98,093		116,691		282,424		293,476
Total	$	147,316	$	155,752	$	439,872	$	420,509

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,
	2020		2019		2020		2019
	($ in thousands)
Premiums written
Direct	$	96,391	$	78,917	$	301,232	$	245,371
Assumed	101,089		171,043		289,077		353,256
Ceded	(50,164)		(94,208)		(150,437)		(178,118)
Net	$	147,316	$	155,752	$	439,872	$	420,509
Premiums earned
Direct	$	98,278	$	73,741	$	276,367	$	207,704
Assumed	101,070		94,028		291,046		323,131
Ceded	(53,317)		(41,937)		(149,808)		(107,591)
Net	$	146,031	$	125,832	$	417,605	$	423,244
Losses and loss adjustment expenses
Direct	$	81,657	$	65,310	$	252,642	$	176,690
Assumed	77,263		69,072		222,320		242,247
Ceded	(43,107)		(38,168)		(143,687)		(100,457)
Net	$	115,813	$	96,214	$	331,275	$	318,480

The Company monitors the financial condition of its reinsurers and attempts to place coverages only with financially sound carriers. At September 30, 2020 and December 31, 2019, approximately 100% of ceded loss and loss adjustment reserves were due from carriers which had an A.M. Best or a Standard & Poor’s rating of “A-” or better.

At September 30, 2020 and December 31, 2019, approximately 43% and 47%, 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, 2020 and 2019.


	Nine Months Ended September 30,
	2020		2019
	($ in thousands)
Gross reserve for losses and loss adjustment expenses at beginning of period	$	1,263,628	$	1,032,760
Unpaid losses and loss adjustment expenses recoverable	165,549		81,267
Net reserve for losses and loss adjustment expenses at beginning of period	1,098,079		951,493

Net incurred losses and loss adjustment expenses relating to losses occurring in:
Current period	331,861		318,812
Prior years	(586)		(332)
Total net losses and loss adjustment expenses	331,275		318,480

Foreign exchange (gains) losses	(6,506)		(9,971)

Net paid losses and loss adjustment expenses relating to losses occurring in:
Current period	(45,015)		(35,686)
Prior years	(193,622)		(198,682)
Total paid losses and loss adjustment expenses	(238,637)		(234,368)

Net reserve for losses and loss adjustment expenses at end of period	1,184,211		1,025,634
Unpaid losses and loss adjustment expenses recoverable	245,445		139,311
Gross reserve for losses and loss adjustment expenses at end of period	$	1,429,656	$	1,164,945

During the nine months ended September 30, 2020, the Company recorded net favorable development on prior year loss reserves of $0.6 million. Net favorable development was experienced on casualty reinsurance losses of $5.9 million, other specialty reinsurance losses of $4.5 million, and property catastrophe reinsurance losses of $1.9 million, offset by unfavorable development on insurance losses of $11.7 million.

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 of $0.3 million, offset in part by unfavorable development on insurance losses of $2.0 million.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

6. Allowance for expected credit losses

Premiums Receivable

The following table presents the balances of premiums receivable, net of the allowance for expected credit losses, at January 1, 2020 and September 30, 2020 and changes in the allowance for expected credit losses for the three and nine months ended September 30, 2020.


	At and For the Three Months Ended September 30, 2020				At and For the Nine Months Ended September 30, 2020
	Premiums Receivable, Net of Allowance		Allowance for Expected Credit Losses		Premiums Receivable, Net of Allowance		Allowance for Expected Credit Losses
	($ in thousands)
Balance at beginning of period	$	258,178	$	156	$	273,657	$	—
Cumulative effect of adoption of updated accounting guidance for credit losses at January 1, 2020			—				156
Current period change for expected credit losses			—				—
Write-offs charged against the allowance			—				—
Balance at end of period	$	263,748	$	156	$	263,748	$	156

Reinsurance Recoverables

The following table presents the balances of reinsurance recoverables, net of the allowance for expected credit losses, at January 1, 2020 and September 30, 2020, and changes in the allowance for expected credit losses for the three and nine months ended September 30, 2020.


	At and For the Three Months Ended September 30, 2020				At and For the Nine Months Ended September 30, 2020
	Reinsurance Recoverables, Net of Allowance		Allowance for Expected Credit Losses		Reinsurance Recoverables, Net of Allowance		Allowance for Expected Credit Losses
	($ in thousands)
Balance at beginning of period	$	229,746	$	281	$	170,974	$	—
Cumulative effect of adoption of updated accounting guidance for credit losses at January 1, 2020 (1)			—				297
Current period change for expected credit losses			10				(6)
Write-offs charged against the allowance			—				—
Balance at end of period	$	263,293	$	291	$	263,293	$	291

(1) As at September 30, 2020, the allowance for credit losses is gross of deferred tax of $23 thousand.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

7. Investment information

Available for Sale Investments

The following tables summarize the fair value of the Company’s securities classified as available for sale as of September 30, 2020 and December 31, 2019:


	Cost or Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses (1)		Fair Value
	($ in thousands)
September 30, 2020
Fixed maturities:
U.S. government and government agency bonds	$	201,738	$	1,245	$	(8)	$	202,975
Non-U.S. government and government agency bonds	145,558		5,946		(2,159)		149,345
Corporate bonds	186,908		7,844		(1,900)		192,852
Asset-backed securities	90,558		336		(6,193)		84,701
Mortgage-backed securities	19,215		—		(1,100)		18,115
Municipal government and government agency bonds	1,686		107		—		1,793
Total investments, available for sale	$	645,663	$	15,478	$	(11,360)	$	649,781

(1) Effective January 1, 2020, the Company adopted ASU 2016-13, and as a result any credit impairment losses on the Company’s available for sale securities are recorded as an allowance, subject to reversal. See Note 2. “Basis of presentation and significant accounting policies-(b) Recent accounting pronouncements-Issued and effective as of September 30, 2020 - Credit Losses” above for more information about ASU 2016-13. Included within the gross unrealized losses for corporate bonds is a credit allowance of $0.4 million for securities with an unrealized loss of $1.6 million as of September 30, 2020.


	Cost or Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	($ in thousands)
December 31, 2019
Fixed maturities:
U.S. government and government agency bonds	$	282,076	$	1,708	$	(137)	$	283,647
Corporate bonds	155,834		2,326		(41)		158,119
Asset-backed securities	145,555		614		(735)		145,434
Non-U.S. government and government agency bonds	129,456		3,530		(1,033)		131,953
Mortgage-backed securities	24,776		18		(44)		24,750
Municipal government and government agency bonds	1,759		46		—		1,805
Total investments, available for sale	$	739,456	$	8,242	$	(1,990)	$	745,708

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
	($ in thousands)
September 30, 2020
Fixed maturities:
U.S. government and government agency bonds	$	15,972	$	(8)	$	—	$	—	$	15,972	$	(8)
Non-U.S. government and government agency bonds	94,273		(2,159)		—		—		94,273		(2,159)
Corporate bonds	41,540		(1,900)		—		—		41,540		(1,900)
Asset-backed securities	61,525		(4,380)		17,896		(1,813)		79,421		(6,193)
Mortgage-backed securities	16,879		(1,053)		979		(47)		17,858		(1,100)
Total	$	230,189	$	(9,500)	$	18,875	$	(1,860)	$	249,064	$	(11,360)
December 31, 2019
Fixed maturities:
U.S. government and government agency bonds	$	36,540	$	(137)	$	—	$	—	$	36,540	$	(137)
Non-U.S. government and government agency bonds	51,779		(1,027)		5,410		(6)		57,189		(1,033)
Corporate bonds	9,854		(41)		—		—		9,854		(41)
Asset-backed securities	55,194		(504)		19,430		(231)		74,624		(735)
Mortgage-backed securities	14,481		(44)		—		—		14,481		(44)
Total	$	167,848	$	(1,753)	$	24,840	$	(237)	$	192,688	$	(1,990)

At September 30, 2020, 69 positions out of a total of 157 positions were in an unrealized loss position. The unrealized loss position increased during the nine-month period from $2.0 million to $11.4 million. The decrease in value can be attributed to the market movements resulting from the COVID-19 global pandemic, which primarily impacted the asset-backed securities, and unfavorable foreign exchange rates impacting the non-U.S. government agency bonds during the period.

At December 31, 2019, 48 positions out of a total of 146 positions were in an unrealized loss position; however, the unrealized loss was less than 10% of the fair value for all 48 positions. The decrease in value can be attributed to movement in foreign exchange rates for the non-U.S. government agency bonds since purchase and the decrease in value for the asset-backed securities, primarily driven by market movements during the period. The Company believes that such securities were temporarily impaired at December 31, 2019.

Allowance for expected credit losses

The Company recognized changes in the allowance for expected credit losses on available for sale securities of $0.1 million and $0.4 million for the three and nine months ended September 30, 2020. The credit allowance as of September 30, 2020 was $0.4 million. No credit losses were previously recognized and there were no write-offs charged against the allowance. The change in allowance is recognized in “realized and unrealized gains (losses) on investments” in the Company’s consolidated statements of income (loss). There were no impairments of securities which the Company intends to sell or more likely than not will be required to sell.

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, 2020 and December 31, 2019 are shown in the following tables.


	September 30, 2020
	Amortized Cost		Estimated Fair Value		% of Fair Value
	($ in thousands)
Due in one year or less	$	26,977	$	27,048	4.1	%
Due after one year through five years	360,779		367,624		56.6	%
Due after five years through ten years	130,445		135,615		20.9	%
Due after ten years	17,689		16,678		2.6	%
Asset-backed securities	90,558		84,701		13.0	%
Mortgage-backed securities	19,215		18,115		2.8	%
Total investments, available for sale	$	645,663	$	649,781	100.0	%


	December 31, 2019
	Amortized Cost		Estimated Fair Value		% of Fair Value
	($ in thousands)
Due in one year or less	$	9,235	$	9,248	1.3	%
Due after one year through five years	414,235		417,921		56.0	%
Due after five years through ten years	133,822		136,329		18.3	%
Due after ten years	11,833		12,026		1.6	%
Asset-backed securities	145,555		145,434		19.5	%
Mortgage-backed securities	24,776		24,750		3.3	%
Total investments, available for sale	$	739,456	$	745,708	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, 2020 and December 31, 2019, 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
	($ in thousands)
September 30, 2020
Term loan investments	$	969,929	$	6,623	$	(83,522)	$	893,030
Fixed maturities:
Corporate bonds	472,281		17,788		(32,909)		457,160
U.S. government and government agency bonds	468		9		—		477
Asset-backed securities	197,221		2,153		(34,384)		164,990
Mortgage-backed securities	6,576		2,024		—		8,600
Non-U.S. government and government agency bonds	1,431		51		(45)		1,437

Short-term investments	348,479		2,011		(99)		350,391

Equities	50,456		15,605		(5,110)		60,951
Investments, fair value option	$	2,046,841	$	46,264	$	(156,069)	$	1,937,036
Fair Value Through Net Income:
Equities, fair value through net income	$	63,038	$	6,004	$	(16,213)	$	52,829


	Cost or Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	($ in thousands)
December 31, 2019
Term loan investments	$	1,113,212	$	7,340	$	(58,618)	$	1,061,934
Fixed maturities:
Corporate bonds	221,024		8,430		(15,100)		214,354
U.S. government and government agency bonds	1,963		1		(2)		1,962
Asset-backed securities	200,361		3,329		(12,953)		190,737
Mortgage-backed securities	7,399		712		(405)		7,706
Non-U.S. government and government agency bonds	1,449		18		(11)		1,456
Municipal government and government agency bonds	380		—		(1)		379
Short-term investments	325,542		3,817		(56)		329,303
Other investments	28,672		2,264		(475)		30,461
Equities	54,893		10,690		(5,784)		59,799
Investments, fair value option	$	1,954,895	$	36,601	$	(93,405)	$	1,898,091
Fair Value Through Net Income:
Equities, fair value through net income	$	78,031	$	2,360	$	(15,053)	$	65,338

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, 2020 and December 31, 2019 are shown in the following tables:


	September 30, 2020
	Amortized Cost		Estimated Fair Value		% of Fair Value
	($ in thousands)
Due in one year or less	$	427,967	$	421,853	22.4	%
Due after one year through five years	874,038		817,579		43.6	%
Due after five years through ten years	482,447		455,416		24.3	%
Due after ten years	8,136		7,647		0.4	%
Asset-backed securities	197,221		164,990		8.8	%
Mortgage-backed securities	6,576		8,600		0.5	%
Total	$	1,996,385	$	1,876,085	100.0	%


	December 31, 2019
	Amortized Cost		Estimated Fair Value		% of Fair Value
	($ in thousands)
Due in one year or less	$	368,452	$	370,479	20.5	%
Due after one year through five years	779,643		742,960		41.1	%
Due after five years through ten years	514,961		495,416		27.4	%
Due after ten years	514		533		—	%
Asset-backed securities	200,361		190,737		10.6	%
Mortgage-backed securities	7,399		7,706		0.4	%
Total	$	1,871,330	$	1,807,831	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 are 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 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, 2020 and December 31, 2019, 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, Kroll Bond Rating Agency, or KBRA, or DBRS Morningstar, or DBRS, as applicable:


	Credit Rating (1)
September 30, 2020	Fair Value		AAA		AA		A		BBB		BB		B		CCC		CC		C		D		Not Rated
	($ in thousands)
Term loan investments	$	893,030	$	—	$	—	$	—	$	11,074	$	27,214	$	533,876	$	233,186	$	8,970	$	4,469	$	13,325	$	60,916
Fixed maturities:
Corporate bonds	650,012		—		20,016		87,672		94,715		73,959		207,670		126,388		6,070		1,171		14,415		17,936
U.S. government and government agency bonds	203,452		—		203,452		—		—		—		—		—		—		—		—		—
Asset-backed securities	249,691		—		—		22,746		151,920		33,180		9,277		8,667		842		—		—		23,059
Mortgage-backed securities	26,715		—		—		1,733		16,382		1,182		—		—		—		—		3,149		4,269
Non-U.S. government and government agency bonds	150,782		—		150,782		—		—		—		—		—		—		—		—		—
Municipal government and government agency bonds	1,793		784		595		414		—		—		—		—		—		—		—		—
Total fixed income instruments	2,175,475		784		374,845		112,565		274,091		135,535		750,823		368,241		15,882		5,640		30,889		106,180
Short-term investments	350,391		59,574		176,195		63,871		48,485		—		—		443		—		—		—		1,823
Total fixed income instruments and short-term investments	2,525,866		60,358		551,040		176,436		322,576		135,535		750,823		368,684		15,882		5,640		30,889		108,003
Other Investments	—
Equities	113,780
Total	$	2,639,646	$	60,358	$	551,040	$	176,436	$	322,576	$	135,535	$	750,823	$	368,684	$	15,882	$	5,640	$	30,889	$	108,003

(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, followed by ratings from DBRS.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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


	Credit Rating (1)
December 31, 2019	Fair Value		AAA		AA		A		BBB		BB		B		CCC		CC		C		D		Not Rated
	($ in thousands)
Term loan investments	$	1,061,934	$	—	$	—	$	—	$	—	$	9,617	$	761,168	$	215,909	$	6,823	$	2,119	$	—	$	66,298
Fixed maturities:
Corporate bonds	372,473		—		36,128		81,401		41,103		9,003		58,345		135,613		—		—		—		10,880
U.S. government and government agency bonds	285,609		—		285,609		—		—		—		—		—		—		—		—		—
Asset-backed securities	336,171		2,006		—		29,179		223,956		29,695		18,381		—		—		—		—		32,954
Mortgage-backed securities	32,456		—		—		1,100		23,650		976		—		—		—		—		2,497		4,233
Non-U.S. government and government agency bonds	133,409		—		132,460		—		949		—		—		—		—		—		—		—
Municipal government and government agency bonds	2,184		1,135		573		476		—		—		—		—		—		—		—		—
Total fixed income instruments	2,224,236		3,141		454,770		112,156		289,658		49,291		837,894		351,522		6,823		2,119		2,497		114,365
Short-term investments	329,303		25,783		136,842		34,903		115,155		—		—		8,359		—		—		—		8,261
Total fixed income instruments and short-term investments	2,553,539		28,924		591,612		147,059		404,813		49,291		837,894		359,881		6,823		2,119		2,497		122,626
Other Investments	30,461
Equities	125,137
Total	$	2,709,137	$	28,924	$	591,612	$	147,059	$	404,813	$	49,291	$	837,894	$	359,881	$	6,823	$	2,119	$	2,497	$	122,626

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 Company’s 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, 2020 and 2019 were derived from the following sources:


	Three Months Ended September 30, 2020
	Net Interest Income		Net Unrealized Gains (Losses)		Net Realized Gains (Losses)		Net Investment Income (Loss)
	($ in thousands)
Net investment income (loss) by asset class:
Term loan investments	$	19,821	$	38,661	$	(606)	$	57,876
Fixed maturities - Fair value option	11,444		15,640		6,823		33,907
Fixed maturities - Available for sale (1)	2,935		—		(821)		2,114
Short-term investments	353		(110)		128		371
Equities (2)	—		2,459		2		2,461
Equities, fair value through net income (2)	—		232		3,723		3,955
Other investments	—		(5,471)		5,521		50
Other (3)	—		3,159		(1,345)		1,814
Investment management fees - related parties	(4,380)		—		—		(4,380)
Borrowing and miscellaneous other investment expenses	(3,657)		—		—		(3,657)
Investment performance fees - related parties	—		—		—		(1,758)
	$	26,516	$	54,570	$	13,425	$	92,753

(1) Net realized gains (losses) from the fixed maturities available for sale portfolio consists of realized gains and realized losses of $0.9 million and $1.7 million, respectively. Realized losses include an allowance for expected credit losses on available for sale securities of $0.1 million for the three months ended September 30, 2020.

(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, 2019
	Net Interest Income		Net Unrealized Gains (Losses)		Net Realized Gains (Losses)		Net Investment Income (Loss)
	($ in thousands)
Net investment income (loss) by asset class:
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 $1.4 million and $0.2 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, 2020
	Net Interest Income		Net Unrealized Gains (Losses)		Net Realized Gains (Losses)		Net Investment Income (Loss)
	($ in thousands)
Net investment income (loss) by asset class:
Term loan investments	$	58,861	$	(25,621)	$	(14,893)	$	18,347
Fixed maturities - Fair value option	31,399		(28,254)		5,809		8,954
Fixed maturities - Available for sale (1)	11,243		—		10,270		21,513
Short-term investments	5,084		(37)		253		5,300
Equities (2)	—		5,589		(86)		5,503
Equities, fair value through net income (2)	573		2,476		(4,601)		(1,552)
Other investments	1,670		(1,788)		5,521		5,403
Other (3)	—		(5,187)		105		(5,082)
Investment management fees - related parties	(12,994)		—		—		(12,994)
Borrowing and miscellaneous other investment expenses	(14,089)		—		—		(14,089)
Investment performance fees - related parties	—		—		—		(1,758)
	$	81,747	$	(52,822)	$	2,378	$	29,545

(1) Net realized gains (losses) from the fixed maturities available for sale portfolio consists of realized gains and realized losses of $13.7 million and $3.4 million, respectively. Realized losses include an allowance for expected credit losses on available for sale securities of $0.4 million for the nine months ended September 30, 2020.

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

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


	Nine Months Ended September 30, 2019
	Net Interest Income		Net Unrealized Gains (Losses)		Net Realized Gains (Losses)		Net Investment Income (Loss)
	($ in thousands)
Net investment income (loss) by asset class:
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)

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, 2020 and December 31, 2019, the Company held $2.2 billion and $2.1 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 $7.8 million and $6.4 million, respectively, in deposits with U.S. regulatory authorities.

Non-cash investing activities

During the nine months ended September 30, 2020, $75.0 million of investments converted or exchanged in non-cash transactions from fixed maturities or preferred equity positions to short term investments, fixed maturities or common stock equity positions, as presented on the consolidated statement of cash flows.

During 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. The fund fully redeemed during the three months ended September 30, 2020.

During 2019, as a result of the restructuring of an investment position held by the Company, $16.9 million of term loans were converted to $23.0 million of common and preferred stock held within “equity securities, fair value through net income,” along with cash funding from short-term investments of $6.5 million.

8. 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

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

•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 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 $2.6 billion of net financial assets and liabilities measured at fair value at September 30, 2020, approximately $120.0 million, or 4.6%, were priced using non-binding broker-dealer quotes or modeled valuations. Of the $2.6 billion of net financial assets and liabilities measured at fair value at December 31, 2019, approximately $131.8 million, or 5.0%, 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

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

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.

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

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

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 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 9, “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

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

fair value of these securities are classified within Level 2. Refer to Note 9, “Derivative instruments” for more information.

Other Investments. The fair value of the Company’s investments in private funds are measured using the most recently available net asset valuations, or NAVs, as advised by the third-party administrators.

Measuring the Fair Value of Other Investments Using Net Asset Valuations

The fair value of the Company’s investments in private funds are measured using the most recently available NAVs as advised by the third-party administrators. 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 funds are measured using the NAVs as a practical expedient, therefore the fair value of the funds have 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, 2020 and December 31, 2019:


			Fair Value Measurement Using:
September 30, 2020	Estimated Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	($ in thousands)
Assets measured at fair value:
Term loans	$	893,030	$	—	$	842,389	$	50,641
Fixed maturities:
Corporate bonds	650,012		—		649,048		964
U.S. government and government agency bonds	203,452		203,341		111		—
Asset-backed securities	249,691		—		249,691		—
Mortgage-backed securities	26,715		—		26,715		—
Non-U.S. government and government agency bonds	150,782		—		150,782		—
Municipal government and government agency bonds	1,793		—		1,793		—
Short-term investments	350,391		350,391		—		—
Equities	113,780		7,323		5,842		100,615
Other underwriting derivative assets	20		—		20		—
Investment derivative assets (1)	34		—		34		—

Total assets measured at fair value	$	2,639,700	$	561,055	$	1,926,425	$	152,220

Liabilities measured at fair value:

Investment derivative liabilities (2)	$	3,804	$	—	$	3,804	$	—
Payable for securities sold short:
Corporate bonds	21,211		—		21,211		—
U.S. government and government agency bonds	3,698		3,698		—		—
Total liabilities measured at fair value	$	28,713	$	3,698	$	25,015	$	—

(1) 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.

(2) 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 September 30, 2020.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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


			Fair Value Measurement Using:
December 31, 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)
	($ in thousands)
Assets measured at fair value:
Term loans	$	1,061,934	$	—	$	1,025,886	$	36,048
Fixed maturities:
Corporate bonds	372,473		—		371,540		933
U.S. government and government agency bonds	285,609		285,500		109		—
Asset-backed securities	336,171		—		336,171		—
Mortgage-backed securities	32,456		—		32,456		—
Non-U.S. government and government agency bonds	133,409		—		133,409		—
Municipal government and government agency bonds	2,184		—		2,184		—
Short-term investments	329,303		318,012		11,291		—
Equities	125,137		13,548		2,998		108,591
Other underwriting derivative assets	148		—		148		—
Investment derivative assets (1)	1,667		—		1,667		—
Other investments measured at net asset value (2)	30,461		—		—		—
Total assets measured at fair value	$	2,710,952	$	617,060	$	1,917,859	$	145,572

Liabilities measured at fair value:
Investment derivative liabilities (1)	$	257	$	—	$	257	$	—
Payable for securities sold short:
Corporate bonds	66,257		—		66,257		—

Total liabilities measured at fair value	$	66,514	$	—	$	66,514	$	—

(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, 2019.

(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.

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, 2020 and 2019:


Three Months Ended September 30, 2020	Beginning Balance		Net Purchases (Sales)(1)		Net Unrealized Gains (Losses)(2)		Net Unrealized Foreign Exchange Gains (Losses)		Ending Balance
	($ in thousands)
Term loans	$	28,653	$	21,572	$	416	$	—	$	50,641
Corporate bonds	998		—		(34)		—		964

Equities	107,844		(8,349)		1,120		—		100,615
Total	$	137,495	$	13,223	$	1,502	$	—	$	152,220


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
	($ in thousands)
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

(1) For the three months ended September 30, 2020, the net purchases (sales) consisted of sales, calls and redemptions of equities of $8.3 million and term loans of $0.1 million, offset by purchases of $21.7 million of term loans. 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 $0.1 million of term loans, offset by purchases of $11.9 million of equities and $0.2 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, 2020	Beginning Balance		Net Purchases (Sales)(2)		Net Unrealized Gains (Losses)(3)		Net Unrealized Foreign Exchange Gains (Losses)		Ending Balance
	($ in thousands)
Term loans	$	36,048	$	14,314	$	279	$	—	$	50,641
Corporate bonds	933		65		(34)		—		964

Equities	108,591		(20,520)		12,544		—		100,615
Total	$	145,572	$	(6,141)	$	12,789	$	—	$	152,220

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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


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
	($ in thousands)
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

(1) During the nine months ended September 30, 2019, the Company obtained pricing for an asset-backed security, for 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, 2020, the net purchases (sales) consisted of sales, calls and redemptions of $33.4 million of equities and $7.4 million of term loans, offset by purchases of $21.7 million of term loans, $12.9 million of equities and $65.0 thousand of corporate bonds. 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, $0.2 million of redemptions of term loans and $0.1 million of calls and redemptions of corporate bonds.

(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).

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, 2020 and December 31, 2019 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, 2020, the Company’s senior notes were carried at cost, net of debt issuance costs, of $172.6 million and had a fair value of $183.8 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. There were no such triggering events or changes in circumstances as of September 30, 2020. There were no additional assets measured at fair value on a non-recurring basis as of September 30, 2020 and December 31, 2019.

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, 2020. There were no additional assets measured at fair value on a non-recurring basis as of September 30, 2020 and December 31, 2019.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

9. 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 income (loss). The risk in force of these transactions is considered the notional amount.

As of September 30, 2020 and December 31, 2019, the Company posted $10.5 million and $13.1 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. The Company invests 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 were purchased and sold in the first quarter of 2020.

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 securities” on its consolidated balance sheets. Such put options were sold in the first quarter of 2019.

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, 2020 and December 31, 2019, the Company had collateral funds held by the counterparty of $63.5 million and $64.1 million, respectively, 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 income (loss).

The Company did not hold any derivatives designated as hedging instruments at September 30, 2020 and December 31, 2019.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

The following table summarizes information on the fair values and notional amount of the Company’s derivative instruments at September 30, 2020 and December 31, 2019:


	Estimated Fair Value
	Asset Derivatives		Liability Derivatives		Net Derivatives		Notional Amount (1)
	($ in thousands)
September 30, 2020
Other underwriting derivatives	$	20	$	—	$	20	$	46,040
Total return swaps	34		3,804		(3,770)		116,623
Total	$	54	$	3,804	$	(3,750)	$	162,663

December 31, 2019
Other underwriting derivatives	$	148	$	—	$	148	$	59,879
Total return swaps	1,667		257		1,410		162,678
Total	$	1,815	$	257	$	1,558	$	222,557

(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 (loss), as summarized in the following table:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
	($ in thousands)
Underwriting derivatives:
Other underwriting income (loss)	$	546	$	579	$	1,547	$	1,844
Investment derivatives:
Net realized and unrealized gains (losses):
Options	(90)		—		991		799
Total return swaps	1,814		980		(5,082)		3,895

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,
	2020		2019		2020		2019
	($ in thousands except share and per share data)
Numerator:
Net income (loss) before preference dividends and redemption costs	$	79,154	$	6,924	$	2,483	$	78,196
Preference dividends	(1,061)		(2,608)		(3,341)		(12,423)
Accelerated amortization of costs related to the redemption of preference shares	—		(4,164)		—		(4,164)
Net income (loss) available to common shareholders	$	78,093	$	152	$	(858)	$	61,609

Denominator:
Weighted average common shares outstanding - basic	19,890,784		22,765,802		19,901,921		22,729,848
Effect of dilutive common share equivalents:
Weighted average non-vested restricted share units (1)(2)	13,267		10,402		—		4,616
Weighted average common shares outstanding - diluted (3)	19,904,051		22,776,204		19,901,921		22,734,464
Earnings (loss) per common share:
Basic	$	3.93	$	0.01	$	(0.04)	$	2.71
Diluted	$	3.92	$	0.01	$	(0.04)	$	2.71

(1) During the three months ended June 30, 2020, the Company issued 100,958 common shares, relating to restricted share units granted in the second quarter of 2019. Of these shares, 27,456 common shares vested during the three months ended June 30, 2020. During the three months ended September 30, 2020, the Company did not issue any common shares.

(2) During the three months ended September 30, 2020, the Company did not grant any restricted share units or common shares. During the nine months ended September 30, 2020 and September 30, 2019, the Company granted an aggregate of 63,591 and 165,287, respectively, of restricted share units and common shares to certain employees and directors. Of the total restricted share units and common shares granted, 103,820 are non-vested as of September 30, 2020. The weighted average non-vested restricted share units of 8,998 are excluded from the calculation of diluted weighted average common shares outstanding for the nine months ended September 30, 2020, due to a net loss reported. Refer to Note 17, “Share transactions” for further details.

(3) 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 expired on March 25, 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 2018 through 2020 in Gibraltar and 2018 through 2020 in Romania.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

Watford Holdings (U.K.) Limited is incorporated in the United Kingdom and is subject to U.K. corporate income tax. The open tax years that are potentially subject to examination by U.K. tax authorities are 2018 through 2020.

Watford Holdings (U.S.) Inc. is incorporated in the United States and files a consolidated U.S. federal tax return with its subsidiaries, WSIC, WIC, 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 2016 through 2020.

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, 2020 and December 31, 2019, the Company’s valuation allowance was $1.6 million and $1.3 million, respectively. The valuation allowance includes U.S. operating loss carry-forwards that begin to expire in 2037. After consideration of the valuation allowance, the Company had net deferred tax assets of $0.4 million and $Nil as of September 30, 2020 and December 31, 2019, respectively.

After taking into account the impact of the change in the valuation allowance, the Company recognized income tax expense (benefit) of $0.1 million and $Nil in the consolidated statements of income (loss) during the three months ended September 30, 2020 and 2019, respectively. The Company recognized income tax expense (benefit) of $(0.3) million and $0.02 million in the consolidated statements of income (loss) during the nine months ended September 30, 2020 and 2019, respectively.

The Company recognized income tax expense (benefit) of $(0.1) million and $Nil in the consolidated statements of comprehensive income (loss) during the three months ended September 30, 2020 and 2019. The Company recognized income tax expense (benefit) of $0.4 million and $Nil in the consolidated statements of comprehensive income (loss) during the nine months ended September 30, 2020 and 2019.

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, 2020 and December 31, 2019, 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 Company 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 and HPS to participate in the favorable results of the Company in the form of performance fees.

ACGL and affiliates

At September 30, 2020, ARL held approximately 12.6% of the Company’s common equity. Affiliates of ACGL held approximately 6.6% of the Company’s preference shares.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

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.

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

The related balances presented in the consolidated statements of income (loss) for the three and nine months ended September 30, 2020 and 2019 were as follows:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
	($ in thousands)
Consolidated statements of income (loss) items:
Interest expense	$	582	$	562	$	1,747	$	562
Preference dividends	70		173		221		822
Accelerated amortization of costs related to the redemption of preference shares	—		276		—		276

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 in 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.

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 statements of income (loss) for the three and nine months ended September 30, 2020 and 2019 were as follows:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
	($ in thousands)
Consolidated statements of income (loss) items:
Acquisition expenses	$	6,692	$	4,540	$	20,197	$	15,349
General and administrative expenses	1,347		1,528		3,483		5,547
Total	$	8,039	$	6,068	$	23,680	$	20,896

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

Reinsurance transactions with ACGL affiliates

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 terms of the applicable retrocession agreement. Such fees, in addition to origination fees, are reflected in “acquisition expenses” on the Company’s consolidated statements of income (loss).

The related consolidated statements of income (loss) for the three and nine months ended September 30, 2020 and 2019 were as follows:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
	($ in thousands)
Consolidated statements of income (loss) items:
Gross premiums written	$	58,449	$	49,977	$	170,168	$	160,872
Net premiums earned	64,559		51,363		174,441		180,114
Losses and loss adjustment expenses	46,064		37,291		133,364		137,554
Acquisition expenses (1)	15,876		14,384		42,882		55,189

(1) Acquisition expenses relating to the ACGL inward quota share agreements referred to above. For the three months ended September 30, 2020 and 2019, the Company incurred ceding fees to Arch, in aggregate, of $4.8 million and $3.7 million, respectively, under these inward retrocession agreements. For the nine months ended September 30, 2020 and 2019, the Company incurred ceding fees to Arch, in aggregate, of $12.6 million and $12.7 million, respectively, under these inward retrocession agreements.

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 statements of income (loss) for the three and nine months ended September 30, 2020 and 2019 for the outward retrocession transactions were as follows:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
	($ in thousands)
Consolidated statements of income (loss) items:
Gross premiums ceded	$	(15,664)	$	(63,025)	$	(52,666)	$	(95,859)
Net premiums earned	(21,747)		(18,629)		(61,797)		(45,980)
Losses and loss adjustment expenses	(16,937)		(15,057)		(50,309)		(39,978)
Acquisition expenses (1)	(4,050)		(3,422)		(11,906)		(10,110)

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

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

The related consolidated balance sheet account balances as of September 30, 2020 and December 31, 2019 were as follows:


	September 30,		December 31,
	2020		2019
	($ in thousands)
Consolidated balance sheet items:
Total investments	$	746,848	$	815,528
Premiums receivable	108,826		106,462
Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses	113,425		79,597
Prepaid reinsurance premiums	65,893		75,249
Deferred acquisition costs, net	26,676		31,609
Funds held by reinsurers	30,051		29,867
Reserve for losses and loss adjustment expenses	693,701		693,861
Unearned premiums	139,609		143,852
Losses payable	65,551		39,619
Reinsurance balances payable	47,599		62,301
Senior notes	34,524		34,484
Amounts due to affiliates	5,060		4,467
Other liabilities - contingent commissions	4,222		5,516
Contingently redeemable preference shares	3,467		3,462

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 statements of income (loss) for the three and nine months ended September 30, 2020 and 2019 were as follows:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
	($ in thousands)
Consolidated statements of income (loss) items:
Investment management fees - related parties	$	233	$	279	$	709	$	814

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

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 for the first $1.5 billion in net asset value, and 0.75% of the aggregate net value of assets exceeding $1.5 billion, 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 is 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 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 2019, the Company fully redeemed its investment in the Master Fund.

During 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. During the 2020 third quarter, the Company fully redeemed its investment in the limited partnership. The management fees and performance fees on the limited partnership will be subject to the existing fee structure of the existing investment management agreement between the Company and HPS, as discussed above.

The related consolidated statements of income (loss) for the three and nine months ended September 30, 2020 and 2019, and consolidated balance sheet account balances for HPS management fees and performance fees as of September 30, 2020 and December 31, 2019 were as follows:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
	($ in thousands)
Consolidated statements of income (loss) items:
Investment management fees - related parties	$	4,147	$	4,327	$	12,285	$	12,771
Investment performance fees - related parties	1,758		850		1,758		8,342
	$	5,905	$	5,177	$	14,043	$	21,113

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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


	September 30,		December 31,
	2020		2019
	($ in thousands)
Consolidated balance sheet items:
Other investments, at fair value	$	—	$	30,461
Investment management and performance fees payable	7,539		17,762

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, 2020 and 2019.


	Three Months Ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
	($ in thousands)
Fees paid to Artex under insurance management services agreement	$	130	$	83	$	382	$	259

For the three and nine months ended September 30, 2020 and 2019, the Company paid no fees to Arch under this insurance management services agreement.

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, 2020 and December 31, 2019 amounted to $131.7 million and $92.5 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

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

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, 2020 and December 31, 2019, 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 15, 2020, 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, 2021. 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, with which the Company was in compliance at September 30, 2020 and December 31, 2019. At such dates, the Company had $48.5 million and $51.0 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 collateral amounts are reflected as short-term investments in the Company’s consolidated balance sheets.

Unsecured letter of credit facility

On September 17, 2020, Watford Re renewed and amended its 364-day letter of credit agreement with Lloyds Bank Corporate Markets Plc and BMO Capital Markets Corp. (the “Unsecured Facility”). The Unsecured Facility amount was reduced from $100.0 million to $50.0 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. The Unsecured Facility requires the maintenance of certain covenants, as well as certain representations and warranties that are customary for facilities of this type. At September 30, 2020 and December 31, 2019, the Company had $26.1 million and $19.3 million, respectively, in outstanding letters of credit issued from the Unsecured Facility, and was in compliance with the Unsecured Facility requirements.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

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., which expires on November 30, 2021. On August 27, 2020, Watford Re elected to reduce the borrowing capacity from $800.0 million to $640.0 million, under the terms of the amended and restated agreement. 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 $320.0 million, reduced from $400.0 million as of August 27, 2020, 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, 2020, Watford Re had $210.7 million and $52.1 million in borrowings and outstanding letters of credit, respectively. At December 31, 2019, Watford Re had $484.3 million and $52.5 million in borrowings and outstanding letters of credit, respectively. At September 30, 2020 and December 31, 2019, Watford Re was in compliance with all covenants contained in the Secured Facility. On November 9, 2020, Watford Re elected to further reduce the borrowing capacity under the Secured Facility. For additional details, see Note 19, “Subsequent events”.

Custodian bank facilities

As of September 30, 2020 and December 31, 2019, Watford Re had $179.5 million and $Nil, respectively, in borrowings from our custodian banks to purchase U.S. dollar denominated securities.

The custodian banks require the Company to hold cash and investments on deposit, or in an investment account with respect to the borrowed funds. At September 30, 2020 and December 31, 2019, the Company was required to hold $302.5 million and $Nil, 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, the Company’s share-based compensation plans and the reimbursements of expenses.

Investment commitments

As of September 30, 2020, the Company had unfunded commitments of $2.2 million relating to term loans and $23.1 million relating to equities within its investment portfolios. As of December 31, 2019, the Company had unfunded commitments of $8.4 million relating to term loans and $26.4 million relating to equities within its investment portfolios.

Acquisition commitments

The Company has entered into an agreement to acquire Axeria IARD, a property and casualty insurance company based in France. The Company has committed to acquiring 100% of the capital stock of Axeria IARD from the APRIL group. The completion of this transaction is subject to regulatory approval and other customary closing conditions, and is expected to close in the first quarter of 2021.

Proposed merger

On November 2, 2020, the Company entered into an Agreement and Plan of Merger. For additional details, see Note 19, “Subsequent events”.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

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.

The lease includes 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, 2020			Nine Months Ended September 30, 2020
	($ in thousands)
Lease cost:
Operating lease	$	63		$	187
Other information on operating lease:
Cash payments included in the measurement of lease liability reported in operating cash flows	71			212
Right-of-use assets (1)	782			782
Operating lease liability (2)	782			782
Weighted average discount rate	3.9		%	3.9		%
Weighted average remaining lease term in years	3 years			3 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.

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


	September 30, 2020
	($ in thousands)
Remainder of 2020	$	71
2021	283
2022	283
2023	189
Total undiscounted lease payments	826
Less: present value adjustment	(44)
Operating lease liability	$	782

15. 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 is paid semi-annually in arrears on each January 2 and July 2, which commenced on January 2, 2020. The $172.3 million net proceeds from the offering were used to redeem a portion of the Company’s outstanding

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

preference shares, as described in Note 16, “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. After July 2, 2024, 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. 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, 2020.

As of September 30, 2020, the carrying amount of the senior notes was $172.6 million, presented net of unamortized debt issuance costs of $2.4 million. As of December 31, 2019, the carrying amount of the senior notes was $172.4 million, presented net of unamortized debt issuance costs of $2.6 million.

16. 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 basis points; 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 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, 2020 and 2019, dividends paid on the preference shares totaled $1.0 million and $2.6 million, respectively. For the nine months ended September 30, 2020 and 2019, dividends paid on the preference shares totaled $3.3 million and $12.2 million, respectively.

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 preference shares for the nine months ended September 30, 2020 and 2019:


	Nine Months Ended September 30,
	2020		2019
	($ in thousands)
Preference shares:
Balance at the beginning of the period	$	52,305	$	220,992
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	70		125
Balance at the end of the period	$	52,375	$	52,281

17. 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 and the listing of the Company’s common shares on the Nasdaq Global Select Market. 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, 2020, 678,437 shares were available for future issuance.

During the first quarter of 2020, the Company granted an aggregate of 63,591 restricted share units and common shares to certain officers, other employees and directors. On the grant date of March 1, 2020, the fair value of the restricted share units and common shares was approximately $23.00 per share. Of the total restricted share units and common shares granted, 14,675 were vested and fully expensed, including 10,870 common shares issued. The remaining 48,916 restricted share units are being amortized over a three-year vesting period, being the requisite service period. There were no forfeitures or expired awards during the second quarter of 2020.

During the second quarter of 2020, the Company issued 100,958 common shares, of which 27,456 were vested and fully expensed, relating to restricted share units granted on April 26, 2019. The Company did not issue any common shares during the third quarter of 2020.

The effect of compensation cost arising from share-based payment awards on the Company’s consolidated statements of income (loss), within “general and administrative expenses,” for the three months ended September 30, 2020 and 2019, was $0.3 million and $0.2 million, respectively. The effect of compensation cost arising from such share-based payment awards for the nine months ended September 30, 2020 and 2019 was $1.1 million and $2.5 million, respectively. The compensation cost for the nine months ended September 30, 2019 included a one-time accelerated long-term incentive expense recognition for retirement eligible employees.

WATFORD HOLDINGS LTD.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

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

Share repurchase program

In the first quarter of 2020, the board of directors of the Parent authorized the Company’s investment in its common shares through a share repurchase program under which the Company may repurchase up to $50 million of its outstanding common shares (the “current share repurchase program”).

During the first quarter of 2020, the Company purchased 127,744 shares at an average price per share of $22.42 under the current share repurchase program. As of September 30, 2020, approximately $47.1 million of unused share repurchase capacity remained available under the current share repurchase program. Since the inception of the share repurchase programs in 2019, the Company has repurchased a total of 2.9 million shares. At September 30, 2020, the shares are held in treasury, at an aggregate cost of $77.9 million (excluding transaction costs).

Repurchases of the Company’s common shares and other share-based transactions are recorded at cost and result in a reduction of the Company’s shareholders’ equity in its consolidated balance sheets. The Company does not anticipate making any further repurchases under its current share repurchase program as a result of its pending acquisition by Arch and its affiliates. For additional details regarding the acquisition, see Note 19, “Subsequent events”.

18. 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, 2020, the Company was not a 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.

19. Subsequent events

Proposed merger

On October 9, 2020, the Company announced that it had entered into an Agreement and Plan of Merger with ACGL and Greysbridge Ltd. (“Merger Sub”), which provides for the Company to be acquired by ACGL. Further, on November 2, 2020, the Company entered into Amendment No. 1 to the Agreement and Plan of Merger with ACGL and Merger Sub, and ACGL assigned its interests and obligations under the Merger Agreement to Greysbridge Holdings Ltd. (“HoldCo”), a newly formed entity of which ACGL will own approximately 40%, and funds managed by Warburg Pincus LLC and Kelso & Company will each own approximately 30%. ACGL remains contractually responsible for the performance of its obligations under the Merger Agreement.

Pursuant to the Merger Agreement, Merger Sub will merge with and into the Company, with the Company surviving as a wholly-owned subsidiary of HoldCo (the “Merger”). At the effective time of the Merger, holders of the Company’s common shares will be entitled to receive consideration of $35.00 in cash for each common share they own. The Company's preference shares will remain outstanding and will be entitled to the same dividend and other rights and preferences as are now provided to the preference shares. The Merger is expected to close in the first quarter of 2021, subject to customary closing conditions, including regulatory and shareholder approval.

Bank of America secured credit facility

On November 9, 2020, Watford Re elected to reduce the borrowing capacity under the Secured Facility with Bank of America, N.A., which expires on November 30, 2021. The Secured Facility amount was reduced from $640.0 million to $440.0 million, under the terms of the amended and restated agreement. In addition, the Secured Facility allows for Watford Re to issue up to $220.0 million, reduced from $320.0 million, in evergreen standby letters of credit.

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 $1.1 billion in capital as of September 30, 2020, comprised of $172.6 million of senior notes, $52.4 million of contingently redeemable preference shares and $866.9 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.

Proposed merger

On October 9, 2020, we entered into an Agreement and Plan of Merger with Arch and Greysbridge Ltd., or Merger Sub, pursuant to which, among other things, Merger Sub will merge with and into our company. Further, on November 2, 2020, we entered into Amendment No. 1 to the Agreement and Plan of Merger with Arch and Merger Sub, and Arch assigned its interests and obligations under the Merger Agreement to Greysbridge Holdings Ltd., a newly formed entity, or HoldCo, of which Arch will own approximately 40%, and funds managed by Warburg Pincus LLC and Kelso & Company will each own approximately 30%. Arch remains contractually responsible for the performance of its obligations under the Merger Agreement.

In this report, we refer to the Agreement and Plan of Merger, as amended, as the “Merger Agreement,” and we refer to the merger of Merger Sub with and into Watford pursuant to the

Merger Agreement, with Watford surviving as a wholly-owned subsidiary of HoldCo, as the “Merger.”

Pursuant to the Merger Agreement, subject to certain conditions set forth therein, at the effective time of the Merger, each issued and outstanding common share of Watford (other than shares to be canceled pursuant to the Merger Agreement and restricted share units to be canceled and exchanged pursuant to the Merger Agreement), will be converted into the right to receive $35.00 in cash, without interest, and each issued and outstanding 8½% cumulative redeemable preference share of Watford will remain outstanding as a preference share of the surviving company and will be entitled to the same dividend and other relative rights, preferences, limitations and restrictions as are now provided to the preference shares.

The consummation of the Merger is subject to the satisfaction of certain customary closing conditions, including, without limitation, (i) approval of the Merger Agreement and the transactions contemplated thereby by the affirmative votes of not less than 50% of the holders of our outstanding common shares and preference shares voting as a single class at a meeting of our shareholders; (ii) the expiration or early termination of the waiting period applicable to the consummation of the Merger under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, and the receipt of certain other non-U.S. regulatory approvals without the imposition of a Burdensome Condition (as defined in the Merger Agreement); (iii) the absence of any law, judgment or other legal restraint that prevents, makes illegal or prohibits the consummation of the Merger and the other transactions contemplated by the Merger Agreement; (iv) the accuracy of each party’s representations and warranties (subject to certain qualifications); (v) each party’s performance in all material respects of its obligations contained in the Merger Agreement; and (vi) the absence of a material adverse effect on our company since the date of the Merger Agreement. In addition, HoldCo’s and Arch’s obligation to consummate the Merger is conditioned on our non-investment grade portfolio not suffering a loss of more than $208 million from September 30, 2020, through the date that is two business days prior to the closing of the Merger.

The Merger Agreement includes customary representations, warranties and covenants of Watford, HoldCo, Arch and Merger Sub. Among other things, we have agreed to customary covenants regarding the operation of our business prior to the closing. We are permitted to pay regular quarterly dividends on our preference shares pursuant to the Merger Agreement. We currently anticipate that the Merger will close in the first quarter of 2021, subject to the satisfaction of the closing conditions provided for in the Merger Agreement.

Current outlook

The outbreak of COVID-19 began significantly impacting the U.S. and global markets during the 2020 first quarter. Following the 2020 first quarter, the COVID-19 global pandemic has continued to cause unprecedented economic volatility and disruption globally. We remain committed to the safety of our employees, including restricting travel and instituting a work from home policy. These actions have helped prevent a major disruption to our operations or our ability to service our clients.

The impact of the COVID-19 global pandemic on the worldwide economy has changed some aspects of our outlook. There could be elevated claims activity in certain lines of business and growth in written premium may be harder to achieve in a recessionary economy. At this time, there continue to be significant uncertainty surrounding the ultimate number of insurance claims and scope of damage resulting from this pandemic. Our estimates across our insurance and reinsurance lines of business are based on currently available information derived from modeling techniques, preliminary claims information obtained from our clients and brokers, a review of relevant in-force contracts with potential exposure to the pandemic and estimates of reinsurance recoverables. These estimates include losses related only to claims incurred as of September 30, 2020. Actual losses from these events may vary materially from the estimates due to several factors, including the inherent uncertainties in making such determinations and the evolving nature of this pandemic. In spite of

these challenges, we will continue to look for opportunities to find acceptable books of business to underwrite without sacrificing underwriting discipline and will continue to focus on writing medium to long tail business. The severity, duration and long-term impacts of the COVID-19 global pandemic are difficult to predict, but we remain committed to our clients and the markets we serve.

We believe that we are relatively less exposed to COVID-19 global pandemic-related underwriting losses than many industry peers. For example, we have either no, or de minimis, premium writings in life, accident and health, event cancellation, trade credit, travel or pandemic-specific coverages which are likely to respond directly to COVID-19 global pandemic-related losses. With regard to the potential exposure to business interruption losses, we write a limited amount of commercial property exposure, mainly emanating from our property catastrophe line of business, which is consistent with our strategy to target longer duration lines of business. We incurred a loss of $5.2 million in the first half of 2020 for business interruption losses in our property catastrophe lines of business.

We believe that mortgage insurance may potentially be affected. We write U.S. mortgage risk through a government sponsored enterprise (or “GSE”) credit risk transfer program and have some international mortgage exposure. Most of our exposure is for mortgages that were originated prior to 2018. Based upon an internal actuarial review, we have increased our loss provision in the first nine months of 2020 to account for a potential increase in defaults in our mortgage insurance portfolio.

In April 2020, we significantly reduced our exposure to U.S. mortgage risk by transferring part of that risk to other parties. This action bolstered our economic capital position at a time of significant macro-economic uncertainty. While the transferred business had been profitable, we believe this was a prudent and responsible course of action given the negative and uncertain economic outlook created by the pandemic.

We believe the casualty lines most likely to be adversely affected by the COVID-19 global pandemic are professional, medical malpractice and workers’ compensation liability. Other than the nominal casualty provision recognized in the first half of 2020, we have not added IBNR above our loss reserves for COVID-19 global pandemic-related losses occurring prior to September 30, 2020.

On a brighter note, we believe the insurance and reinsurance market environment is showing signs of noticeable price 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 and meet our risk and return criteria. In particular, we continue to see good growth opportunities in the insurance market. In particular, our insurance underwriting platforms in the United States continue their growth in premiums for 2020.

We also see opportunities on the reinsurance side in general liability, commercial auto liability and other casualty lines. Our current underwriting portfolio has concentrations in general liability, professional liability, multiline, workers’ compensation and motor product lines through reinsurance of third-party cedants and retrocessions from Arch.

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. Recently, Arch has been increasing its writings in this line in response to an improving rate environment and, as a result, our premiums have grown in proportion.

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 (excluding accrued investment income), (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, 2020 and 2019:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2020			2019			2020			2019
	($ in thousands, except percentages and per share data)
Key underwriting metrics:
Underwriting income (loss)	$	(8,238)		$	(5,021)		$	(24,959)		$	(16,257)
Combined ratio	105.6		%	104.0		%	106.0		%	103.8		%
Adjusted underwriting income (loss)	$	(5,100)		$	(2,270)		$	(14,381)		$	(5,483)
Adjusted combined ratio	103.5		%	101.8		%	103.4		%	101.3		%
Key investment return metrics:
Net interest income	$	26,516		$	29,536		$	81,747		$	86,385
Net interest income yield on average net assets (1)	1.2		%	1.4		%	4.0		%	4.1		%
Non-investment grade portfolio (1)	1.7		%	1.7		%	5.2		%	5.2		%
Investment grade portfolio (1)	0.3		%	0.6		%	1.3		%	1.8		%
Net investment income (loss)	$	92,753		$	14,040		$	29,545		$	96,181
Net investment income return on average net assets (1)	4.3		%	0.6		%	1.4		%	4.5		%
Non-investment grade portfolio (1)	6.3		%	0.6		%	0.9		%	5.1		%
Investment grade portfolio (1)	0.2		%	0.8		%	2.6		%	2.9		%
Net investment income return on average total investments (excluding accrued investment income) (2)	3.5		%	0.5		%	1.1		%	3.5		%
Non-investment grade portfolio (2)	4.9		%	0.5		%	0.8		%	4.3		%
Investment grade portfolio (2)	0.2		%	0.8		%	2.6		%	2.9		%
Key shareholders’ value creation metrics:
Book value per diluted common share (3)	$	43.36		$	42.05		$	43.36		$	42.05
Growth in book value per diluted share (3)	11.7		%	—		%	(0.3)		%	7.2		%
Annualized return on average equity (4)	N.M.			0.1		%	(0.2)		%	8.7		%

N.M. Ratio is not meaningful.

(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 (excluding accrued investment income) 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 (excluding accrued investment income).

(3) Book value per diluted common share is calculated by dividing total 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 total shareholders’ equity during the period. Annualized return on average equity for the three and nine months ended September 30, 2020 and 2019 is calculated by extrapolating the quarterly return on average equity over a twelve-month period. For the three and nine month periods, the average total shareholders’ equity is calculated as the average of the beginning and ending total shareholders’ equity of each quarterly period. Due to the net realized and unrealized gains on investments, the annualized return on average equity calculation is not meaningful for the three months ended September 30, 2020. For the three months ended September 30, 2020 and 2019, the return on average equity was 9.5% and (0.1)%, respectively.

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 expense (benefit) 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 costs associated with the ongoing operations of the holding company, such as compensation of certain executives and costs associated with the initial setup of subsidiaries. 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 costs associated with the ongoing operations of the holding company, such as compensation of certain executives and costs associated with the initial setup of subsidiaries. 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 (excluding accrued investment income)

Net investment income return on average total investments (excluding accrued investment income) is calculated by dividing net investment income (loss) by average total investments. Net investment income return on average total investments (excluding accrued investment income) 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 (excluding accrued investment income). 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 (excluding accrued investment income).

Growth in book value per diluted common share

Book value per diluted common share is calculated by dividing total 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. Book value per diluted common share is impacted by, among other factors, our underwriting results, our investment returns and our share repurchase activity, which has an accretive or dilutive impact on book value per diluted common share depending on the purchase price.

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 total 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 separate managed account. We pay HPS a management fee equal to 0.60% per annum on the assets in the separate managed account. 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 statements of income (loss), 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 statements of income (loss). The HPS non-investment grade portfolio performance fee, if applicable, is shown on a separate line in our consolidated statements of income (loss).

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 is paid semi-annually in arrears on each January 2 and July 2, which commenced on 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 costs associated with the ongoing operations of the holding company, such as compensation of certain executives and costs associated with the initial setup of subsidiaries (refer to “- Reconciliation of non-U.S. GAAP financial measures” for a discussion about certain corporate expenses).

Other recent developments

In December 2019, we entered into an agreement to acquire Axeria IARD, a P&C insurance company based in France. The completion of this acquisition is subject to regulatory approval (which, as of the date of this report, had not been received) and other customary closing conditions, and is expected to close in the first quarter of 2021. If this pending acquisition is consummated, consistent with our business model, our strategy will be to work closely with Arch to enable Axeria IARD to grow its existing business in France, as well as to develop new insurance opportunities throughout the European Union.

John Rathgeber retired as Chief Executive Officer on March 31, 2020, remaining as a director of the Company. Mr. Rathgeber served as a senior advisor to the Company from April 1, 2020 to June 30, 2020, and subsequently resigned as a member of Watford’s board of directors on October 28, 2020. Jonathan D. Levy succeeded Mr. Rathgeber as our Chief Executive Officer on April 1, 2020 and was also appointed as a member of Watford’s board of directors on May 22, 2020.

Consolidated results - for the three and nine months ended September 30, 2020 and 2019

The following table summarizes our results of operations for the three and nine months ended September 30, 2020 and 2019:


	Three Months Ended September 30,						Nine Months Ended September 30,
	2020		% Change		2019		2020		% Change		2019
	($ in thousands)
Gross premiums written	$	197,480	(21.0)	%	$	249,960	$	590,309	(1.4)	%	$	598,627
Gross premiums ceded	(50,164)				(94,208)		(150,437)				(178,118)
Net premiums written	147,316		(5.4)	%	155,752		439,872		4.6	%	420,509
Net premiums earned	146,031		16.1	%	125,832		417,605		(1.3)	%	423,244
Loss and loss adjustment expenses	(115,813)				(96,214)		(331,275)				(318,480)
Acquisition expenses	(31,110)				(27,612)		(88,963)				(97,003)
General and administrative expenses (1)	(7,346)				(7,027)		(22,326)				(24,018)
Underwriting income (loss) (2)	(8,238)		64.1	%	(5,021)		(24,959)		53.5	%	(16,257)
Other underwriting income (loss)	546				579		1,547				1,844
Interest income	34,553				41,376		108,830				123,113
Investment management fees - related parties	(4,380)				(4,606)		(12,994)				(13,585)
Borrowing and miscellaneous other investment expenses	(3,657)				(7,234)		(14,089)				(23,143)
Net interest income	26,516				29,536		81,747				86,385
Realized and unrealized gain (loss) on investments	67,995				(14,646)		(50,444)				18,138
Investment performance fees - related parties	(1,758)				(850)		(1,758)				(8,342)
Net investment income (loss)	92,753		N.M.		14,040		29,545		(69.3)	%	96,181
Interest expense	(2,912)				(2,841)		(8,735)				(2,841)
Net foreign exchange gains (losses)	(2,926)				167		4,752				(711)
Income tax (expense) benefit	(69)				—		333				(20)
Net income (loss) before preference dividends	79,154				6,924		2,483				78,196
Preference dividends	(1,061)				(2,608)		(3,341)				(12,423)
Accelerated amortization of costs related to the redemption of preference shares	—				(4,164)		—				(4,164)
Net income (loss) available to common shareholders	$	78,093	N.M.		$	152	$	(858)	(101.4)	%	$	61,609

N.M. - Percentage change is not meaningful.


	Three Months Ended September 30,								Nine Months Ended September 30,
	2020			Change		2019			2020			Change		2019
	($ in thousands)
Loss ratio	79.3		%	2.8	%	76.5		%	79.3		%	4.1	%	75.2		%
Acquisition expense ratio	21.3		%	(0.6)	%	21.9		%	21.3		%	(1.6)	%	22.9		%
General & administrative expense ratio	5.0		%	(0.6)	%	5.6		%	5.4		%	(0.3)	%	5.7		%
Combined ratio	105.6		%	1.6	%	104.0		%	106.0		%	2.2	%	103.8		%

Adjusted underwriting income (loss)(2)	$	(5,100)				$	(2,270)		$	(14,381)				$	(5,483)
Adjusted combined ratio (2)	103.5		%	1.7	%	101.8		%	103.4		%	2.1	%	101.3		%
Annualized return on average equity (3)	N.M.					0.1		%	(0.2)		%			8.7		%

N.M. Ratio is not meaningful.

(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 total shareholders’ equity during the period. Annualized return on average equity for the three and nine months ended September 30, 2020 and 2019 is calculated by extrapolating the quarterly return on average equity over a twelve-month period. For the three and nine month periods, the average total shareholders’ equity is calculated as the average of the beginning and ending total shareholders’ equity of each quarterly period. Due to the net realized and unrealized gains on investments, the annualized return on average equity calculation is not meaningful for the three months ended September 30, 2020. For the three months ended September 30, 2020 and 2019, the return on average equity was 9.5% and (0.1)%, respectively.

Results for the three months ended September 30, 2020 versus 2019:

Net income attributable to common shareholders was $78.1 million for the three months ended September 30, 2020, compared to net income of $0.2 million for the three months ended September 30, 2019. The 2020 third quarter net income increase was primarily driven by an increase in net investment income and there were no comparable expenses to those related to the 2019 third quarter redemption of 76.34% of our then outstanding preference shares. This was offset in part by increased underwriting and foreign exchange losses compared to the 2019 third quarter.

During the 2020 third quarter, net investment income increased by $78.7 million versus the prior year quarter, to $92.8 million. The increase in net investment income was primarily due to net realized and unrealized gains increasing by $82.6 million, compared to the 2019 third quarter. The 2020 third quarter net investment income reflected a continued recovery in the credit markets during the quarter, following the initial adverse impact of the COVID-19 global pandemic during the 2020 first quarter.

The 2020 third quarter underwriting loss increased $3.2 million primarily due to an increase in the loss ratio offset in part by reductions in the acquisition and general and administrative expense ratios, compared to the 2019 third quarter.

The 2020 third quarter loss ratio was 79.3%, 2.8 points higher than the 2019 third quarter. In the 2020 third quarter, the increase in loss ratio was driven by current year natural catastrophes of $6.4 million, or 4.4 points, compared to $2.4 million, or 1.9 points in the 2019 third quarter. These losses were primarily attributable to the California wildfires, the MidWest derecho and the Atlantic hurricane season events, arising in the property catastrophe reinsurance business. Other movements in the loss and acquisition expense ratios reflected changes in the mix and type of business. The prior year loss reserve development for both the 2020 and 2019 third quarters was essentially flat.

The 2020 third quarter general and administrative expense ratio was 5.0%, 0.6 points lower than the 2019 third quarter. While the ratio decreased slightly, the general and administrative expenses increased by $0.3 million in the 2020 third quarter, driven by higher corporate expenses, compared to the 2019 third quarter.

Results for the nine months ended September 30, 2020 versus 2019:

Net loss attributable to common shareholders was $0.9 million for the nine months ended September 30, 2020, compared to net income of $61.6 million for the nine months ended September 30, 2019. The nine months ended September 30, 2020 net loss was driven by a decrease in net investment income and an increase in underwriting loss, offset in part by an increase in foreign exchange gains and a reduction in capital servicing expenses associated with our senior notes and preference shares.

During the nine months ended September 30, 2020, net investment income was $29.5 million, versus the prior year comparable period net investment gain of $96.2 million. The decrease in net investment income was primarily due to an increase in net realized and unrealized losses in the 2020 first quarter. The increase in net realized and unrealized losses on investments in the 2020 first quarter reflected the impact of the COVID-19 global pandemic and the adverse economic and market conditions that followed. Conditions partially improved through the 2020 second and third quarters, reducing the net realized and unrealized loss to $50.4 million compared to a prior year net realized and unrealized gain of $18.1 million.

The underwriting loss of $25.0 million for the nine months ended September 30, 2020, compared to the underwriting loss of $16.3 million for the nine months ended September 30, 2019, was primarily the result of an increase in the loss ratio, offset in part by a reduction in the acquisition expense ratio compared to the first nine months of 2019.

The loss ratio for the nine months ended September 30, 2020 was 79.3%, 4.1 points higher than a year ago. The increase in the loss ratio partly reflected a current year natural catastrophe loss provision of $7.9 million or 1.9 points, and the COVID-19 global pandemic-related loss provision of $9.6 million, or 2.2 points, recognized during the first half of 2020. This compares to a natural catastrophe loss incurred of $3.0 million or 0.7 points for the nine months ended September 30, 2019. The COVID-19-related loss provision was partially offset by loss sensitive commissions of $2.0 million or 0.5 points. Other movements in the loss and acquisition expense ratios reflected changes in the mix and type of business. The prior year loss reserve development for both the nine months ended September 30, 2020 and 2019 was essentially flat.

Our general and administrative expense ratio was 5.4% for the nine months ended September 30, 2020, compared to 5.7% for the nine months ended September 30, 2019. The 0.3 point decrease was primarily attributable to a one-time accelerated long-term incentive expense recognized in the 2019 second quarter with no comparable expense booked for the nine months ended September 30, 2020.

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, 2020 and 2019 were as follows:


	Three Months Ended September 30,								Nine Months Ended September 30,
	2020				2019				2020				2019
	Amount		%		Amount		%		Amount		%		Amount		%
	($ in thousands)
Casualty reinsurance	$	64,860	32.8	%	$	145,129	58.1	%	$	173,803	29.4	%	$	253,287	42.3	%
Other specialty reinsurance	31,549		16.0	%	22,453		9.0	%	89,509		15.2	%	84,587		14.1	%
Property catastrophe reinsurance	4,680		2.4	%	3,461		1.4	%	25,765		4.4	%	15,382		2.6	%
Insurance programs and coinsurance	96,391		48.8	%	78,917		31.5	%	301,232		51.0	%	245,371		41.0	%
Total	$	197,480	100.0	%	$	249,960	100.0	%	$	590,309	100.0	%	$	598,627	100.0	%

Results for the three months ended September 30, 2020 versus 2019:

Gross premiums written were $197.5 million for the three months ended September 30, 2020 compared to $250.0 million for the three months ended September 30, 2019, a decrease of $52.5 million, or 21.0%. The reduction in casualty reinsurance was partially offset in part by premium increases in insurance programs and coinsurance, other specialty reinsurance and property catastrophe reinsurance.

Casualty reinsurance gross premiums written decreased $80.3 million, or 55.3%, over the prior year quarter. The premium decrease in casualty reinsurance was driven by an $81.1 million, three-year excess of loss contract written in the third quarter of 2019. The entire premium for this contract was recorded as written in the 2019 third quarter and will be earned over a three-year period. There was no comparable premium written in the third quarter of 2020.

Our insurance programs and coinsurance line of business gross premiums written increased $17.5 million, or 22.1%, to $96.4 million. The premium growth was driven by the continued expansion of our U.S. and European insurance programs and coinsurance. During the 2020 third quarter, the U.S. platform increased gross premiums written by $7.1 million, or 25.5%, to $34.9 million. Premium growth in the United States was driven by increased writings for commercial auto, where we are seeing significant rate improvement. This growth was partially offset by premium reductions in one U.S. insurance program non-renewed in 2020 and in which the underlying insureds either reported lower revenues or canceled their policies in the face of the economic shutdown related to the COVID-19 global pandemic. In addition, during the 2020 third quarter, the European platform

increased its insurance gross premiums written by $10.4 million, or 20.3%, to $61.5 million. The increase in gross premiums written primarily related to increased U.K. motor writings.

Other specialty reinsurance gross premiums written increased $9.1 million, or 40.5%, over the prior year quarter. The other specialty reinsurance premium increase was primarily attributable to an increase in our Irish motor book, as well as a reduction in the estimated premium of one European motor program in the prior year quarter. This was offset in part by mortgage reinsurance premium, which decreased as a result of the reduction in our exposure to U.S. mortgage risk, effective in the prior quarter.

Our property catastrophe reinsurance gross premiums written increased 35.2% over the prior year quarter, from $3.5 million to $4.7 million. Our primary involvement in this line of business is a 7.5% quota share participation of ARL’s worldwide property catastrophe excess of loss portfolio. Recently, Arch has been increasing its writings in this line in response to an improving rate environment and, as a result, our premiums have grown in proportion.

Results for the nine months ended September 30, 2020 versus 2019:

Gross premiums written were $590.3 million for the nine months ended September 30, 2020 compared to $598.6 million for the nine months ended September 30, 2019, a decrease of $8.3 million, or 1.4%. The decrease primarily related to premium decreases in casualty reinsurance, which were offset in part by increases in insurance programs and coinsurance, property catastrophe reinsurance and a slight written premium increase in other specialty reinsurance.

Casualty reinsurance gross premiums written decreased $79.5 million, or 31.4%, over the prior year period. The premium decrease in casualty reinsurance was driven by the $81.1 million, three-year excess of loss contract written in the third quarter of 2019, with no comparable premium written during the current period.

The $55.9 million growth 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 nine months ended September 30, 2020, the U.S. business collectively grew its insurance programs’ gross premiums written by $43.8 million, or 52.6%, to $127.2 million. Premium growth in the United States was driven by increased writings for commercial auto, where there was significant rate improvement. In addition, during the nine months ended September 30, 2020, our European business increased its insurance gross premiums written by $12.0 million, or 7.4%, to $174.1 million, primarily due to increased U.K. motor business.

Our property catastrophe reinsurance gross premiums written increased 67.5% over the prior year period, from $15.4 million to $25.8 million. Our primary involvement in this line of business is a 7.5% quota share participation of ARL’s worldwide property catastrophe excess of loss portfolio. Recently, Arch has been increasing its writings in this line in response to an improving rate environment and, as a result, our premiums have grown in proportion.

Other specialty reinsurance gross premiums written increased 5.8% over the prior year period, from $84.6 million to $89.5 million. The other specialty reinsurance premium increase was primarily attributable to an increase in our Irish motor book, the reduction in estimated premium in the prior year for one European motor program described above, offset in part by a $6.2 million contract written and earned in the prior year with no comparable premium in the current year.

Premiums ceded

Premiums ceded were $50.2 million for the three months ended September 30, 2020, compared to $94.2 million for the three months ended September 30, 2019, a decrease of $44.0 million. Premiums ceded were $150.4 million for the nine months ended September 30, 2020, compared to $178.1 million for the nine months ended September 30, 2019, a decrease of $27.7 million. The

drivers of the decrease in premiums ceded are the same as those impacting gross premiums written, as discussed above.

Net premiums written

Net premiums written for the three and nine months ended September 30, 2020 and 2019 were as follows:


	Three Months Ended September 30,								Nine Months Ended September 30,
	2020				2019				2020				2019
	Amount		%		Amount		%		Amount		%		Amount		%
	($ in thousands)
Casualty reinsurance	$	63,247	42.9	%	$	92,084	59.1	%	$	171,688	39.1	%	$	199,226	47.3	%
Other specialty reinsurance	30,157		20.5	%	22,093		14.2	%	85,484		19.4	%	81,798		19.5	%
Property catastrophe reinsurance	4,680		3.2	%	3,040		2.0	%	25,018		5.7	%	14,643		3.5	%
Insurance programs and coinsurance	49,232		33.4	%	38,535		24.7	%	157,682		35.8	%	124,842		29.7	%
Total	$	147,316	100.0	%	$	155,752	100.0	%	$	439,872	100.0	%	$	420,509	100.0	%

Results for the three months ended September 30, 2020 versus 2019:

Net premiums written were $147.3 million for the three months ended September 30, 2020 compared to $155.8 million for the three months ended September 30, 2019, a decrease of $8.5 million, or 5.4%. The decrease in our net premiums written was a result of the reduction in gross premiums written, which more than offset the decrease in premiums ceded, as discussed above.

Results for the nine months ended September 30, 2020 versus 2019:

Net premiums written were $439.9 million for the nine months ended September 30, 2020 compared to $420.5 million for the nine months ended September 30, 2019, an increase of $19.4 million, or 4.6%. The increase in our net premiums written was in line with our gross premiums written and ceded premium movements, as discussed above.

Net premiums earned

Net premiums earned for the three and nine months ended September 30, 2020 and 2019 were as follows:


	Three Months Ended September 30,								Nine Months Ended September 30,
	2020				2019				2020				2019
	Amount		%		Amount		%		Amount		%		Amount		%
	($ in thousands)
Casualty reinsurance	$	54,566	37.4	%	$	52,266	41.5	%	$	155,477	37.2	%	$	183,085	43.2	%
Other specialty reinsurance	32,833		22.5	%	31,563		25.1	%	98,073		23.5	%	118,759		28.1	%
Property catastrophe reinsurance	6,589		4.5	%	3,617		2.9	%	17,297		4.1	%	9,707		2.3	%
Insurance programs and coinsurance	52,043		35.6	%	38,386		30.5	%	146,758		35.1	%	111,693		26.4	%
Total	$	146,031	100.0	%	$	125,832	100.0	%	$	417,605	100.0	%	$	423,244	100.0	%

Results for the three months ended September 30, 2020 versus 2019:

Net premiums earned were $146.0 million for the three months ended September 30, 2020 compared to $125.8 million for the three months ended September 30, 2019, an increase of $20.2 million, or 16.1%. The increase in net premiums earned reflected increased writings in the U.S. insurance programs and coinsurance primarily due to increased commercial auto writings, and, to a lesser extent, greater assumed property catastrophe reinsurance.

Results for the nine months ended September 30, 2020 versus 2019:

Net premiums earned were $417.6 million for the nine months ended September 30, 2020 compared to $423.2 million for the nine months ended September 30, 2019, a decrease of $5.6 million, or 1.3%. The decrease in net premiums earned reflected non-renewals and gradual reductions in casualty and other specialty reinsurance contracts. This was partially offset by increased writings in insurance programs and coinsurance, and, to a lesser extent, greater assumed property catastrophe reinsurance during 2020.

Loss ratio

The following table shows the components of our loss and loss adjustment expenses for the three and nine months ended September 30, 2020 and 2019:


	Three Months Ended September 30,								Nine Months Ended September 30,
	2020				2019				2020				2019
	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	$	116,012	79.4	%	$	96,417	76.6	%	$	331,861	79.4	%	$	318,812	75.3	%
Prior year development (favorable)/adverse	(199)		(0.1)	%	(203)		(0.1)	%	(586)		(0.1)	%	(332)		(0.1)	%
Loss and loss adjustment expenses	$	115,813	79.3	%	$	96,214	76.5	%	$	331,275	79.3	%	$	318,480	75.2	%

Results for the three months ended September 30, 2020 versus 2019:

Our loss ratio was 79.3% for the three months ended September 30, 2020, compared to 76.5% for the three months ended September 30, 2019, an increase of 2.8 points. The increase in loss ratio was were primarily attributable to the California wildfires, the MidWest derecho and the Atlantic hurricane season, which resulted in losses of $6.4 million, or 4.4 points, arising in the property catastrophe reinsurance business as compared to 2.4 million or 1.9 points for the prior year quarter. Other movements in the loss and acquisition expense ratios reflected changes in the mix and type of business. The prior year loss reserve development for both the 2020 and 2019 second quarters was essentially flat.

Results for the nine months ended September 30, 2020 versus 2019:

Our loss ratio was 79.3% for the nine months ended September 30, 2020, compared to 75.2% for the nine months ended September 30, 2019, an increase of 4.1 points. The increase in the loss ratio partly reflected natural catastrophe losses of $6.4 million or 1.5 points, as compared to $3.0 million or 0.7 points in the prior year as discussed above. Additionally, the loss ratio reflected losses incurred related to the COVID-19 global pandemic of $9.6 million, or 2.2 points, which impacted our property catastrophe business, and, to a lesser extent, mortgage reinsurance business and cyber reinsurance within our other specialty reinsurance line of business, recognized in the first half of 2020. Other movements in the loss and acquisition expense ratios reflected changes in the mix and type of business. The prior year loss reserve development for the nine months ended September 30, 2020 and 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, 2020 versus 2019:

Our acquisition expense ratio was 21.3% for the three months ended September 30, 2020, compared to 21.9% for the three months ended September 30, 2019, a decrease of 0.6 points. The lower acquisition expense ratio this quarter reflected an increased percentage of insurance programs and coinsurance net premiums earned and its lower associated acquisition expense ratio.

Results for the nine months ended September 30, 2020 versus 2019:

Our acquisition expense ratio was 21.3% for the nine months ended September 30, 2020, compared to 22.9% for the nine months ended September 30, 2019, a decrease of 1.6 points. The lower acquisition expense ratio was driven by an increased percentage of insurance programs and coinsurance net premiums earned and its lower associated acquisition expense ratio, plus certain sliding scale commission reductions offsetting increases in losses incurred in the first half of 2020 related to the COVID-19 global pandemic totaling an 0.5 point reduction.

General and administrative expense ratio

Results for the three months ended September 30, 2020 versus 2019:

Our general and administrative expense ratio was 5.0% for the three months ended September 30, 2020, compared to 5.6% for the three months ended September 30, 2019. While the ratio decreased slightly, the general and administrative expenses increased by $0.3 million in the 2020 third quarter driven by higher corporate expenses, compared to the 2019 third quarter.

Results for the nine months ended September 30, 2020 versus 2019:

Combined ratio

Results for the three months ended September 30, 2020 versus 2019:

Our combined ratio was 105.6% for the three months ended September 30, 2020, compared to 104.0% for the three months ended September 30, 2019, an increase of 1.6 points. In the 2020 third quarter, there was a 2.8 point increase in the loss expense ratio, offset in part by a 0.6 point decrease in the acquisition expense ratio and a 0.6 point decrease in the general and administrative expense ratio, versus the prior period, as described above.

Results for the nine months ended September 30, 2020 versus 2019:

Our combined ratio was 106.0% for the nine months ended September 30, 2020, compared to 103.8% for the nine months ended September 30, 2019, an increase of 2.2 points. In the first nine months of 2020, there was a 4.1 point increase in the loss ratio, offset in part by a 1.6 point decrease in acquisition expense ratio and a 0.3 point decrease in the general and administrative expense ratio, versus the prior year 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,
	2020			2019			2020			2019
	($ in thousands)
Interest income	$	34,553		$	41,376		$	108,830		$	123,113
Investment management fees - related parties	(4,380)			(4,606)			(12,994)			(13,585)
Borrowing and miscellaneous other investment expenses	(3,657)			(7,234)			(14,089)			(23,143)
Net interest income	26,516			29,536			81,747			86,385
Net realized gains (losses) on investments	13,425			645			2,378			2,716
Net unrealized gains (losses) on investments	54,570			(15,291)			(52,822)			15,422
Investment performance fees - related parties	(1,758)			(850)			(1,758)			(8,342)
Net investment income (loss)	$	92,753		$	14,040		$	29,545		$	96,181

Net interest income yield on average net assets (1)	1.2		%	1.4		%	4.0		%	4.1		%
Non-investment grade portfolio (1)	1.7		%	1.7		%	5.2		%	5.2		%
Investment grade portfolio (1)	0.3		%	0.6		%	1.3		%	1.8		%
Net investment income return on average net assets (1)	4.3		%	0.6		%	1.4		%	4.5		%
Non-investment grade portfolio (1)	6.3		%	0.6		%	0.9		%	5.1		%
Investment grade portfolio (1)	0.2		%	0.8		%	2.6		%	2.9		%
Net investment income return on average total investments (excluding accrued investment income) (2)	3.5		%	0.5		%	1.1		%	3.5		%
Non-investment grade portfolio (2)	4.9		%	0.5		%	0.8		%	4.3		%
Investment grade portfolio (2)	0.2		%	0.8		%	2.6		%	2.9		%

Results for the three months ended September 30, 2020 versus 2019:

Net investment income was $92.8 million for the three months ended September 30, 2020 compared to net investment income of $14.0 million for the three months ended September 30, 2019, an increase of $78.8 million. The 2020 third quarter net investment income return on average net assets was 4.3% as compared to 0.6% for the prior period.

The 2020 third quarter net investment return was driven by net unrealized gains of $54.6 million, which reflected the continued recovery of the credit market during the quarter, following the initial adverse impact of the COVID-19 global pandemic during the 2020 first quarter. Net interest income decreased to $26.5 million from $29.5 million, a decrease of 10.2% quarter over quarter.

The 2020 third quarter non-investment grade portfolio net interest income was $24.8 million, compared to net interest income of $27.2 million in the third quarter of 2019. The decrease in net interest income in the 2020 third quarter versus the 2019 third quarter can be attributed to a portfolio shift to higher rated instruments, as well as a decrease in LIBOR. The net realized and unrealized gains reported in the 2020 third quarter were $68.7 million, reflective of the continued market recovery discussed above.

The 2020 third quarter investment grade portfolio net interest income yield was 0.3%, a decrease from 0.6% in the prior year quarter. The reduced yield this quarter reflected a reduction in interest rates versus the prior year quarter. In addition, the investment grade results reflected a reduction of net invested assets, due to collateral management actions in the prior quarter. The investment grade portfolio recognized $0.7 million of net realized losses in the quarter as compared to net realized gains of $1.4 million in the third quarter of 2019.

Results for the nine months ended September 30, 2020 versus 2019:

Net investment income was $29.5 million for the nine months ended September 30, 2020 compared to net investment income of $96.2 million in the prior year period, a decrease of $66.7 million. For the nine months ended September 30, 2020, the net investment income return on average net assets was 1.4% as compared to 4.5% for the prior year period.

The net investment income for the nine months ended September 30, 2020 was driven by net realized and unrealized losses of $50.4 million, compared to net realized and unrealized gains of $18.1 million in the prior year period. Net realized and unrealized losses in the first nine months of 2020 were driven by investment market volatility caused by the economic shutdown mandated by governments around the world related to the COVID-19 global pandemic in the first quarter of 2020, which partially recovered in the second and third quarters of 2020.

The non-investment grade portfolio net interest income for the nine months ended September 30, 2020 was $76.7 million, compared to a net interest income of $80.2 million, in the prior year period, a decrease of $3.5 million. The decrease can be attributed to a portfolio shift to higher rated instruments, as well as a decrease in LIBOR during the period. Net investment income return on average net assets was 0.9% for the nine months ended September 30, 2020, compared to 5.1% in the prior year period. The decrease was driven by net realized and unrealized losses reported through the nine months ended September 30, 2020 totaled $60.9 million, reflecting investment market volatility caused by the COVID-19 global pandemic, which partially recovered in the second and third quarter of 2020.

The investment grade portfolio net interest income yield for the nine months ended September 30, 2020 was 1.3%, a decrease from 1.8% in the prior year period. The reduction in net interest income yield was driven by lower interest rates period over period. In addition, the investment grade results reflected a reduction of net invested assets, due to collateral management actions in the prior quarter. The investment grade portfolio recognized $10.4 million of net realized and unrealized gains in the first nine months of 2020, consistent with net realized and unrealized gains of $10.3 million in the same period in 2019. The investment-grade results reflected collateral management actions in the second quarter, as we sold certain assets that were held in collateral trust as the collateral requirements had changed. Given the interest rate movements in the period, these assets realized net gains on disposal.

Growth in book value per diluted common share

Results for the three months ended September 30, 2020 versus June 30, 2020:

Book value per diluted common share was $43.36 as of September 30, 2020, compared to $38.82 per share as of June 30, 2020, an increase of $4.54, or 11.7%. The increase was driven by net investment income of $92.8 million, and other comprehensive income of $12.4 million, offset in part by

underwriting losses of $8.2 million, interest expense of $2.9 million, foreign exchange losses of $2.9 million and preference dividends of $1.1 million.

Results for the nine months ended September 30, 2020 versus December 31, 2019:

Book value per diluted common share was $43.36 as of September 30, 2020, compared to $43.49 per share as of December 31, 2019, a decrease of $0.13 or 0.3%. The decrease was primarily driven by underwriting losses of $25.0 million, interest expense of $8.7 million, preference dividends of $3.3 million and other comprehensive losses of $2.4 million, offset in part by a net investment income of $29.5 million and foreign exchange gains of $4.8 million.

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 (excluding accrued investment income), 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 costs associated with the ongoing operations of the holding company, such as compensation of certain executives and costs associated with the initial setup of subsidiaries. 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 expense (benefit) 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 expense (benefit), 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 (excluding accrued investment income), 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, 2020 and 2019 as follows:


	Three Months Ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
	($ in thousands)
Net income (loss) available to common shareholders	$	78,093	$	152	$	(858)	$	61,609
Preference dividends	1,061		2,608		3,341		12,423
Accelerated amortization of costs related to the redemption of preference shares	—		4,164		—		4,164
Net income (loss) before preference dividends and redemption costs	79,154		6,924		2,483		78,196
Income tax expense (benefit)	69		—		(333)		20
Interest expense	2,912		2,841		8,735		2,841
Net foreign exchange (gains) losses	2,926		(167)		(4,752)		711
Net investment (income) loss	(92,753)		(14,040)		(29,545)		(96,181)
Other underwriting (income) loss	(546)		(579)		(1,547)		(1,844)
Underwriting income (loss)	(8,238)		(5,021)		(24,959)		(16,257)
Certain corporate expenses	2,592		2,172		9,031		8,930
Other underwriting income (loss)	546		579		1,547		1,844
Adjusted underwriting income (loss)	$	(5,100)	$	(2,270)	$	(14,381)	$	(5,483)

Reconciliation of the adjusted combined ratio

The adjusted combined ratio reconciles to the combined ratio for the three and nine months ended September 30, 2020 and 2019 as follows:


	Three Months Ended September 30,
	2020								2019
	Amount			Adjustment		As Adjusted			Amount			Adjustment		As Adjusted
	($ in thousands)
Losses and loss adjustment expenses	$	115,813		$	—	$	115,813		$	96,214		$	—	$	96,214
Acquisition expenses	31,110			—		31,110			27,612			—		27,612
General & administrative expenses (1)	7,346			(2,592)		4,754			7,027			(2,172)		4,855
Net premiums earned (1)(2)	146,031			546		146,577			125,832			579		126,411

Loss ratio	79.3		%						76.5		%
Acquisition expense ratio	21.3		%						21.9		%
General & administrative expense ratio (1)	5.0		%						5.6		%
Combined ratio	105.6		%						104.0		%
Adjusted loss ratio						79.0		%						76.1		%
Adjusted acquisition expense ratio						21.2		%						21.8		%
Adjusted general & administrative expense ratio						3.3		%						3.9		%
Adjusted combined ratio						103.5		%						101.8		%

(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,
	2020								2019
	Amount			Adjustment		As Adjusted			Amount			Adjustment		As Adjusted
	($ in thousands)
Losses and loss adjustment expenses	$	331,275		$	—	$	331,275		$	318,480		$	—	$	318,480
Acquisition expenses	88,963			—		88,963			97,003			—		97,003
General & administrative expenses (1)	22,326			(9,031)		13,295			24,018			(8,930)		15,088
Net premiums earned (1)(2)	417,605			1,547		419,152			423,244			1,844		425,088

Loss ratio	79.3		%						75.2		%
Acquisition expense ratio	21.3		%						22.9		%
General & administrative expense ratio (1)	5.4		%						5.7		%
Combined ratio	106.0		%						103.8		%
Adjusted loss ratio						79.0		%						74.9		%
Adjusted acquisition expense ratio						21.2		%						22.8		%
Adjusted general & administrative expense ratio						3.2		%						3.6		%
Adjusted combined ratio						103.4		%						101.3		%

(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, 2020 and 2019 are as follows:


	Three Months Ended September 30, 2020												Three Months Ended September 30, 2019
	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	$	31,473		$	3,080		$	—		$	34,553		$	35,014		$	6,362		$	—		$	41,376
Investment management fees - related parties	(4,024)			(356)			—			(4,380)			(4,204)			(402)			—			(4,606)
Borrowing and miscellaneous other investment expenses	(2,678)			(270)			(709)			(3,657)			(3,573)			(225)			(3,436)			(7,234)
Net interest income	24,771			2,454			(709)			26,516			27,237			5,735			(3,436)			29,536
Net realized gains (losses) on investments	14,131			(706)			—			13,425			(750)			1,395			—			645
Net unrealized gains (losses) on investments (1)	54,574			(4)			—			54,570			(15,668)			377			—			(15,291)
Investment performance fees - related parties	(1,758)			—			—			(1,758)			(850)			—			—			(850)
Net investment income (loss)	$	91,718		$	1,744		$	(709)		$	92,753		$	9,969		$	7,507		$	(3,436)		$	14,040

Average total investments (excluding accrued investment income) (2)	$1,868,180			$771,316			$	—		$2,639,496			$1,854,911			$915,081			$	—		$2,769,992
Average net assets (3)	$1,463,905			$775,848			$(94,250)			$2,145,503			$1,586,134			$915,632			$(328,751)			$2,173,015

Net interest income yield on average net assets (3)	1.7		%	0.3		%				1.2		%	1.7		%	0.6		%				1.4		%
Net investment income return on average total investments (excluding accrued investment income) (2)	4.9		%	0.2		%				3.5		%	0.5		%	0.8		%				0.5		%
Net investment income return on average net assets (3)	6.3		%	0.2		%	(0.8)		%	4.3		%	0.6		%	0.8		%	(1.0)		%	0.6		%

(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.

(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, 2020												Nine Months Ended September 30, 2019
	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	$	96,647		$	12,183		$	—		$	108,830		$	104,845		$	18,268		$	—		$	123,113
Investment management fees - related parties	(11,940)			(1,054)			—			(12,994)			(12,446)			(1,139)			—			(13,585)
Borrowing and miscellaneous other investment expenses	(8,010)			(707)			(5,372)			(14,089)			(12,240)			(667)			(10,236)			(23,143)
Net interest income	76,697			10,422			(5,372)			81,747			80,159			16,462			(10,236)			86,385
Net realized gains (losses) on investments	(8,006)			10,384			—			2,378			392			2,324			—			2,716
Net unrealized gains (losses) on investments (1)	(52,869)			47			—			(52,822)			7,446			7,976			—			15,422
Investment performance fees - related parties	(1,758)			—			—			(1,758)			(8,342)			—			—			(8,342)
Net investment income (loss)	$	14,064		$	20,853		$	(5,372)		$	29,545		$	79,655		$	26,762		$	(10,236)		$	96,181

Average total investments (excluding accrued investment income) (2)	$1,813,645			$795,203			$	—		$2,608,848			$1,874,014			$910,784			$	—		$2,784,798
Average net assets (3)	$1,480,543			$800,695			$(223,083)			$2,058,155			$1,546,871			$909,169			$(324,452)			$2,131,588

Net interest income yield on average net assets (3)	5.2		%	1.3		%				4.0		%	5.2		%	1.8		%				4.1		%
Net investment income return on average total investments (excluding accrued investment income) (2)	0.8		%	2.6		%				1.1		%	4.3		%	2.9		%				3.5		%
Net investment income return on average net assets (3)	0.9		%	2.6		%	(2.4)		%	1.4		%	5.1		%	2.9		%	(3.2)		%	4.5		%

(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, 2020									As of September 30, 2019
	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 (excluding accrued investment income) - QTD	$	1,868,180		$	771,316	$	—	$	2,639,496	$	1,854,911		$	915,081	$	—	$	2,769,992
Average total investments (excluding accrued investment income) - YTD	1,813,645			795,203		—		2,608,848		1,874,014			910,784		—		2,784,798

Average net assets - QTD	1,463,905			775,848		(94,250)		2,145,503		1,586,134			915,632		(328,751)		2,173,015
Average net assets - YTD	1,480,543			800,695		(223,083)		2,058,155		1,546,871			909,169		(324,452)		2,131,588

Total investments	$	1,889,956		$	749,690	$	—	$	2,639,646	$	1,876,346		$	893,532	$	—	$	2,769,878
Accrued Investment Income	13,745			2,489		—		16,234		13,805			4,472		—		18,277
Receivable for Securities Sold	1,681			49		—		1,730		25,274			9		—		25,283
Less: Payable for Securities Purchased	67,602			—		—		67,602		36,870			3,716		—		40,586
Less: Payable for Securities Sold Short	24,909			—		—		24,909		65,736			—		—		65,736
Less: Revolving credit agreement borrowings	365,445			—		24,750		390,195		190,447			—		328,750		519,197
Net assets	$	1,447,426		$	752,228	$	(24,750)	$	2,174,904	$	1,622,372		$	894,297	$	(328,750)	$	2,187,919
Non-investment grade borrowing ratio (1)	25.2		%							11.7		%

Unrealized gains on investments	$	52,176		$	15,570	$	—	$	67,746	$	34,794		$	11,399	$	—	$	46,193
Unrealized losses on investments	(172,198)			(11,444)		—		(183,642)		(131,453)			(9,534)		—		(140,987)
Net unrealized gains (losses) on investments	$	(120,022)		$	4,126	$	—	$	(115,896)	$	(96,659)		$	1,865	$	—	$	(94,794)

(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 compiled relatively limited historical information through September 30, 2020. 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” contained in our Annual Report on Form 10-K for the year ended December 31, 2019, updated, where applicable, in the notes accompanying our consolidated financial statements included in this report, including Note 2, “Basis of presentation and significant accounting policies”.

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 interest on our senior notes, dividends on our preference shares and operating expenses we may incur. During the nine months ended September 30, 2020 and the year ended December 31, 2019, we received dividends of $9.0 million and $13.4 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, 2019, 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, as of December 31, 2019, Watford Re was able to pay dividends of up to $276.6 million to us during 2020 without the requirement of filing such an affidavit with the BMA. This is subject to ongoing monitoring of capital throughout 2020. 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 service our indebtedness, pay required dividends on our preference shares and satisfy other current outstanding obligations.

Financial condition

Shareholders’ equity

2020 versus 2019: Total shareholders’ equity was $866.9 million as of September 30, 2020, compared to $872.4 million as of December 31, 2019, a decrease of $5.5 million or 0.6%.

The decrease in shareholders’ equity was primarily driven by an underwriting loss of $25.0 million, an interest expense of $8.7 million, preference dividends of $3.3 million, other comprehensive loss of $2.4 million, offset in part by net investment income of $29.5 million, net foreign exchange gains of $4.8 million and other underwriting income of $1.5 million. In addition, the repurchase of 127,744 common shares during the 2020 first quarter under our $50 million share repurchase program reduced shareholders’ equity by $2.9 million.

Investment portfolios

The table below summarizes the credit quality of our non-investment grade and investment grade portfolios as of September 30, 2020 and December 31, 2019, 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, DBRS Morningstar, or DBRS, as applicable:


	Credit Rating (1)
September 30, 2020	Fair Value		AAA		AA		A		BBB		BB		B		CCC		CC		C		D		Not Rated
	($ in thousands)
Non-Investment Grade Portfolio:
Term loan investments	$	893,030	$	—	$	—	$	—	$	11,074	$	27,214	$	533,876	$	233,186	$	8,970	$	4,469	$	13,325	$	60,916
Corporate bonds	456,655		—		—		—		14,037		68,968		207,670		126,388		6,070		1,171		14,415		17,936
Asset-backed securities	164,990		—		—		5,989		88,704		28,452		9,277		8,667		842		—		—		23,059
Mortgage-backed securities	8,600		—		—		—		—		1,182		—		—		—		—		3,149		4,269
Short-term investments	252,901		54,458		132,306		63,871		—		—		—		443		—		—		—		1,823
Total fixed income instruments and short-term investments	1,776,176		54,458		132,306		69,860		113,815		125,816		750,823		368,684		15,882		5,640		30,889		108,003

Equities	113,780
Total Non-Investment Grade Portfolio	$	1,889,956	$	54,458	$	132,306	$	69,860	$	113,815	$	125,816	$	750,823	$	368,684	$	15,882	$	5,640	$	30,889	$	108,003

Investment Grade Portfolio:
Corporate bonds	$	193,357	$	—	$	20,016	$	87,672	$	80,678	$	4,991	$	—	$	—	$	—	$	—	$	—	$	—
U.S. government and government agency bonds	203,452		—		203,452		—		—		—		—		—		—		—		—		—
Asset-backed securities	84,701		—		—		16,757		63,216		4,728		—		—		—		—		—		—
Mortgage-backed securities	18,115		—		—		1,733		16,382		—		—		—		—		—		—		—
Non-U.S. government and government agency bonds	150,782		—		150,782		—		—		—		—		—		—		—		—		—
Municipal government and government agency bonds	1,793		784		595		414		—		—		—		—		—		—		—		—
Short-term investments	97,490		5,116		43,889		—		48,485		—		—		—		—		—		—		—
Total Investment Grade Portfolio	$	749,690	$	5,900	$	418,734	$	106,576	$	208,761	$	9,719	$	—	$	—	$	—	$	—	$	—	$	—
Total	$	2,639,646	$	60,358	$	551,040	$	176,436	$	322,576	$	135,535	$	750,823	$	368,684	$	15,882	$	5,640	$	30,889	$	108,003


	Credit Rating (1)
December 31, 2019	Fair Value		AAA		AA		A		BBB		BB		B		CCC		CC		C		D		Not Rated
	($ in thousands)
Non-Investment Grade Portfolio:
Term loan investments	$	1,061,934	$	—	$	—	$	—	$	—	$	9,617	$	761,168	$	215,909	$	6,823	$	2,119	$	—	$	66,298
Corporate bonds	213,841		—		—		—		—		9,003		58,345		135,613		—		—		—		10,880
Asset-backed securities	190,738		—		—		4,002		105,706		29,695		18,381		—		—		—		—		32,954
Mortgage-backed securities	7,706		—		—		—		—		976		—		—		—		—		2,497		4,233
Short-term investments	232,436		—		116,805		34,903		64,108		—		—		8,359		—		—		—		8,261
Total fixed income instruments and short-term investments	1,706,655		—		116,805		38,905		169,814		49,291		837,894		359,881		6,823		2,119		2,497		122,626
Other Investments	30,461
Equities	125,137
Total Non-Investment Grade Portfolio	$	1,862,253	$	—	$	116,805	$	38,905	$	169,814	$	49,291	$	837,894	$	359,881	$	6,823	$	2,119	$	2,497	$	122,626

Investment Grade Portfolio:
Corporate bonds	$	158,632	$	—	$	36,128	$	81,401	$	41,103	$	—	$	—	$	—	$	—	$	—	$	—	$	—
U.S. government and government agency bonds	285,609		—		285,609		—		—		—		—		—		—		—		—		—
Asset-backed securities	145,433		2,006		—		25,177		118,250		—		—		—		—		—		—		—
Mortgage-backed securities	24,750		—		—		1,100		23,650		—		—		—		—		—		—		—
Non-U.S. government and government agency bonds	133,409		—		132,460		—		949		—		—		—		—		—		—		—
Municipal government and government agency bonds	2,184		1,135		573		476		—		—		—		—		—		—		—		—
Short-term investments	96,867		25,783		20,037		—		51,047		—		—		—		—		—		—		—
Total Investment Grade Portfolio	$	846,884	$	28,924	$	474,807	$	108,154	$	234,999	$	—	$	—	$	—	$	—	$	—	$	—	$	—
Total	$	2,709,137	$	28,924	$	591,612	$	147,059	$	404,813	$	49,291	$	837,894	$	359,881	$	6,823	$	2,119	$	2,497	$	122,626

The following tables summarize the composition of the Company’s non-investment grade and investment grade portfolios by sector as of September 30, 2020 and December 31, 2019:


	September 30, 2020
	Total		Financials		Health Care		Technology		Consumer Services		Industrials		Consumer Goods		Oil & Gas		All Other (1)
	($ in thousands)
Non-Investment Grade Portfolio:
Term loan investments	$	893,030	$	188,791	$	155,104	$	154,834	$	136,778	$	121,996	$	27,779	$	29,779	$	77,969
Corporate bonds	456,655		44,767		50,186		32,676		95,102		41,723		66,282		36,173		89,746
Equities - sector specific	96,641		63,740		21,812		7,168		—		2,437		—		311		1,173
Short-term investments - sector specific	2,265		—		443		1,822		—		—		—		—		—
Subtotal	1,448,591		297,298		227,545		196,500		231,880		166,156		94,061		66,263		168,888
Equities - non-sector specific	17,139
Short-term investments - non-sector specific	250,636
Asset-backed securities	164,990

Mortgage-backed securities	8,600
Total Non-Investment Grade Portfolio	$	1,889,956	$	297,298	$	227,545	$	196,500	$	231,880	$	166,156	$	94,061	$	66,263	$	168,888

Investment Grade Portfolio:
Corporate bonds	$	193,357	$	52,606	$	10,390	$	18,844	$	24,440	$	14,713	$	42,506	$	15,221	$	14,637
Short-term investments	97,490
U.S. government and government agency bonds	203,452
Non-U.S. government and government agency bonds	150,782
Asset-backed securities	84,701
Mortgage-backed securities	18,115
Municipal government and government agency bonds	1,793
Total Investment Grade Portfolio	$	749,690	$	52,606	$	10,390	$	18,844	$	24,440	$	14,713	$	42,506	$	15,221	$	14,637
Total Investments	$	2,639,646	$	349,904	$	237,935	$	215,344	$	256,320	$	180,869	$	136,567	$	81,484	$	183,525

(1) Includes telecommunications, utilities and basic materials.


	December 31, 2019
	Total		Financials		Health Care		Technology		Consumer Services		Industrials		Consumer Goods		Oil & Gas		All Other (1)
	($ in thousands)
Non-Investment Grade Portfolio:
Term loan investments	$	1,061,934	$	212,800	$	221,982	$	232,659	$	121,434	$	111,912	$	46,827	$	52,200	$	62,120
Corporate bonds	213,841		17,547		19,160		10,972		28,144		13,822		23,491		27,632		73,073
Equities - sector specific	101,551		55,946		30,640		11,263		—		1,283		—		1,040		1,379
Short-term investments - sector specific	16,620		8,261		—		3,030		—		5,329		—		—		—
Subtotal	1,393,946		294,554		271,782		257,924		149,578		132,346		70,318		80,872		136,572
Equities - non-sector specific	23,586
Short-term investments - non-sector specific	215,816
Asset-backed securities	190,738
Other investments	30,461
Mortgage-backed securities	7,706
Total Non-Investment Grade Portfolio	$	1,862,253	$	294,554	$	271,782	$	257,924	$	149,578	$	132,346	$	70,318	$	80,872	$	136,572

Investment Grade Portfolio:
Corporate bonds	$	158,632	$	72,707	$	12,087	$	8,035	$	11,752	$	10,548	$	32,046	$	5,734	$	5,723
Short-term investments	96,867
U.S. government and government agency bonds	285,609
Non-U.S. government and government agency bonds	133,409
Asset-backed securities	145,433
Mortgage-backed securities	24,750
Municipal government and government agency bonds	2,184
Total Investment Grade Portfolio	$	846,884	$	72,707	$	12,087	$	8,035	$	11,752	$	10,548	$	32,046	$	5,734	$	5,723
Total Investments	$	2,709,137	$	367,261	$	283,869	$	265,959	$	161,330	$	142,894	$	102,364	$	86,606	$	142,295

(1) Includes telecommunications, utilities and basic materials.

The fair value of our term loans, fixed maturities and short-term investments in our non-investment grade and investment grade portfolios, summarized by contractual maturity as of September 30, 2020 and December 31, 2019 were as follows:


	Contractual Maturity
September 30, 2020	Fair Value		Due in One Year or Less		Due After One Through Two Years		Due After Three Through Five Years		Due After Five Through Ten Years		Due After Ten Years
	($ in thousands)
Non-Investment Grade Portfolio:
Term loan investments	$	893,030	$	70,728	$	132,592	$	405,492	$	284,218	$	—
Corporate bonds	456,655		28		59,603		218,179		171,198		7,647
Short-term investments	252,901		252,901		—		—		—		—
Subtotal	1,602,586		323,657		192,195		623,671		455,416		7,647
Asset-backed securities	164,990
Mortgage-backed securities	8,600

Equities	113,780
Total Non-Investment Grade Portfolio	$	1,889,956	$	323,657	$	192,195	$	623,671	$	455,416	$	7,647

Investment Grade Portfolio:
Corporate bonds	$	193,357	$	4,496	$	24,326	$	65,018	$	82,839	$	16,678
U.S. government and government agency bonds	203,452		863		177,953		21,031		3,605		—
Non-U.S. government and government agency bonds	150,782		22,395		27,557		51,659		49,171		—
Municipal government and government agency bonds	1,793		—		1,379		414		—		—
Short-term investments	97,490		97,490		—		—		—		—
Subtotal	646,874		125,244		231,215		138,122		135,615		16,678
Asset-backed securities	84,701
Mortgage-backed securities	18,115
Total - Investment Grade Portfolio	$	749,690	$	125,244	$	231,215	$	138,122	$	135,615	$	16,678
Total	$	2,639,646	$	448,901	$	423,410	$	761,793	$	591,031	$	24,325


	Contractual Maturity
December 31, 2019	Fair Value		Due in One Year or Less		Due After One Through Two Years		Due After Three Through Five Years		Due After Five Through Ten Years		Due After Ten Years
	($ in thousands)
Non-Investment Grade Portfolio:
Term loan investments	$	1,061,934	$	23,683	$	289,985	$	314,908	$	433,358	$	—
Corporate bonds	213,841		15,746		21,879		113,750		61,933		533
Short-term investments	232,436		232,436		—		—		—		—
Subtotal	1,508,211		271,865		311,864		428,658		495,291		533
Asset-backed securities	190,738
Mortgage-backed securities	7,706
Other Investments	30,461
Equities	125,137
Total Non-Investment Grade Portfolio	$	1,862,253	$	271,865	$	311,864	$	428,658	$	495,291	$	533

Investment Grade Portfolio:
Corporate bonds	$	158,632	$	2,760	$	45,676	$	54,584	$	43,586	$	12,026
U.S. government and government agency bonds	285,609		1,490		212,884		41,976		29,259		—
Non-U.S. government and government agency bonds	133,409		6,745		31,443		32,213		63,008		—
Municipal government and government agency bonds	2,184		—		253		1,330		601		—
Short-term investments	96,867		96,867		—		—		—		—
Subtotal	676,701		107,862		290,256		130,103		136,454		12,026
Asset-backed securities	145,433
Mortgage-backed securities	24,750
Total - Investment Grade Portfolio	846,884		$	107,862	$	290,256	$	130,103	$	136,454	$	12,026
Total	$	2,709,137	$	379,727	$	602,120	$	558,761	$	631,745	$	12,559

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, 2020:

Total: $1,890.0 million

Total: $749.7 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 12 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. For a discussion of the risks related to the potential future impacts of the COVID-19 global pandemic on our liquidity and capital resources, see Part II, Item 1A, “Risk Factors” in this report.

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 and routine sales of investments. The following table summarizes our cash flows from operating, investing and financing activities for the nine months ended September 30, 2020 and 2019:


	Nine Months Ended September 30,
	2020		2019
	($ in thousands)
Cash and cash equivalents provided by (used for):
Operating activities	$	142,594	$	177,182
Investing activities	53,502		28,485
Financing activities	(100,231)		(187,453)
Effects of exchange rate changes on foreign currency	(2,969)		(1,353)
Change in cash and cash equivalents	$	92,896	$	16,861

Results for the nine months ended September 30, 2020:

•Cash provided by operating activities for the nine months ended September 30, 2020 was lower than the same period in 2019. We continued to generate strong operating cash inflows, primarily driven by our premium receipts, however this positive cash flow impact was negated by higher paid claims and lower net investment income received than for the same period in 2019.

•Cash provided by investing activities for the nine months ended September 30, 2020 was higher than the same period in 2019. This was driven by an increase in net sales of term loans and equity securities, and a decrease in the net purchases of short-term investments for the nine months ended September 30, 2020 than the same period in 2019.

•Cash used for financing activities for the nine months ended September 30, 2020 was lower than the same period in 2019, due to lower dividends paid on preference shares and increased use of the custodian bank facilities, offset in part by an increase in borrowing repayments during the 2020 period. In addition, we purchased $2.9 million of our own common shares under our $50 million share repurchase program during the 2020 first quarter.

Our investments in certain securities and loans may be illiquid due to contractual provisions or may prove to be illiquid in certain investment market conditions. Changes in general economic conditions could have a material adverse effect on the value and liquidity of the investments in our investment portfolios. The COVID-19 global pandemic has severely impacted the financial markets, which has had a material adverse effect on our non-investment grade portfolio, in particular. If we require significant amounts of cash on short notice in excess of our 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 our debt service obligations and payment of dividends on our preference shares. 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, strengthens our ability to fund the payment of claims and to service our other outstanding obligations without having to sell securities or loans 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 continue our business operations and execute our strategy, 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.

In the first quarter of 2020, our board of directors authorized a share repurchase program, which allows us to make repurchases of up to $50 million of our common shares from time to time in open market or privately negotiated transactions. During the first quarter of 2020, we repurchased 127,744 common shares at an average price of $22.42 per share for an aggregate cost of $2.9 million. With the onset of the COVID-19 global pandemic, we temporarily halted repurchases under the program following the first quarter of 2020, and we did not repurchase any of our common shares during the second or third quarters of 2020. As of September 30, 2020, approximately $47.1 million of unused share repurchase capacity remained available under the program. However, we do not anticipate making any further repurchases under the share repurchase program as a result of our entry into the Merger Agreement, which generally prohibits us from repurchasing our shares as well as certain other securities. Accordingly, 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, 2020				December 31, 2019
	Amount		% of Total Capital		Amount		% of Total Capital
	($ in thousands)
Debt:
Senior notes	$	172,621	15.8	%	$	172,418	15.7	%
Shareholders’ equity:
Preference shares	52,375		4.8	%	52,305		4.8	%
Shareholders’ equity	866,899		79.4	%	872,353		79.5	%
Total shareholders’ equity	919,274		84.2	%	924,658		84.3	%
Total capital available to Watford	$	1,091,895	100.0	%	$	1,097,076	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. For more information regarding the current status of our ratings, see “-Ratings” below.

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.

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. The aggregate principal amount was in line with our then-current limit on Tier 3 capital credit under the BMA’s regulatory framework. Interest on our senior notes is paid semi-annually in arrears on each January 2 and July 2, which commenced on January 2, 2020. Affiliates of ACGL 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 incur interest expenses and a reduction of preference dividends, 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 financing 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. 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 cedants, program administrators, agents, brokers and insureds targeted in our marketing plan.

In response to the unrealized, adverse mark-to-market impact on the valuation of our investment portfolios caused by the economic shutdown related to the COVID-19 global pandemic, A.M. Best and KBRA issued press releases noting potential future rating actions. In particular, on May 1, 2020, A.M. Best announced that it had placed the “A-” financial strength ratings of our operating

subsidiaries “under review with negative implications.” In addition, A.M. Best also placed “under review with negative implications” the long-term issuer credit rating of “BBB-” and the long-term issuer credit rating of “BB” on our cumulative contingently-redeemable preference shares. The designation of being “under review with negative implications” indicates that a previously-published rating has the potential for a near-term change (typically within six months) due to a recent event or abrupt change in the financial condition of the entity to which the rating applies. The rating remains under review until A.M. Best is able to determine the implications of the circumstances that facilitated the under review status, before making its final opinion. In addition, on June 17, 2020, after previously putting our ratings on “watch” status following the COVID-19 global pandemic related impact to our investment portfolios, KBRA reaffirmed the “A” insurance financial strength ratings of our operating subsidiaries and revised the outlook for all of our ratings to negative. Further, following and as a result of our announcement that we had entered into the Merger Agreement, on October 9, 2020, KBRA announced that it had placed all of our ratings on “watch developing” status.

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.

In general, notwithstanding the prevailing global economic uncertainty related to the COVID-19 global pandemic, the current insurance and reinsurance market environment overall remains extremely competitive but is starting to show signs of hardening. 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. 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. However, due to recent property catastrophe losses, higher perceived social inflation, the reduction in risk free rates, and the uncertainty for the P&C business created by the COVID-19 global pandemic, pricing on certain product lines are firming and becoming more attractive on a risk adjusted basis.

In recent years, there have been certain product lines that have experienced a favorable hardening, such as U.K. and 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, 2020 and 2019 were $61.5 million and $51.2 million, respectively. Gross premiums written by WICE for the nine months ended September 30, 2020 and 2019 were $174.1 million and $162.1 million, respectively. The majority of such premiums relate to U.K. motor insurance.

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 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, 2020, our largest modeled peak peril and zone net occurrence PML was 4.5% 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.

For more information regarding our current outlook related to the impact of the COVID-19 global pandemic on the insurance and reinsurance industry and our business, see “-Current outlook” above.

Contractual obligations and commitments

Lloyds letter of credit facility

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, 2020 and December 31, 2019. At such dates, we had approximately $48.5 million and $51.0 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 collateral amounts are reflected as short-term investments in our consolidated balance sheets.

Unsecured letter of credit facility

On September 17, 2020, Watford Re renewed and amended its 364-day letter of credit agreement with Lloyds Bank Corporate Markets Plc and BMO Capital Markets Corp. (the “Unsecured Facility”). The Unsecured Facility amount was reduced from $100.0 million to $50.0 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. The Unsecured Facility requires the maintenance of certain covenants, as well as certain representations and warranties that are customary for facilities of this type. At September 30, 2020 and December 31, 2019, we had $26.1 million and $19.3 million, respectively, in outstanding letters of credit issued from the Unsecured Facility, and were in compliance with the Unsecured Facility requirements.

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. On August 27, 2020, Watford Re elected to reduce the borrowing capacity from $800.0 million to $640.0 million, under the terms of the amended and restated agreement. Watford Re owns all of the beneficial interests of Watford Trust. The Secured 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 Secured 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 Secured Facility, 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 under the Secured 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 Secured Facility allows for us to issue up to $320.0 million, reduced from $400.0 million as of August 27, 2020, 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.

On November 9, 2020, Watford Re elected to further reduce the borrowing capacity under the Secured Facility from $640.0 million to $440.0 million, under the terms of the amended and restated

agreement. In addition, the Secured Facility allows for Watford Re to issue up to $220.0 million, reduced from $320.0 million, in evergreen standby letters of credit.

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


	September 30,		December 31,
	2020		2019
	($ in thousands)
Borrowings to purchase investments	$	185,937	$	155,537
Borrowings to purchase collateral	24,750		328,750
Total secured credit facility borrowings	210,687		484,287
Outstanding letters of credit	52,111		52,533

The Secured Facility contains various affirmative and negative covenants. As of September 30, 2020 and December 31, 2019, Watford Re was in compliance with all covenants contained in the Secured Facility.

Custodian bank facilities

As of September 30, 2020 and December 31, 2019, we had borrowings of $179.5 million and $Nil, respectively, from our custodian banks to purchase U.S. dollar denominated securities. We pay interest based on 3-month LIBOR plus a margin and the borrowed amount is payable upon demand.

The custodian banks require us to hold cash and investments on deposit, or in an investment account with respect to the borrowed funds. At September 30, 2020 and December 31, 2019, we were required to hold $302.5 million and $Nil, 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 is paid semi-annually in arrears on each January 2 and July 2, which commenced on 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. At September 30, 2020, the carrying amount of the senior notes was $172.6 million, presented net of unamortized debt issuance costs of $2.4 million.

Master confirmation of total return swap transactions

On August 13, 2018, Watford Re executed a Master Confirmation of Total Return Swap Transactions (the “Master TRS”) with Credit Suisse International (“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 in Part I, Item 1 of this report for further details.

As of September 30, 2020 and December 31, 2019, we held $2.2 billion and $2.1 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 $7.8 million and $6.4 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, 2020 and December 31, 2019:


	September 30,		December 31,
	2020		2019
	($ in thousands)
Total investments held in trust as collateral for underwriting transactions and regulatory deposits	$	959,713	$	1,087,707
Total investments pledged for Secured Facility	828,198		935,132
Total investments pledged for custodian banks	302,542		—
Total investments pledged for Lloyds Facilities	48,485		51,047
Total investments pledged for Master TRS	63,475		64,107

Contractual obligations and commitments

The following table illustrates our contractual obligations and commitments by due date as of September 30, 2020 and December 31, 2019:


	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, 2020
Estimated gross payments for losses and loss adjustment expenses (1)	$	1,429,656	$	362,294	$	481,224	$	250,134	$	336,004
Interest payments on senior notes (2)	102,375		11,375		22,750		22,750		45,500
Senior notes (2)	175,000		—		—		—		175,000
Revolving credit agreement borrowings (3)	390,195		390,195		—		—		—
Operating lease obligations	826		283		543		—		—
Total	$	2,098,052	$	764,147	$	504,517	$	272,884	$	556,504
December 31, 2019
Estimated gross payments for losses and loss adjustment expenses (1)	$	1,263,628	$	319,685	$	415,163	$	223,406	$	305,374
Interest payments on senior notes (2)	108,094		11,375		22,750		22,750		51,219
Senior notes (2)	175,000		—		—		—		175,000
Revolving credit agreement borrowings (3)	484,287		484,287		—		—		—
Operating lease obligations	1,038		283		566		189		—
Total	$	2,032,047	$	815,630	$	438,479	$	246,345	$	531,593

(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). As of September 30, 2020, the modeled duration of our claims reserves was approximately 4.4 years.

(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 is paid semi-annually in arrears on each January 2 and July 2, which commenced on 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, 2020 and December 31, 2019 totaled $263.3 million and $171.0 million, respectively.

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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.

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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, $1.6 billion, or 40.8%, 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, 2020 and December 31, 2019, net loss and loss adjustment expense reserves included $485.6 million and $413.7 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, 2020 and December 31, 2019, our total net long exposure to foreign denominated investments represented 11.9% and 11.5% of our total investment portfolios of $2.6 billion and $2.7 billion, respectively.

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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, 2020 and December 31, 2019:


	September 30,		December 31,
	2020		2019
(U.S. dollars in thousands, except per share data)
Assets, net of insurance liabilities, denominated in foreign currencies, excluding shareholders’ equity and derivatives	$	84,031	$	56,382
Shareholders’ equity denominated in foreign currencies (1)	(21,713)		(26,529)
Net assets denominated in foreign currencies	$	62,318	$	29,853
Pre-tax impact of a hypothetical 10% appreciation of the U.S. dollar against foreign currencies:
Shareholders’ equity	$	(6,232)	$	(2,985)
Book value per diluted common share	$	(0.31)	$	(0.15)
Pre-tax impact of a hypothetical 10% decline of the U.S. dollar against foreign currencies:

Shareholders’ equity	$	6,232	$	2,985
Book value per diluted common share	$	0.31	$	0.15

(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.

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The following table estimates the impact that a 50 basis point and 100 basis point increase or decrease in interest rates would have had on the value of our investment portfolios as of September 30, 2020 and December 31, 2019:


	Interest Rate Shift in Basis Points
(U.S. dollars in millions)	-100			-50			0			+50			+100
September 30, 2020
Total fair value	$	2,707		$	2,673		$	2,640		$	2,611		$	2,585
Change from base	2.5		%	1.3		%	—		%	(1.1)		%	(2.1)		%
Change in unrealized value	$	67		$	33		$	—		$	(29)		$	(55)

December 31, 2019
Total fair value	$	2,739		$	2,724		$	2,709		$	2,693		$	2,679
Change from base	1.1		%	0.6		%	—		%	(0.6)		%	(1.1)		%
Change in unrealized value	$	30		$	15		$	—		$	(16)		$	(30)

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 the value of our investment portfolios as of September 30, 2020 and December 31, 2019:


	Percentage Shift in Credit Spreads
(U.S. dollars in millions)	-50%			-10%			0			+10%			+50%
September 30, 2020
Total fair value	$	2,829		$	2,679		$	2,640		$	2,596		$	2,433
Change from base	7.2		%	1.5		%	—		%	(1.7)		%	(7.8)		%
Change in unrealized value	$	189		$	39		$	—		$	(44)		$	(207)

December 31, 2019
Total fair value	$	2,836		$	2,735		$	2,709		$	2,681		$	2,569
Change from base	4.7		%	1.0		%	—		%	(1.0)		%	(5.2)		%
Change in unrealized value	$	127		$	26		$	—		$	(28)		$	(140)

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

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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, 2020 and December 31, 2019, represented 5.8% and 5.4% of our total investments, respectively. If we require significant amounts of cash on short notice in excess of anticipated 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.

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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 on 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 fiscal quarter ended September 30, 2020 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. We have not experienced any material impact to our internal controls over financial reporting despite the fact that most employees of the Company and of our service providers have had to work from home during the COVID-19 global pandemic, though we will continue to assess the impact on the design and operating effectiveness of our internal controls.

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.

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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. In addition, potential plaintiffs may file lawsuits challenging the Merger, which could prevent or delay the consummation of the Merger, result in substantial costs to us or otherwise adversely affect our business, financial condition, results of operations or cash flows. As of September 30, 2020, 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 securities involves risks. For a discussion of the these potential risks or uncertainties, please see Part I—Item 1A—“Risk Factors” and Part II—Item 7—“Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2019 filed with the SEC (or our 2019 Annual Report), and Part I—Item 2—“Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this report, in each case as updated by our subsequent periodic filings with the SEC.

Other than as described below, there have been no material changes from the risk factors previously disclosed in Part I—Item 1A, “Risk Factors” of our 2019 Annual Report.

Risks related to the COVID-19 global pandemic

The impact of the COVID-19 global pandemic and related risks could materially affect our results of operations, financial position and/or liquidity.

The continuing, global pandemic caused by the novel coronavirus COVID-19 has continued to impact the global economy, financial markets and our results of operations. In addition, the COVID-19 global pandemic could materially disrupt the business operations of Arch, HPS or other third parties with whom we interact. Because of the size and breadth of this pandemic, all of the direct and indirect consequences of the COVID-19 global pandemic are not yet known and are likely to continue to emerge for some time.

The pandemic could have a significant effect on our business, results of operations, and current and future financial performance. We may continue to experience higher levels of loss and claims activity in certain lines of business and our premiums written and earned could also be adversely affected by a suppression of global commercial activity that results in a reduction in insurable assets and other exposures. Conditions in the financial markets resulting from the COVID-19 global pandemic continue to have a negative effect on the value and quality of the assets we hold within our investment portfolios, thereby adversely affecting our investment income and increasing our credit and related risk. Certain lines of our business may require additional forms of collateral in the event of a decline in the fair value of investments and benchmarks to which those repayment mechanisms are linked. The continued impacts of the pandemic to the financial markets may also adversely affect our ability to access funding through public or private equity offerings, debt financings, and through other means at acceptable terms. In addition, in connection with our pending acquisition of Axeria IARD, we are also evaluating Axeria’s potential exposure to COVID-19 global pandemic related losses.

In particular, disruption in the financial markets related to the COVID-19 global pandemic has contributed to net realized and unrealized losses, due to the impact of changes in fair value on our non-investment grade investment portfolio, and, to a lesser extent, our investment grade

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investment portfolio. Our investment portfolios may continue to be adversely impacted by ratings downgrades, increased bankruptcies and credit spread widening in distressed industries, such as energy, gaming, lodging and leisure, autos, airlines and retail. Our investment portfolios also include mortgage-backed securities, which could continue to be adversely impacted by declines in real estate valuations and/or financial market disruption, including a heightened collection risk on the underlying mortgages and on rent receivables. Further disruptions in global financial markets due to the continuing impact of the COVID-19 global pandemic could result in additional net realized and unrealized investment losses, including potential impairments in our investment portfolios. In addition, declines in fixed income yields would result in decreases in net investment income from future investment activity, including re-investments.

For further discussion of certain of the risks related to our underwriting and investment portfolios, see “Claims for natural catastrophic events or unanticipated losses from war, pandemic, terrorism and political instability could cause large losses and substantial volatility in our results of operations and could have a material adverse effect on our financial position and results of operations,” “Emerging claim and coverage issues may adversely affect our business,” “The performance of our investments is highly dependent upon conditions in the global economy or financial markets that are outside of our Investment Managers’ control and can be difficult to predict,” and “The determination of the amount of allowances and impairments taken on our investments is highly subjective and could materially impact our results of operations or financial position.” included in Part I—Item 1A—“Risk Factors” in our 2019 Form 10-K. In addition, for more information regarding our current outlook related to the impact of the COVID-19 global pandemic on the insurance and reinsurance industry and our business, see Part I, Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Current outlook” in this report.

Governmental and regulatory actions or judicial interpretations in response to the COVID-19 global pandemic may adversely affect our financial performance and our ability to conduct our businesses as we have in the past.

Federal, state and/or local government actions or judicial interpretations in the United States and other countries where we do business to address and mitigate the impact of the COVID-19 global pandemic have adversely affected us and may adversely affect us in the future. For example, the coverages we provide are potentially subject to legislative and/or regulatory action or judicial interpretations that seek to retroactively mandate coverage for losses which our (re)insurance policies were not designed or priced to cover or that otherwise look to extend or interpret the language of our policies.

In particular, in the case of business interruption insurance, if any laws, regulations or interpretations were to determine that a pandemic constitutes physical damage, which is the risk primarily insured in business interruption policies, this could have a material adverse effect on the volume and scope of claims in the business interruption coverage we write in our property catastrophe reinsurance line of business. One such example of regulatory action is the ongoing U.K. Financial Conduct Authority, or FCA, test case that was initiated in June 2020 against a group of insurers to clarify the interpretation and application of commonly-used insurance coverage extensions in business interruption insurance policies in the context of losses arising from the COVID-19 global pandemic. In September 2020, the High Court of England and Wales delivered a judgment in this case, finding for the FCA on the majority of the issues of interpretation. In late September, the parties to the case, including those insurers directly impacted, filed an application for permission to appeal with the U.K. Supreme Court, which appeal the court will hear in mid-November. The test case was not intended to encompass all possible disputes, but to resolve some key contractual uncertainties and causation issues to provide clarity for policyholders and insurers. However, each policyholder’s claim is different and the ultimate outcome in this case will depend on the relevant policy and underlying circumstances. We are not a party to this test case. However, the case is being monitored by parties in other jurisdictions and could lead to similar actions or proceedings in those jurisdictions. Furthermore, in some U.S. states there currently is proposed

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legislation to require insurers to cover business interruption claims irrespective of terms, exclusions or other conditions included in the policies that would otherwise preclude coverage.

In addition, a number of states have instituted, and other states are considering instituting, changes designed to effectively expand workers’ compensation coverage by creating presumptions of compensability of claims for certain types of workers. Regulatory restrictions or requirements have impacted or may impact pricing, risk selection and our rights and obligations with respect to our policies and insureds, including our ability to cancel and non-renew policies and to collect premiums. Several state regulators have issued orders requiring insurers to issue partial premium refunds, and regulators in other states could take similar actions. Many insurers, including us, have also voluntarily provided, and may further provide, partial premium refunds to their customers. It is also possible that changes in economic conditions and steps taken by federal, state and local governments in response to the COVID-19 global pandemic could require an increase in taxes at the federal, state and local levels, which could adversely impact our results of operations. In addition, in connection with our pending acquisition of Axeria IARD, we are also evaluating the potential impact such governmental actions, restrictions and requirements could have on Axeria’s business.

The disruption and other effects caused by the COVID-19 global pandemic could continue to adversely affect our business operations, financial performance and results.

To protect our employees and in response to the global and regional restrictions on interpersonal contact and travel because of the COVID-19 global pandemic, our work force is working remotely, placing increased demands on our IT systems. Remote working arrangements may increase the risk of cyber-security attacks or data security incidents. While we believe we have continued to conduct our business effectively, there is no assurance that our ability to continue to function in this new environment will not be adversely affected by an extended period of limited access to our physical facilities or by other developments such as an extended disruption to our systems that support our remote work capability. We also depend on Arch, HPS and other third-party platforms and infrastructure to operate our business and provide certain of our products and services, and such third-party infrastructures face similar risks. In addition, the continuation of the COVID-19 global pandemic may continue to adversely affect our business operations, including our ability to carry on business development activities and unavailability of employees due to illness or quarantines, among others. In addition, in connection with our pending acquisition of Axeria IARD, we are also evaluating the potential impact of such disruptions and restrictions could have on Axeria’s operations. For a further discussion, see “We depend on our ability to maintain effective operating procedures, and our operational structure remains under development.” “Any acquisitions, growth or expansion of our operations may expose us to risks.” and “Technology breaches or failures, including those resulting from a cyberattack on us or our service providers and program administrators, could disrupt or otherwise negatively impact our business.” included in Part I-Item 1A-“Risk Factors” in our 2019 Form 10-K.

As a result of the above risks, the COVID-19 global pandemic could materially and adversely impact our results of operations, financial position and/or liquidity.

Risks related to our company

A ratings downgrade or other negative action by a rating agency could materially affect our business, financial condition and results of operations.

Various rating agencies review the financial performance and condition of insurance and reinsurance companies, including our operating subsidiaries, and publish their financial strength ratings as indicators of an insurer’s or reinsurer’s ability to fulfill its contractual obligations. These ratings are important to maintaining public confidence in our insurance and reinsurance products. A downgrade or other negative action by a rating agency with respect to the financial strength ratings of our operating subsidiaries could negatively affect us by limiting or restricting the ability

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of our operating subsidiaries to pay dividends to us and reducing our revenues by adversely affecting our ability to write insurance and reinsurance business.

Rating agencies also publish credit ratings for us. Credit ratings are indicators of a debt issuer’s ability to meet the terms of debt obligations in a timely manner. These ratings are important to our overall ability to access certain types of capital. Actual or anticipated downgrades in our credit ratings, or an announcement that our ratings are under further review for a downgrade, could potentially have a negative effect on our financial condition and results of operations. Such an event could limit our access to capital markets, increase the cost of debt, or impair our ability to raise capital to refinance maturing debt obligations, thereby potentially limiting our capacity to support growth at our operating subsidiaries or making it more difficult to maintain or improve the current financial strength ratings of our operating subsidiaries.

In particular, in May 2020, A.M. Best announced that it had placed the financial strength ratings of our operating subsidiaries and our credit ratings under review with negative implications. In addition, in June 2020, KBRA reaffirmed the “A” insurance financial strength ratings of our operating subsidiaries, and revised the outlook for all of the ratings to negative and, on October 9, 2020, placed all of the ratings on “watch developing” status as a result of our entry into the Merger Agreement. For more information, see Part I, Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Financial Condition, Liquidity and Capital Resources- Liquidity and Capital Resources-Ratings” in this report.

Ratings reflect only a rating agency’s views and are not recommendations to buy, sell or hold our securities. Rating agencies assign ratings based upon several factors. While most of the factors relate to the rated company, some of the factors relate to the views of the rating agency, general economic conditions and circumstances outside the rated company’s control. In addition, rating agencies use various models and formulas to assess the strength of a rated company, and from time to time rating agencies have, in their discretion, altered the models. Changes to the models could impact a rating agency’s judgment of the rating to be assigned to the rated company. There can be no assurance that our current financial strength and credit ratings will remain in effect for any given period of time, particularly in light of the recent announcements by A.M. Best and KBRA, or that these ratings will not be lowered, suspended or withdrawn entirely by the rating agencies. We cannot predict what actions A.M. Best, KBRA or other rating agencies may take, or what actions we may take in response to the actions of the rating agencies, which could negatively affect our business, financial condition and results of operations.

Risks related to the proposed Merger

The Merger is subject to closing conditions, including governmental, regulatory and shareholder approvals, as well as other uncertainties and there can be no assurances as to whether and when it may be completed. Failure to complete the Merger could negatively impact our share price, future business and financial results.

There can be no assurance that the proposed Merger will occur. Consummation of the Merger is subject to certain customary conditions, including, without limitation: (i) approval of the Merger Agreement and the transactions contemplated thereby by the affirmative votes of not less than 50% of the holders of our outstanding common shares and preference shares voting as a single class at a meeting of our shareholders; (ii) the expiration or early termination of the waiting period applicable to the consummation of the Merger under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, and the receipt of certain other non-U.S. regulatory approvals without the imposition of a Burdensome Condition (as defined in the Merger Agreement); (iii) the absence of any law, judgment or other legal restraint that prevents, makes illegal or prohibits the consummation of the Merger and the other transactions contemplated by the Merger Agreement; (iv) the accuracy of each party’s representations and warranties (subject to certain qualifications); (v) each party’s performance in all material respects of its obligations contained in the Merger Agreement; and (vi) the absence of a material adverse effect on our

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company since the date of the Merger Agreement. In addition, HoldCo’s and Arch’s obligation to consummate the Merger is conditioned on our non-investment grade portfolio not suffering a loss of more than $208 million from September 30, 2020, through the date that is two business days prior to the closing of the Merger.

While we believe we will receive the requisite approvals, there can be no assurance that these and other conditions to closing will be satisfied at all or satisfied on the proposed terms and schedules as contemplated by the parties. Satisfaction of the closing conditions may delay the consummation of the Merger, and if certain closing conditions are not satisfied prior to the end date specified in the Merger Agreement, the parties will not be obligated to complete the Merger.

In particular, the ongoing COVID-19 global pandemic could delay and adversely affect the completion of the Merger. Each of our company and HoldCo may be required to incur additional costs to remedy disruptions caused by the COVID-19 global pandemic. Additional time may be required to process our regulatory applications, and insurance and other regulatory agencies may impose additional requirements on us or HoldCo that must be satisfied prior to completion of the Merger.

If the Merger is not completed for any reason, we will have incurred substantial expenses. We have incurred substantial legal, accounting and financial advisory fees that are payable by us whether or not the Merger is completed, and our management has devoted considerable time and effort in connection with the pending Merger. The Merger Agreement contains specified termination rights for each of the parties. Upon termination of the Merger Agreement under specified circumstances, including with respect to our entry into an agreement with respect to a qualifying “Superior Proposal” (as defined in the Merger Agreement), we will be required to pay HoldCo a termination fee of $28.1 million. For these and other reasons, a failed merger could materially adversely affect our business, operating results or financial condition. In addition, the trading price of our common shares could be adversely affected to the extent that the current price reflects an assumption that the Merger will be completed.

The pendency of the Merger may cause disruptions in our business, which could have an adverse effect on our business, financial condition or results of operations.

The pendency of the Merger could cause disruptions in and create uncertainty regarding our business, which could have an adverse effect on our financial condition and results of operations, regardless of whether the Merger is completed. These risks, which could be exacerbated by a delay in the consummation of the Merger, include the following:

•key management and other employees may be difficult to retain or may become distracted from day-to-day operations because matters related to the Merger may require substantial commitments of their time and resources, which could adversely affect our operations and financial results;

•our ability to pursue alternative business opportunities, including strategic acquisitions, is limited by the terms of the Merger Agreement. If the Merger is not completed for any reason, there can be no assurance that any other transaction acceptable to us will be offered or that our business, prospects or results of operations will not be adversely affected;

•our business relationships may be subject to disruption as brokers, insurers, cedants, customers and other third parties attempt to negotiate changes in existing business relationships or consider entering into business relationships with parties other than Watford or Arch;

•our ability to make appropriate changes to our business may be restricted by covenants in the Merger Agreement; these restrictions generally require us to conduct our business in the ordinary course and subject us to a variety of specified limitations absent HoldCo’s prior written consent. We may find that these and other contractual restrictions in the Merger Agreement may delay or prevent us from responding, or limit our ability to respond, effectively to competitive pressures,

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industry developments and future business opportunities that may arise during such period, even if our management believes they may be advisable; and

•the costs and potential adverse outcomes of any litigation relating to the Merger.

Risks related to our common shares

The market price of our common shares may experience volatility, thereby causing a potential loss of value to our investors.

The market price for our common shares may fluctuate substantially in response to various factors, some of which are beyond our control, and could cause investment losses. The price of our common shares may not remain at or exceed current levels. In addition to the risk factors described herein, the factors that could affect our share price are:

•general market conditions;

•domestic and international economic factors unrelated to our performance;

•actual or anticipated fluctuations in our quarterly operating results, including as a result of catastrophes or our investment performance;

•changes in or failure to meet publicly disclosed expectations as to our future financial performance;

•changes in securities analysts’ estimates of our financial performance or lack of research and reports by industry analysts;

•changes in our financial strength and credit ratings and outlook;

•action by institutional shareholders or other large shareholders, including future sales;

•speculation in the press or investment community;

•investor perception of us and our industry;

•changes in market valuations or earnings of similar companies;

•announcements by us, our service providers or our competitors of significant products, contracts, acquisitions or strategic partnerships;

•the inability to complete the Merger due to the failure to satisfy the conditions to the consummation of the Merger, including receipt of the required shareholder approval or the required regulatory approvals;

•the risk that the Merger Agreement may be terminated in certain limited circumstances that require us to pay HoldCo a termination fee of $28.1 million;

•risks that the proposed Merger disrupts our current plans and operations or affects our ability to retain or recruit key employees;

•risks related to the Merger diverting management’s or employees’ attention from ongoing business operations;

•the effect of the pending Merger on our business relationships (including, without limitation customers and suppliers), operating results and business generally;

•the amount of the costs, fees, expenses and charges related to the Merger;

•any future sales of our common shares or other securities;

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•potential characterization of us or any of our subsidiaries as a PFIC;

•regulatory developments; and

•additions or departures of key personnel.

In particular, there is a risk that our share price may decline significantly if the Merger is not completed.

In addition, recently, the stock market has experienced significant price and volume fluctuations as a result of the COVID-19 global pandemic. In the past, following periods of volatility in the market price of a company’s securities, class action litigation has often been instituted against such company. Any litigation of this type brought against us could result in substantial costs and a diversion of our management’s attention and resources, which would harm our business, operating results and financial condition.

Shareholder activism, including public criticism of our company or our management team, may adversely affect us.

In May 2020, Capital Returns Management LLC published and delivered a letter to our Board of Directors that, among other things, urged our Board to undertake a strategic review of our company. Any perceived uncertainties as to our future direction, strategy or leadership created as a consequence of this letter or other activist shareholder initiatives may adversely affect our business or cause our share price to experience periods of volatility or stagnation.

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

In the first quarter of 2020, our board of directors authorized a share repurchase program, which allows us to make repurchases of up to $50 million of our common shares from time to time in open market or privately negotiated transactions. For more information, see Part I Item 2 “Management’s discussion and analysis of financial condition and results of operations—Liquidity and capital resources—Capital resources.”

During the three months ended September 30, 2020, we did not repurchase any of our common shares under our share repurchase program and approximately $47.1 million of unused share repurchase capacity remained available under the program. However, we do not anticipate making any further repurchases under our share repurchase program as a result of our entry into the Merger Agreement, which generally prohibits us from repurchasing our shares as well as certain other securities.


	Issuer Purchases of Common Shares
Period	Total Number of Shares Purchased	Average Price Paid Per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs	Approximate Dollar Value of Shares that May Yet be Purchased Under the Plan or Program
Beginning dollar amount available to be repurchased					$	47,136
7/1/2020 - 7/31/2020	—	$	—	—	—
8/1/2020 - 8/31/2020	—	—		—	—
9/1/2020 - 9/30/2020	—	—		—	—
Total	—	$	—	—	$	47,136

Item 3. Defaults upon senior securities

None.

Item 4. Mine safety disclosures

None.

Item 5. Other information

On September 20, 2020, Watford Re renewed its letter of credit facility with Lloyds Bank Corporate Markets Plc and BMO Capital Markets Corp. from September 20, 2020 through to September 19, 2021. For additional information regarding the Unsecured Facility, see Part I Item 2 “Management’s discussion and analysis of financial condition and results of operations - Contractual obligations and commitments - Unsecured letter of credit facility.”

In addition, and as contemplated by the Merger Agreement, on November 10, 2020, we entered into amended and restated employment agreements with our executive officers, including amended and restated employment agreements with Jonathan D. Levy, our chief executive officer, Robert L. Hawley, our chief financial officer, and Laurence B. Richardson, II, our chief operating officer. The amended and restated employment agreements with Messrs. Levy, Hawley and Richardson, among other things:

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•provide for a cash payment of $325,000 to Mr. Levy and $250,000 to each of Messrs. Hawley and Richardson, in each case, on the six month anniversary of the closing date of the Merger if the applicable executive officer remains employed by us or an affiliate of ours on that anniversary, unless the executive officer is terminated without Cause (as defined in the applicable employment agreement) prior thereto, in which case the amount will be paid within five days of termination, and (ii) if the closing date of the Merger occurs in 2021, a cash payment to each of Messrs. Levy, Hawley and Richardson on the closing date of a pro-rata 2021 annual bonus based on the number of days elapsed in 2021 through the closing date and target annual bonus levels (with the equity component of such annual bonus being paid in cash in lieu of units or shares), which shall be no less than 2020 target annual bonus levels;

•provide that the change of control severance payments payable under the applicable employment agreement will also be due if we give notice of any non-extension at the end of the original or any extended employment period;

•revise the length of the period under the non-competition covenant under the applicable employment agreement from twelve months following termination of employment to three months following termination of employment; and

•in the case of Mr. Levy, provide that, if we elect not to renew the term of Mr. Levy's employment agreement, if we terminate Mr. Levy’s employment without Cause or if Mr. Levy terminates his employment for Good Reason, we will continue to pay Mr. Levy his base salary for 18 months (36 months if the termination follows a change in control of Watford Holdings Ltd.), pay him 100% of his target annual bonus (300% if the termination follows a change in control), and his outstanding unvested restricted share units will remain outstanding and continue to vest in accordance with their terms for 18 months (all unvested restricted share units will vest if the termination is following a change in control, with performance-vesting units vesting at “target” levels).

The above summary description of certain terms contained in the amended and restated employment agreements with Messrs. Levy, Hawley and Richardson does not purport to be complete and is qualified in its entirety by reference to the full text of the agreements, copies of which are filed as Exhibits 10.2, 10.3 and 10.4 hereto, respectively.

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Item 6. Exhibit index

Incorporated by Reference

Exhibit
Number

Exhibit Description

Form

Original Exhibit Number

Date Filed

Filed Herewith

2.1

Agreement and Plan of Merger, dated as of October 9, 2020, by and among Watford Holdings Ltd., Arch Capital Group Ltd. and Greysbridge Ltd.

8-K

2.1

October 13, 2020

2.2

Amendment No. 1, dated November 2, 2020, by and among Watford Holdings Ltd., Arch Capital Group Ltd. and Greysbridge Ltd., to the Agreement and Plan of Merger, dated as of October 9, 2020.

8-K

2.1

November 2, 2020

10.1

Second amendment to the 364-Day Letter of Credit Agreement between Watford Holdings Ltd., Lloyds Bank Corporate Markets Plc and BMO Capital Markets Corp. dated September 17, 2020.

10.2

Amended and Restated Employment Agreement between Watford Holdings Ltd. and Jonathan D. Levy, dated November 1 0 , 2020

10.3

Amended and Restated Employment Agreement between Watford Holdings Ltd. and Robert L. Hawley, dated November 10, 2020

10.4

Amended and Restated Employment Agreement between Watford Holdings Ltd. and Laurence B. Richardson, II, dated November 10, 2020

10.5

Amended and Restated Employment Agreement between Watford Holdings Ltd. and Liz Cunningham, dated November 10, 2020

10.6

Amended and Restated Employment Agreement between Watford Holdings Ltd. and Alexandre Scherer, dated November 10, 2020

10.7

Voting and Support Agreement, dated as of November 2, 2020, by and among Watford Holdings Ltd., Arch Capital Group Ltd., Enstar Group Limited and Cavello Bay Reinsurance Limited.

8-K

10.1

November 2, 2020

31.1

Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2

Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1

Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2

Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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The following financial information from Watford Holdings Ltd.’s Quarterly Report for the quarter ended September 30, 2020 formatted in XBRL: (i) Consolidated Balance Sheets at September 30, 2020 and December 31, 2019; (ii) Consolidated Statements of Income for the three and nine months ended September 30, 2020 and 2019; (iii) Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2020 and 2019; (iv) Consolidated Statements of Changes in Shareholders’ Equity for the three and nine months ended September 30, 2020 and 2019; (v) Consolidated Statements of Cash Flows for the three and nine months ended September 30, 2020 and 2019; and (vi) Notes to Consolidated Financial Statements.

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Signatures

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


		WATFORD HOLDINGS LTD.
		(REGISTRANT)

		/s/ Jonathan D. Levy
Date:	November 10, 2020	Jonathan D. Levy, Chief Executive Officer

Date:	November 10, 2020	/s/ Robert L. Hawley
		Robert L. Hawley, Chief Financial Officer

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