Watford Holdings Ltd.
Annual Report 2018

Plain-text annual report

Watford Holdings Ltd. 2018 Annual Report Waterloo House, 1st Floor 100 Pitts Bay Road Pembroke HM 08, Bermuda Dear Shareholder, We are pleased to provide you with the 2018 Annual Report for Watford Holdings Ltd. We are off to a strong financial start in 2019. Our six-month combined ratio of 103.8% (101.1% on an adjusted basis) was in line with projections given our mix of business. There were no major insured catastrophe events impacting our results, and our loss reserves for prior accident periods continue to hold steady. The net interest income yield on net assets under HPS management was 3.5% for six months, or 7.0% annualized. As of June 30, 2019 the ratio of net assets under HPS management to shareholders’ equity was 1.6:1. Through six months, our book value per share is up 7.3% and now stands at $42.07. More important perhaps than the financial results for the first six months, were the positive outcomes achieved in several areas that are significant to our competitive positioning and future results. In March, the Company successfully executed a public listing of its shares on the NASDAQ Exchange, trading under the ticker symbol “WTRE.” The listing provides liquidity for our initial shareholders without diluting book value per share and ready access to the public markets for future capital raises. In June, the Company’s financial strength ratings were reaffirmed by both A.M. Best and Kroll. Watford carries an A- rating from A.M. Best and an A rating from Kroll. The reaffirmation of our ratings with a stable outlook is an important prerequisite for continuing to attract quality business so, while not unexpected, this was very positive news. Also in June, Watford was added to the Russell 3000 index. This should have and, indeed, already seems to be having, a positive impact on liquidity and trading volume. It is also further evidence of the long term value creation that we are building. A little over 5 years ago, Watford was only a concept on paper. Today, Watford is among the 3,000 largest companies actively traded on a major U.S. stock exchange. In July, the Company completed a $175 million senior note offering with a 6½% coupon which was done as a private placement. The net proceeds were used to redeem 76.34% of our preference shares which initially had an 8½% coupon and recently converted to a higher, floating rate. This will result in substantial savings going forward in our debt and preferred equity servicing costs. We were particularly pleased that Arch participated for $35 million which further demonstrates Arch’s commitment to Watford’s success and strengthens the alignment of interests. Underwriting market conditions seem to be noticeably improving in most lines of business. There is a growing consensus that we have entered, if not a “hard market,” a “seller’s market.” Primary rates in most casualty lines with the exception of workers compensation appear to firming to a larger extent than previous quarters. Property catastrophe reinsurance rates were up meaningfully for the June Florida renewals and ceding commissions are reducing on many casualty reinsurance quota share contracts. Whether these trends will continue and, if so, for how long, is the subject of much debate and remains to be seen. However, in our view the near-term forward outlook is promising. In particular, we continue to see good growth opportunities in the insurance space as new program submission activity is strong. The Board and Management Team are excited about our prospects going forward and believe the Company is now fully ramped and well-positioned to deliver strong long-term book value growth. John F. Rathgeber Chief Executive Officer Watford Holdings Ltd. Index to Annual Report Explanatory note Cautionary note regarding forward looking statements Business ....................................................................................................................................... Item 1. Item 2. Market price of and dividends on the registrant's common equity .......................................... Selected financial and other information .................................................................................. Item 3. Item 4. Management's discussion and analysis ...................................................................................... Supplementary financial information ........................................................................................ Changes in and disagreements with accountants on accounting and financial disclosure...... Item 6. Item 7. Directors and executive officers ................................................................................................. Consolidated financial statements ............................................................................................. Item 8. Item 5. Page i ii 1 43 44 47 93 94 95 99 Explanatory note - Certain defined terms Unless the context suggests otherwise, any reference in this report to: • “ACGL” refers to Arch Capital Group Ltd. and its controlled subsidiaries; • “Arch” refers to any one or more of the following direct or indirect subsidiaries of ACGL, as applicable in the context in which such term appears: • Arch Investment Management Ltd., or AIM, which manages the majority of our investment grade portfolio; • Arch Reinsurance Company, or ARC, which is a party to certain quota share agreements with one or more of our operating subsidiaries and a services agreement with Watford Holdings (U.S.) Inc.; • Arch Reinsurance Ltd., or ARL, which is a party to certain quota share agreements with one or more of our operating subsidiaries and owned approximately 11% of our outstanding common shares as of December 31, 2018; • 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; • 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; • “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; • “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 Trust” refers to Watford Asset Trust I, a statutory trust organized under the laws of the State of Delaware; • “Watford Re” refers to Watford Re Ltd., a Bermuda domiciled insurance company and a wholly-owned subsidiary of our company; • “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. i Cautionary note regarding forward-looking statements The Private Securities Litigation Reform Act of 1995 (or the PSLRA) provides a “safe harbor” for forward- looking statements. This report contains forward-looking statements that are intended to enhance the reader’s ability to assess our future financial and business performance. These statements are based on the beliefs and assumptions of our management, and are subject to risks and uncertainties. Generally, statements that are not about historical facts, including statements concerning our possible or assumed future actions or results of operations are forward-looking statements. Forward-looking statements include, but are not limited to, statements that represent our beliefs, expectations or estimates concerning future operations, strategies, financial results or performance, financings, investments, acquisitions, expenditures or other developments and anticipated trends and competition in the markets in which we operate. Forward- looking statements, for purposes of the PSLRA or otherwise, can also be identified by the use of forward- looking terminology such as “may,” “believes,” “intends,” “anticipates,” “plans,” “estimates,” “expects,” “should” or similar expressions. Forward-looking statements involve our current assessment of risks and uncertainties. Actual events and results may differ materially from those expressed or implied in these statements. Important factors that could cause actual events or results to differ materially from those indicated in such statements are discussed below and elsewhere in this report and in our other reports and other documents filed with the Securities and Exchange Commission, or the SEC, and include: • our limited operating history; • fluctuations in the results of our operations; • our ability to compete successfully with more established competitors; • our losses exceeding our reserves; • downgrades, potential downgrades or other negative actions by rating agencies; • our dependence on key executives and inability to attract qualified personnel, or the potential loss of Bermudian personnel as a result of Bermuda employment restrictions; • our dependence on letter of credit facilities that may not be available on commercially acceptable terms; • our potential inability to pay dividends or distributions; • our potential need for additional capital in the future and the potential unavailability of such capital to us on favorable terms or at all; • our dependence on clients’ evaluations of risks associated with such clients’ insurance underwriting; • the suspension or revocation of our subsidiaries’ insurance licenses; • Watford Holdings potentially being deemed an investment company under U.S. federal securities law; • the potential characterization of us and/or any of our subsidiaries as a passive foreign investment company, or PFIC; • our dependence on Arch for services critical to our underwriting operations; • changes to our strategic relationship with Arch or the termination by Arch of any of our services agreements or quota share agreements; • our dependence on HPS and AIM to implement our investment strategy; • the termination by HPS or AIM of any of our investment management agreements; • risks associated with our investment strategy being greater than those faced by competitors; • changes in the regulatory environment; • our potentially becoming subject to U.S. federal income taxation; ii • our potentially becoming subject to U.S. withholding and information reporting requirements under the U.S. Foreign Account Tax Compliance Act, or FATCA, provisions; and 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. iii Item 1. Business Our company We are a global property and casualty, or P&C, insurance and reinsurance company with approximately $1.1 billion in capital as of December 31, 2018 and with operations in Bermuda, the United States and Europe. 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 comprising primarily non-investment grade corporate credit assets, managed by HPS Investment Partners, LLC, or HPS. We have designed our investment strategy to complement the characteristics of our target underwriting portfolio in order to generate attractive risk-adjusted returns for our shareholders. Our strategy involves a greater degree of investment risk balanced with a less volatile underwriting portfolio, especially in relation to the amount of catastrophe exposure we assume, as compared with traditional insurers and reinsurers. We were formed in Bermuda in the second quarter of 2013. In March 2014, we raised $1.1 billion in our initial funding and began underwriting reinsurance in the first half of 2014. Our operating subsidiaries all carry a financial strength rating of “A-” (Excellent) with a stable outlook from A.M. Best Company, or A.M. Best, which is the fourth highest of 15 ratings that A.M. Best confers. Each of our operating subsidiaries also carries a financial strength rating of “A” with a stable outlook from Kroll Bond Rating Agency, or KBRA, which is the sixth highest of 22 ratings that KBRA confers. These ratings are each intended to provide an independent opinion of an insurer’s ability to meet its obligations to policyholders and are not ratings of our common shares. We manage our insurance and reinsurance underwriting through our relationship with Arch, which, through Arch Reinsurance Ltd., or ARL, is one of our founding equity investors. ARL, which is a subsidiary of Arch Capital Group Ltd., or ACGL, a leading global insurance and reinsurance company whose shares are listed on the Nasdaq Global Select Market under the symbol “ACGL,” invested $100 million in our common shares. ACGL had approximately $11.2 billion in capital and a market capitalization of approximately $10.8 billion as of December 31, 2018 and provides a full range of property, casualty and mortgage insurance and reinsurance lines, with a particular focus on writing specialty lines on a worldwide basis through operations in Bermuda, the United States, Canada, Europe, Australia and South Africa. Our strategic relationship with Arch provides us with unique underwriting expertise and market access based upon our ability to leverage Arch’s global underwriting infrastructure and distribution platform and has enabled us to build a diversified global portfolio of insurance and reinsurance risks. Our operating subsidiaries have written an aggregate of approximately $2.6 billion in gross premiums written from inception to December 31, 2018. Our main operating subsidiary is Watford Re Ltd., or Watford Re, a Bermuda-based company that began writing business in early 2014 and is registered as a Class 4 insurer with the Bermuda Monetary Authority, or the BMA. Bermuda is one of the largest insurance and reinsurance centers in the world, particularly for P&C markets, providing insurance and reinsurance capacity for risks on a global basis. In addition to traditional P&C lines, Watford Re also writes mortgage insurance and reinsurance on a worldwide basis. Our Bermuda presence gives us direct and efficient access to reinsure these risks. In mid-2015, we formed and capitalized Watford Insurance Company Europe Limited, or WICE, in Gibraltar to conduct business in Europe. In December 2015, WICE began writing business with access to markets across the European Union, targeting both personal lines and commercial lines of P&C insurance, which it distributes through coinsurance relationships and specialized insurance agents (also known as program managers). In late 2015, we formed and capitalized Watford Specialty Insurance Company, or WSIC, a U.S.-based excess & surplus, or E&S, lines insurer. In April 2016, WSIC began writing insurance business in the U.S. E&S market, concentrating its efforts on commercial lines of property and casualty coverage, which it distributes through program managers. We further expanded our U.S. capabilities in August 2016 through the acquisition and capitalization of Watford Insurance Company, or WIC, which has enabled us to access the larger admitted (or licensed) U.S. insurance market, also through program managers. Between WSIC and WIC, we are able to access the entire U.S. P&C insurance market, offering either admitted insurance products or E&S insurance products to service market demand. The majority of our investments are allocated to non-investment grade corporate credit assets managed by HPS, which we refer to as our non-investment grade portfolio. 1 HPS is a global investment platform with a focus on non-investment grade credit. HPS had approximately $47 billion of assets under management as of December 31, 2018. HPS manages our non-investment grade portfolio pursuant to investment guidelines formulated to complement our underwriting portfolio. The primary objective of our non-investment grade investment strategy is to generate attractive risk-adjusted returns comprising current interest income, trading gains and capital appreciation, with an emphasis on capital preservation. As of December 31, 2018, non-investment grade corporate credit assets comprised approximately 69% of our overall investment portfolio. We refer to the remainder of our invested assets as our investment grade portfolio, which is primarily managed by Arch Investment Management Ltd., or AIM, a subsidiary of Arch that manages the investments of Arch’s own funds. We also have several investment grade accounts managed by other Investment Managers, including HPS. Our management team is led by John Rathgeber, a highly respected industry veteran with over 35 years of experience. Mr. Rathgeber served as the Chief Executive Officer of Arch Reinsurance Company, or ARC, Arch’s U.S. reinsurance operations, from its inception in 2001 until 2009. Mr. Rathgeber has also served as Vice Chairman of Arch Worldwide Reinsurance Group. In addition, we have recruited a management team that has significant senior leadership and underwriting experience in the insurance and reinsurance industry. We believe our management team’s industry experience is an important competitive advantage. Since formation, we have meaningfully grown our business, generating sizable underwriting revenue and significant interest income. We believe that we are well-positioned to continue delivering prudent growth by balancing our complementary underwriting and investment strategies. From inception through December 31, 2018, our net premiums written and net interest income were as follows: Net premiums written ....................................................... $ Net interest income ........................................................... 604,175 $ 553,117 $ 513,788 $ 2,411,495 107,533 86,523 89,818 374,981 Year Ended December 31, 2018 2017 2016 ITD ($ in thousands) Competitive strengths Global insurance and reinsurance company We are a highly-rated global insurance and reinsurance company with a strong balance sheet and access to the key global insurance markets in Bermuda, Europe and the United States. We benefit from a multi-year, renewable strategic relationship with Arch, which sources opportunities and distributes our products through its global platform in accordance with our underwriting guidelines. The recent establishment of our U.S. and European insurance operations enables direct distribution of our products to our targeted clients, providing us with the flexibility to write on an insurance, reinsurance, or retrocessional basis depending upon the risk- adjusted pricing of particular markets. Our book of specialty P&C lines is diversified by both territory and line of business. We believe our prudently underwritten, diversified, global book of insurance and reinsurance business is a competitive advantage. Differentiated, balanced business model We operate a differentiated, innovative business model compared to traditional insurers and reinsurers. The innovation in our total return business model is the marriage of the income generation potential of higher- coupon, corporate credit fixed income, fixed maturity investments with the underwriting of primarily lower volatility, medium- to long-tail casualty business. Our model is designed to create relatively stable and predictable cash flows from both underwriting (net premium receipts) and investments (interest income and scheduled principal repayments) to meet our underwriting liabilities, which should allow us to avoid being forced to sell assets at inopportune times. Our dynamic, integrated approach to our underwriting and investments is reflected throughout our organization and enables us, through Arch and HPS, to be nimble and creative in evaluating risks on both sides of our balance sheet. We have engaged Arch and/or HPS, as applicable, to continuously evaluate underwriting and/or investment opportunities, as applicable, on our behalf, and, by leveraging their 2 respective expertise and market access, we may increase or decrease our underwriting premium, adjust our mix of the underwriting portfolio, adjust investment leverage and/or adjust our mix of investment assets depending upon underwriting market conditions, credit market conditions or both. Our investment activities are complementary to our underwriting activities and provide us the ability to compete more effectively for insurance and reinsurance business. We believe this hybrid approach makes us better equipped than traditional insurance and reinsurance companies to navigate the insurance and reinsurance underwriting cycles that have historically been experienced by the industry. During hard phases of the insurance and/or reinsurance cycles, through our strategic relationship with Arch we have the ability to increase our business volume to capture higher rate levels in the market. An example of this dynamic is our increased writings of European motor insurance, as rates have hardened in recent years. Through our relationship with HPS, we have the ability to generate higher returns from investment income even when the industry is experiencing soft phases of the insurance and/or reinsurance cycles, and this higher investment income enables us to be competitive in writing soft cycle insurance and reinsurance business that might not otherwise meet our return thresholds. Additionally, we maintain the ability to generate higher investment income returns when the credit markets provide attractive opportunities. In the period since our inception, while the insurance and reinsurance markets have been in a general softening phase, the credit investment market experienced both a widening and then a tightening of credit spreads. See “-Our operations-Investment operations-Non-investment grade portfolio-Investment strategy.” As demonstrated by the chart below entitled “Deployment of Assets into Non-Investment Grade Investment Strategy,” our usage of borrowings to purchase additional assets in the non-investment grade portfolio increased as the Credit Suisse High Yield Index’s Spread-to-Worst widened, reflecting HPS’s view that these periods presented more attractive risk-adjusted investment opportunities, which generated increased net interest income. When credit spreads later tightened, assets were sold and the proceeds were used to repay borrowings from the credit facility. In recognition of our hybrid, total return approach, Arch and HPS each share a portion of their management fees and performance fees related to services provided by Arch and HPS to Watford Re with the other pursuant to a fee sharing agreement. This fee sharing arrangement also provides a marginal alignment of interest benefit by encouraging and rewarding collaborative efforts by allowing both Arch and HPS to participate in the revenue generated by the components of our business that are managed by the other. We pay each of Arch and HPS the fees due under the respective services agreements and the fee sharing agreement does not affect the total amount of fees that we pay; we do not monitor, and we are not made aware of, the actual sharing payments between Arch and HPS. With the exception of the right to consent to any proposed amendment, we have no rights under the fee sharing agreement. We view the fee sharing agreement as a positive factor that strengthens the commitment of each of Arch and HPS to ensuring the quality of the services each performs on our behalf and fosters a cooperative approach to working toward our overall success; however, we neither consider the fee sharing agreement to be central to our business model nor depend on the fee sharing agreement to balance any potential conflicts of interest. Our relationship with Arch We believe that our strategic relationship with Arch provides us with a meaningful competitive advantage in both access and expense for our reinsurance business and in launching our recently initiated insurance business. We believe that our ability to leverage Arch’s risk evaluation expertise, global reach, broad distribution network and industry stature provides us with attractive underwriting opportunities that many of our principal competitors do not have the resources or infrastructure to access. On our behalf, Arch monitors opportunities that provide attractive risk-adjusted returns with a particular focus on product lines in which Arch has experience and expertise, particularly any which may have previously experienced adverse results and are therefore beginning to benefit from an increase in premium rates. Similarly, Arch’s underwriting acumen brings us value in determining product lines that due to market conditions are not providing adequate returns and for which writings should be reduced. For instance, because of the prolonged softening of the property catastrophe product line, we have purposely written less premium in that line versus what was originally planned. As a result of our relationship with Arch, we are able to distribute our products through Arch’s worldwide platform on a variable cost basis, thus avoiding the fixed expense of maintaining our own global underwriting infrastructure. In addition to its $100 million equity investment in our company and its 3 assumption of a minimum 15% share of exposures underwritten by us, Arch is aligned with us through the premium-based fees it receives, and strategically through the ability to provide additional solutions to its clients. The table below provides the fees and reimbursements we have incurred for Arch’s services relating to our insurance and reinsurance operations for the years ended December 31, 2018, 2017 and 2016. Year Ended December 31, 2018 2017 2016 ($ in thousands) Fees and Reimbursements to Arch ............................................................... $ 39,944 $ 34,375 $ 28,840 Strong balance sheet We have a strong balance sheet, unencumbered by many of the legacy exposures the industry assumed in the past, and we are committed to preserving our financial strength. In addition, we utilize low operating leverage and have limited catastrophe exposure. As of December 31, 2018, our total assets were $3.4 billion and our invested assets totaled $2.7 billion across our investment strategies. Our $1.1 billion total capitalization (which includes our preference shares) provides us with the flexibility to engage in attractive underwriting and investment opportunities while maintaining our financial strength. Variable cost structure For our underwriting operations, we are able to access Arch’s worldwide underwriting platform which allows us to operate on a predominantly premium-based, variable cost expense structure, incurring operational and underwriting expense only as premiums are written, thus avoiding the fixed expense of maintaining our own global underwriting staff and infrastructure. To date, this access has permitted us to achieve a lower expense ratio than most of our competitors. Our fixed costs are largely limited to supporting enterprise risk management and corporate management functions. This is a meaningful advantage versus other industry participants who face rising expense ratios as market cycles cause premium volumes to decline. This variable cost structure provides us flexibility in managing expenses, which is of particular benefit in the highly competitive, cyclical reinsurance markets in which we operate and for our recently formed insurance operations as we ramp up their premium writings. Further, to the extent Arch continues to develop and grow its platform and capabilities, we benefit through increased opportunities to write attractive business without adding to our fixed cost expenses. Similarly, we have outsourced our investment management to HPS, AIM and other Investment Managers, and we feel that the structure of the compensation we pay to these managers, comprising a variable, asset-based component in all cases, and for our non-investment grade portfolio an incentive-based fee for HPS, provides benefits to us both in terms of aligning interests and providing cost-effective access to the expertise required to execute our chosen investment strategy. Experienced management team Our senior management team has an average of over 25 years of experience in the insurance industry. Our senior management team is led by John Rathgeber, who has over 35 years of experience in the reinsurance industry as an underwriter, actuary, risk manager and senior executive. Mr. Rathgeber helped found ARC, Arch’s U.S. reinsurance operations, where he served as the Chief Executive Officer from its inception in 2001 until the fall of 2009, at which point he assumed the role of Vice Chairman of Reinsurance for Arch, the position he retained until leaving Arch to join us in early 2014. In addition, our management team includes our Chief Operating Officer, Chief Financial Officer, and Chief Risk Officer. Our team has significant senior leadership and underwriting experience in the insurance and reinsurance industry, with vast expertise in operations, financial analysis and reporting, treasury, risk management and actuarial analysis. Our board of directors has deep insurance, reinsurance and financial services industry experience We have an experienced board of directors comprising accomplished industry veterans who collectively bring decades of experience from their prior roles operating and working in insurance, reinsurance and other 4 financial services companies. Our board of directors currently consists of five independent directors, two directors appointed by Arch and our Chief Executive Officer. Strategy Execute a dynamic business model focused on total returns We are a total return-driven insurance and reinsurance company. We strive to deliver attractive long-term returns to our shareholders by writing a diversified underwriting portfolio through a proven, disciplined approach, augmented by an investment strategy comprising primarily non-investment grade fixed income corporate credit assets and designed to complement our target underwriting business mix. We feel that this combination enhances our opportunity to thoughtfully deploy our capital in the most effective manner and to produce attractive risk-adjusted returns across both sides of the balance sheet, thereby maximizing the total return for our shareholders. Build an insurance platform that supplements our reinsurance business In 2015, we expanded our platform to include P&C insurance business in the United States and European markets. The business we access at the insurance level generally has lower acquisition costs than similar business accessed at the reinsurance level, and provides other operating efficiencies. In addition, we expect that our insurance business will produce further diversification benefits resulting in lower volatility of our underwriting results. The table below shows the net insurance premiums written generated by our insurance business for the years ended December 31, 2018, 2017 and 2016. We intend to continue to grow our insurance business opportunistically by leveraging our strategic relationship with Arch. Year Ended December 31, 2018 2017 2016 ($ in thousands) Insurance programs and coinsurance - net premiums written ................... $ 139,838 $ 103,213 $ 55,909 Capitalize on the expertise and infrastructure of Arch, our exclusive underwriting manager We have partnered with Arch to source and manage our underwriting portfolio in accordance with our underwriting guidelines. We believe this relationship will enable us to execute our chosen, casualty-focused underwriting strategy based on Arch’s expertise in our target lines of business. This arrangement provides us with access to Arch’s global underwriting infrastructure and distribution platform, and has allowed us to quickly build a global portfolio of diversified insurance and reinsurance risks. Pursue an investment approach that complements our underwriting strategy Our investment strategy seeks to generate attractive risk-adjusted returns comprising interest income, trading gains and capital appreciation with an emphasis on capital preservation. This investment strategy complements our underwriting portfolio, which predominantly targets medium- to long-tail casualty business. Our non-investment grade portfolio, which is managed by HPS, consists of high yielding corporate credit assets. Our goal in pursuing this strategy is to generate superior investment returns, as compared with investment returns achieved by our peers, through disciplined and prudent credit risk analysis and proper pricing for the risk assumed. We seek to achieve risk-adjusted returns that exceed those of typical reinsurer investment portfolios while also producing stable cash flows from scheduled interest payments. Our lower volatility, casualty-focused underwriting portfolio should have predictability in terms of the timing of payments to insurance claimants, thereby mitigating the risk of having to sell assets during times of temporary investment market stresses. Maintain a robust risk management program We have a strong risk management function, overseen by our Chief Risk Officer. We benefit from our ability to leverage the risk management infrastructures in place within each of Arch and HPS. We regularly receive relevant exposure and modeling information from Arch and HPS. On that data we overlay our proprietary analytics, tailored risk appetites and controls for an integrated approach to monitoring and reviewing our 5 exposures. We maintain active oversight of our underwriting and investment management service providers at both the management and board level. Conservative approach to underwriting risk We have designed our underwriting and investment strategies toward the goal of maintaining our balance sheet strength on a long-term basis through varying phases of market cycles. We target a medium-to long- term, lower volatility underwriting portfolio with tightly managed natural catastrophe exposure. We seek to limit our modeled net probable maximum loss, or PML, for property catastrophe exposures for each peak peril and peak zone from a 1-in-250 year occurrence to no more than 10% of the value of our total shareholders’ equity plus our contingently redeemable preference shares, or our total capital, which is less than most of our principal reinsurance competitors. As of December 31, 2018, this modeled net PML was 2.4% of our total capital. Our conscious effort to limit our catastrophe exposure lowers the volatility of our overall underwriting portfolio and provides 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 of our 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, thereby providing us an underwriting modeling advantage when competing for those target lines of business. We have a robust process for setting loss reserves, leveraging the established processes and procedures employed by Arch, making our own analyses and judgments, and through periodic reviews by external actuarial firms. We also regularly monitor our investment portfolios, including performance of the underlying credits, overall liquidity and how well that liquidity matches with the projected claims payments related to our underwriting portfolio. Being prudent stewards of our balance sheet allows us to maintain the confidence of all of our constituents and thereby to position ourselves to better achieve our goals. Our operations Underwriting operations: insurance and reinsurance Through our underwriting operations we are able to offer a variety of P&C insurance and reinsurance products on a global basis. We target an underwriting portfolio that is diversified by line of business and geography, with a focus on medium- to long-tail casualty business. Given the recent inception of our insurance operations, our underwriting portfolio to-date has been predominantly reinsurance, although we expect our insurance writings to increase going forward. We have built a diversified, low volatility portfolio by purposely limiting our modeled natural catastrophe exposure to a level lower than many other insurers and reinsurers. As of December 31, 2018, our largest peril and zone modeled net PML from a 1-in-250 year occurrence was 2.4% of our total capital. Our strategy is to operate in lines of business in which underwriting skill and specialized knowledge can make a meaningful difference in operating results. We have been well-received in the market and successful in writing what we believe to be attractive underwriting opportunities. We benefit from Arch’s broad underwriting expertise and worldwide distribution network. Arch’s global, multi-line market presence facilitates the ability for Arch to strategically adapt our mix of business by geography, product line or type as we or Arch perceive potential opportunities. In addition, as a result of our operating subsidiaries’ “A-” (Excellent) rating from A.M. Best and “A” rating from KBRA, as well as our strong balance sheet, we are well-positioned to increase our premium volume in favorable market cycles, creating additional attractive underwriting opportunities. Similar to other reinsurers and to other insurers writing business through program managers, we do not separately evaluate each individual risk assumed and are, therefore, largely dependent upon the original underwriting decisions made by the ceding companies and program managers in accordance with agreed underwriting guidelines. However, we believe Arch’s experience in portfolio risk selection and detailed monitoring of cedants and program managers provides us with a competitive advantage. Our Bermuda-based operating subsidiary, Watford Re, writes a broad range of P&C coverages. In addition to traditional P&C lines, Watford Re also writes mortgage insurance and reinsurance on a worldwide basis. Our reinsurance business leverages Arch’s global underwriting platform to distribute a wide variety of products covering lines of business around the world. We write business for third-party cedants and also assume a meaningful portion of our business as a reinsurance or retrocession of business that Arch has underwritten for its own portfolio and that also meets our underwriting guidelines and return metrics. The table below 6 provides the percentage of our total gross premiums written assumed from Arch for years ended December 31, 2018, 2017 and 2016. Year Ended December 31, 2018 2017 2016 Gross premiums written - assumed from Arch ............................................ 34.4% 48.2% 63.3% Arch competes with us and will continue to underwrite business for its own distinct portfolios in accordance with its own policies, strategies and business plans. In sourcing insurance and reinsurance opportunities through its worldwide platform, Arch evaluates the perceived risk exposure pursuant to its proprietary underwriting methodology, and then models the required pricing based on both its and our underwriting criteria. In furtherance of our underwriting philosophy to pursue lines of business in which underwriting knowledge and expertise can drive attractive returns, our underwriting guidelines are based largely on Arch’s own, leveraging the experience of Arch’s underwriting professionals. Our underwriting guidelines differ from Arch’s in several aspects, most notably in that our guidelines purposely limit catastrophe risk and our portfolio focus is on mid- to long-tail casualty and other lines of business with similar tenor, whereas Arch’s target business mix includes more catastrophe exposure and a higher percentage of shorter-tail lines. In underwriting business on our behalf, Arch fundamentally employs the same qualitative and quantitative evaluation and selection criteria for our underwriting portfolio as it does for its own account and each potential contract is evaluated qualitatively and quantitatively for both Arch’s portfolio and ours. For each opportunity that passes Arch’s qualitative and quantitative screening, when performing the pricing evaluation of a contract on our behalf, Arch applies our investment return assumptions to determine our expected return on the allocated capital for each such business opportunity. The determination by Arch as to whether to offer only Arch capacity, only our capacity, or both as side-by-side capacity, depends on the result of the pricing analysis using differing investment assumptions for us and Arch, reflecting our differentiated investment strategies. The mid- to long-tail business on which we focus can benefit from a higher return on the premium float and thus, certain opportunities that meet our metrics may not meet those of insurers and reinsurers like Arch with a more traditional investment strategy. In underwriting operations, “float” arises when premiums are received before losses and other expenses are paid and is an interval that sometimes extends over many years. During that time, the insurer invests the premiums, earns interest income and may generate capital gains and losses. In order to provide solutions to its reinsurance brokers and potential insurance clients, Arch has a strategic incentive to place that business with us rather than simply declining to provide capacity to the broker or potential client in such circumstances. Other than with respect to renewals of business previously written by our underwriting subsidiaries, Arch is not required to allocate any particular business opportunities to us, but we believe that Arch has strong incentives to allocate attractive business to us, based on Arch’s $100 million investment in our common shares, our contractual arrangements through which Arch earns premium-based fees and a profit commission for business written on our behalf, and as well as Arch’s ability to offer potential clients additional solutions, thus gaining a strategic benefit in the competitive, syndicated reinsurance market in which it is often necessary to be on an expiring contract in order to have the opportunity to bid to provide capacity at the next annual renewal. Through our relationship with Arch, we have built a diversified portfolio of medium- to long-tail commercial lines casualty, other specialty and property risks. 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 and 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 7 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. Our insurance operations are conducted in the United States and Europe. We established our insurance platform as a complement to our reinsurance strategy to expand our distribution channels. Our insurance strategy is focused on pursuing attractive underwriting opportunities in the U.S. and European insurance markets and we view our insurance platform as having the potential to provide meaningful premium growth. In the United States, we are authorized to write commercial P&C lines of business in both the admitted market and the E&S market through our WIC and WSIC subsidiaries, respectively, with distribution through coinsurance relationships or through select program managers that develop and distribute specialized insurance products for these subsidiaries. In Europe, we write direct insurance and coinsurance business, primarily in personal P&C lines, through lead insurers and program managers that develop and distribute specialized insurance products for our WICE subsidiary. We operate and monitor our lines of business through our underwriting operations. The table below provides a breakdown of our gross premiums written for the years ended December 31, 2018, 2017 and 2016: Year Ended December 31, 2018 2017 2016 Amount % Amount % Amount % ($ in thousands) Casualty reinsurance ............................... $ 274,661 37.4% $ 284,481 47.4% $ 331,127 Other specialty reinsurance .................... Property catastrophe reinsurance .......... Insurance programs and coinsurance .... 196,170 10,424 253,760 26.7% 1.4% 34.5% 169,100 12,740 133,983 28.2% 2.1% 22.3% 125,404 11,756 66,807 61.9% 23.4% 2.2% 12.5% Total ........................................................ $ 735,015 100.0% $ 600,304 100.0% $ 535,094 100.0% Reinsurance operations Watford Re is a licensed, Class 4 Bermuda-based reinsurer operating under the supervision of the BMA. Arch serves as our exclusive reinsurance portfolio manager and provides reinsurance-related services including exposure modeling, loss reserve recommendations, claims handling and other related services as part of our long-term services agreements with them. All reinsurance contracts are bound on our behalf by designated employees made available to us by Arch, or, in certain circumstances, by Watford Re management. We assume reinsurance from third-party cedants or from Arch entities on a reinsurance or retrocessional basis. The retrocessions from Arch are from its reinsurance operations in the United States, Bermuda, Europe, and Australia, levering Arch’s distribution and local expertise in its markets. We also have provided, and may continue to provide, reinsurance to Arch’s insurance operations in the United States, the United Kingdom and elsewhere. Insurance operations In 2015 and 2016, we established insurance operations in Europe and the United States. These insurance operations provide additional points of access to our target lines of business, with the potential added benefit for lower acquisition costs and other distribution efficiencies. All of our insurance subsidiaries carry our A.M. Best “A-” (Excellent) rating and our KBRA “A” rating and through them we pursue insurance product lines similar to those we target through our reinsurance operations. In the United States, our principal insurance subsidiaries are WSIC and its wholly-owned subsidiary, WIC, both of which are domiciled in New Jersey. WSIC is an eligible E&S lines insurer in all 50 states and the District of Columbia. WIC is an admitted insurer in all 50 states and the District of Columbia. Following our acquisition 8 of WIC in 2016, we have expanded our certificates of authority to cover a broad range of lines of business in 46 states and the District of Columbia, and we are in the process of similarly expanding our authority in the remaining seven states. Both WSIC and WIC are located in Morristown, New Jersey. Through WSIC and WIC we have the flexibility to access both the E&S and admitted sectors of the U.S. P&C market. Our U.S. insurance subsidiaries concentrate primarily on commercial casualty lines of insurance and have initiated writing business through select program managers. Our insurance operations in Europe are conducted through WICE, which has its principal office in the British Overseas Territory of Gibraltar. WICE was formed to provide access to insurance risks across the European Union. WICE concentrates on U.K. and Western European risks, predominantly in personal lines of insurance but will also entertain commercial casualty lines. Our goal within our insurance operations is to be a valued, long-term capacity partner with a select group of well-established, proven program managers, with our integrated total return strategy providing them with competitive solutions for their clients. We have a strong market position with approximately $1.1 billion in capital and an “A-” rating from A.M. Best for each of our operating subsidiaries. Many of the insurers providing capacity to program managers are neither as substantially capitalized nor as highly rated as we are; having a strong insurance partner gives program managers an edge when promoting products to clients. We believe that our ability to enter insurance markets on a largely variable cost basis, unburdened by the fixed costs that would otherwise be required to create a standalone insurance operation, provides us with another significant and fundamental advantage. We benefit from AUI’s and AUL’s industry contacts and market acumen to identify, attract, and retain those program managers who satisfy our guidelines in terms of reputation, technical track record and quality of administration. While we benefit from AUI’s and AUL’s infrastructure, our acquisition and administrative costs are largely based on premiums actually produced. Subject to our overall underwriting guidelines, on our behalf, AUL, for WICE, or AUI, for WSIC and WIC, thoroughly diligences each prospective program manager and approves underwriting guidelines for each specific line and class of business before delegation of the underwriting and/or claims-handling authority to any such program manager. We believe that by stringently vetting potential program managers we can advantageously and efficiently access a broad customer base while maintaining underwriting control and discipline. Fundamentally, AUL and AUI employ the same evaluation and selection criteria in scrutinizing our prospective program managers as they do for Arch’s own account. The determination by AUL and AUI as to whether to offer our policies, Arch’s policies, or both, depends on the result of the pricing analysis using the differing return assumptions of each company. On an ongoing basis, we and AUL or AUI, as applicable, monitor the business produced and financial condition of each program manager through periodic audits of underwriting, claims and operations. Sourcing and underwriting We have a strategic relationship pursuant to which Arch assists us in our pursuit of a highly disciplined underwriting approach, targeting lines of business that we believe will allow us to generate attractive risk- adjusted returns throughout industry market cycles. On our behalf, Arch continuously monitors the broad insurance and reinsurance market for opportunities. Specifically, Arch monitors opportunities that are anticipated to provide attractive risk-adjusted returns with a particular focus on product lines which may have previously experienced adverse results and are therefore beginning to benefit from an increase in premium rates, and thus provide a potentially beneficial time to enter, or increase activity in, those markets. Similarly, on our behalf, Arch analyzes the market for softening product lines for which the applicable rates may provide less attractive risk-adjusted returns and potentially reduces our exposure to such lines accordingly at renewal. Our strategy is to operate in lines of business in which underwriting expertise can make a meaningful difference in operating results. We are opportunistic in our pursuit of underwriting risks and binding business where we believe we have a competitive advantage in risk evaluation, distribution, investment strategy, or a combination of these factors. Our recent establishment of U.S. and European insurance operations enables us to directly access similar types of underlying risk premium as we underwrite as reinsurance, with what we believe to be better risk-adjusted pricing. Accessing premium through our insurance operations should also provide the benefit of lower acquisitions costs. Our underwriting philosophy is based on prudent risk selection, risk diversification, and comprehensive pricing analysis. We believe that the key to our approach is adherence to underwriting rigor across all types 9 of business we underwrite. We employ a disciplined, analytical approach to underwriting. As part of the underwriting process, a variety of factors are typically assessed, including: (i) adequacy of underlying rates combined with the expected return on equity for a given insurance or reinsurance program; (ii) the industry reputation, track record, perceived financial strength and stability of the proposed client, or program manager in the case of our insurance business; (iii) the likelihood of establishing a long-term relationship with the client or program manager; (iv) the specialized knowledge and access to business that they possess; (v) the geographic area in which the client or program manager does business, together with our aggregate exposures in that area; (vi) historical loss data for the client or program manager; and (vii) projections of future loss frequency and severity. Pursuant to our underwriting guidelines, we target an underwriting portfolio with tightly managed natural catastrophe exposure. We currently seek to limit our modeled PML for property catastrophe exposures for each peak peril and peak zone from a 1-in-250 year occurrence to no more than 10% of our total capital, which is less than most of our principal reinsurance competitors. Our conscious effort to limit our catastrophe exposure lowers the volatility of our overall underwriting portfolio and provides greater certainty as to future claims-related payout patterns and timing, dovetailing well with our non-investment grade investment strategy by minimizing the possibility of needing to sell investments at inopportune times in the investment market cycles. We believe that our experienced senior management, combined with Arch’s underwriting expertise and broad market access, allows us to identify business with attractive risk-reward characteristics. As new underwriting opportunities are identified, we explore the suitability of underwriting the new business in order to take advantage of perceived market trends, particularly in lines of business for which Arch already possesses deep underwriting expertise. Policy service and claims management Arch provides underwriting services, portfolio management, exposure modeling, loss reserve recommendations, claims-handling, legal oversight, regulatory compliance, policy issuance and development, underwriting systems review, program manager audits, accounting support and administrative support, in each case, subject to the terms and conditions of our services agreements with Arch, including our underwriting and operational guidelines, as well as the oversight of our management and board of directors. We believe that handling claims is an important component of customer service through which we can differentiate ourselves from our competitors. The ability to handle claims in accordance with industry best practices and standards fosters credibility in the market both with customers and with program managers. Through this arrangement with Arch, we gain access on a very cost-effective basis to highly experienced underwriting, claims, and support function professionals and benefit from the exemplary customer service reputation Arch has earned over its 16-year history. In administering claims on our behalf, Arch may engage third-party claims-handling firms to monitor, adjust and pay claims up to designated approval levels. Arch provides close supervision over any such third-party managers. Claims-handling firms are monitored and audited on an ongoing basis. When considering any proposed claims-handling delegation, Arch evaluates the candidate’s expertise, track record, staffing adequacy, reputation and licensing as required. Reinsurance relationships We have entered into outward quota share reinsurance agreements with Arch for each of our operating subsidiaries, which we believe provides a strong alignment of interest through Arch’s assuming a direct and meaningful sharing of the risk it underwrites for us. Subject to limited exceptions, Arch participates in a minimum 15% interest in all risks written by us, either by its own original participation, writing a companion line with us, or by accepting a minimum 15% quota share participation on all other contracts. From time to time, we purchase third-party reinsurance when deemed advantageous from a portfolio management standpoint. We only use reinsurers carrying an “A-” or higher rating from A.M. Best or Standard & Poor’s or, alternatively, reinsurers that provide sufficient collateral to mitigate credit risk exposure. 10 Investment operations Overview Our invested assets are funded with our capital, accumulated net underwriting float, reinvested net interest income, net capital gains and borrowings to purchase investments. These invested assets are allocated between our non-investment grade portfolio and our investment grade portfolio. As of December 31, 2018, our non-investment grade portfolio represented approximately 69% of our invested assets and our investment grade portfolio represented approximately 31% of our invested assets. Our investment operations are monitored by our Chief Risk Officer and the investment committee of our board of directors. Our non-investment grade portfolio is comprised principally of corporate credit assets managed by HPS pursuant to separate investment management agreements with Watford Re, Watford Asset Trust I, or Watford Trust, and each of our insurance subsidiaries. Each such investment management agreement with HPS includes investment guidelines. Subject to these guidelines, HPS makes all investment decisions with respect to our non-investment grade portfolio on our behalf. Our non-investment grade investment strategy and guidelines are formulated to complement our target underwriting portfolio, and are designed to meet the projected payout characteristics of the medium- to long-tail, lower-volatility underwriting portfolio we underwrite. The remainder of our investment portfolio is invested in investment grade assets, the largest portion of which is managed by AIM. We also have several investment grade accounts managed by other Investment Managers, including HPS. The following chart shows the breakdown of our total investments among our non-investment grade portfolio and our investment grade portfolio as of December 31, 2018: Total: $2,738.4 million 11 The following chart shows the breakdown of our investments by rating within our total investment portfolio as of December 31, 2018: Total: $2,738.4 million Investment grade ratings, such as “BBB” and above, indicate the applicable rating agency’s view that the investment has a low risk of credit default and that the obligor has at least adequate capacity to meet its financial commitments on the obligation. Ratings below investment grade, such as “BB”, “B” and “CCC,” indicate the applicable rating agency’s view that the investment is speculative, that the obligor is more vulnerable than investment grade-rated obligors, and that, in the event of adverse business, financial, or economic conditions, the obligor is less likely to have the capacity to meet its financial commitments on the obligation. Based on published criteria, a “BB” rating reflects the applicable rating agency’s view that, while the obligation is less vulnerable to non-payment than other speculative issues, it faces major ongoing uncertainties or exposure to adverse business, financial, or economic conditions which could lead to the obligor’s inadequate capacity to meet its financial commitment on the obligation. A rating of “B” reflects the applicable rating agency’s view that the obligor currently has the capacity to meet its financial commitment on the obligation, but adverse business, financial, or economic conditions will likely impair the obligor’s capacity or willingness to meet its financial commitment on the obligation. A rating of “CCC” indicates the applicable rating agency’s view that the obligation is currently vulnerable to non-payment and is dependent upon favorable business, financial, and economic conditions for the obligor to meet its financial commitment on the obligation. A rating below “CCC” indicates the applicable rating agency’s view that the obligation is currently highly vulnerable to non-payment. The following is a representative list of the industries in which we may invest: Consumer Products, Food and Beverage, Healthcare, Pharmaceuticals, Tobacco, Technology, Automotive, Consumer Cyclical Services, Home Construction, Restaurants, Retailers, Insurance (Health, Life and Property and Casualty), Communications (Cable and Satellite, Media and Entertainment, Wireless and Wirelines), Banking and Other Financial Services, Capital Goods (Aerospace and Defense, Building Materials, Construction Machinery, Diversified Manufacturing), Energy, Other Industrial, and Transportation. However, we may invest in other industries if presented with attractive opportunities. As of December 31, 2018, the composition of our portfolio by industry, excluding asset-backed securities and mortgage-backed securities was as follows: 14.8% of our portfolio was invested in Consumer Products, 7.2% in Technology and 6.8% in Consumer Cyclical Services, with the remainder invested in other industries (with no other industry comprising greater than 6.6%). As of December 31, 2018, the geographic composition of our portfolio, excluding asset-backed securities and mortgage-backed securities, was as follows: 75.7% in United States, 5.4% in the United Kingdom, 2.4% in Canada, and the remainder in other regions (with no other geographic region comprising greater than 2.0%). 12 A portion of our investment portfolio consists of assets that do not have a rating from one of the major rating agencies. Just as is done in connection with a potential investment in a rated debt obligation, when offered the opportunity to invest our assets into an unrated obligation, HPS thoroughly evaluates the obligor and the potential investment and makes a determination as to the inherent risks and whether the terms provide an attractive risk-adjusted return. A debt issuer may choose to forgo obtaining a rating for a number of reasons, particularly if the debt issuer is doing a small privately placed transaction for which the ratings fees would be a burdensome expense or if the desired transaction date does not allow sufficient time for the completion of the rating process. It is also possible that a prospective issuer or the terms of the proposed obligation would not meet the rating agency requirements for the level of rating desired by the obligor company. The following table shows the components of our net investment income (loss) on investments for the periods indicated: Interest income ............................................................................................. $ Investment management fees - related parties .......................................... Borrowing and miscellaneous other investment expenses ......................... Net interest income ...................................................................................... Realized and unrealized gain (loss) on investments ................................... Investment performance fees - related parties ........................................... Net investment income (loss) ....................................................................... $ Non-investment grade portfolio Year Ended December 31, 2018 2017 2016 ($ in thousands) 152,916 $ 125,463 $ 122,378 (17,006) (28,377) 107,533 (113,834) (48) (21,451) (17,489) 86,523 1,120 (14,905) (16,563) (15,997) 89,818 80,643 (24,065) (6,349) $ 72,738 $ 146,396 Background on HPS. HPS is a global investment firm with a focus on non-investment grade credit. Established in 2007, HPS has over 100 investment professionals and over 250 total employees. HPS manages capital for sophisticated investors, including financial institutions, public and corporate pension funds, sovereign wealth funds, funds of funds, endowments, foundations and family offices, as well as individuals. HPS is headquartered in New York with ten additional offices globally. HPS has approximately $47 billion of assets under management as of December 31, 2018. HPS was originally formed as a unit of Highbridge, a subsidiary of JPMorgan Asset Management Holdings Inc., and formerly known as Highbridge Principal Strategies, LLC. In March 2016, the principals of HPS acquired the firm from JPMorgan Asset Management Holdings Inc., which retained Highbridge’s hedge fund strategies. Investment strategy. Our non-investment grade portfolio seeks to generate attractive risk-adjusted returns comprising current interest income, trading gains and capital appreciation, with an emphasis on capital preservation. To execute the non-investment grade component of our investment strategy, we mandated HPS with a strategy that (i) is designed to meet the projected payout characteristics of the medium- to long- term, lower-volatility underwriting portfolio we underwrite and (ii) seeks to achieve risk-adjusted returns that exceed those of typical reinsurer investment portfolios by focusing on non-investment grade assets, with the flexibility to invest a limited portion of this portfolio in less liquid assets. Specifically, we seek to achieve investment returns that exceed those returns achieved by our competitors from their fixed-income portfolios. We believe this strategy provides us with risk-adjusted returns that are both attractive and appropriate given our underwriting portfolio. HPS manages our non-investment grade corporate credit assets, including bank loans and high yield bonds, and may also invest in other instruments such as mezzanine debt, equities, credit default swaps, structured credit instruments and other derivative products. Our non-investment grade portfolio seeks to generate attractive risk-adjusted returns comprising current interest income, trading gains and capital appreciation, with an emphasis on capital preservation. Pursuant to these investment guidelines, HPS is permitted to hedge the assets in our non-investment grade portfolio to reduce volatility and protect against systemic risks, as well as to enter into opportunistic short positions. Other than cash and cash equivalents, investment positions with a single issuer will comprise no more than 7.5% of the aggregate Long Market Value (defined 13 as the value of the long investments of the portfolio of Watford Re or Watford Trust, valued using the methodologies set forth in Watford Re’s or Watford Trust’s investment management agreement with HPS, as applicable) of our non-investment grade portfolio. Positions established primarily for hedging purposes (including, without limitation, index positions) are not subject to this limit, and capital structure arbitrage positions in an issuer are deemed separate investments for the purposes of these limitations. Through this strategy, we seek to achieve risk-adjusted returns that exceed those of typical reinsurer investment portfolios by focusing on non-investment grade assets, with the flexibility to invest a limited portion of this portfolio in less liquid assets. Limited positions in equity securities are also permitted, subject to our non-investment grade investment guidelines, which are an integral component of each applicable investment management agreement. Generally, any equity investments are not expected, in the aggregate, to represent more than 10% of the Long Market Value of our non-investment grade portfolio, and are expected to be focused on either a value-oriented approach or a catalyst to a realization event, which include restructurings, lawsuits and regulatory changes, among other examples. Equity investments resulting in ownership exceeding 18.5% of the outstanding equity securities of an issuer, measured at the time of investment, will require our prior approval. HPS may also utilize other investment instruments for our non- investment grade portfolio, subject to our non-investment grade investment guidelines. The non-investment grade investment guidelines under Watford Trust’s and our insurance subsidiaries’ respective investment management agreements with HPS also contain certain limitations relating to, among other things, the concentration of investments and utilization of leverage. For more information, see “Certain relationships and related party transactions-Agreements with HPS-Investment management agreements.” As of December 31, 2018, HPS was in compliance with all non-investment grade investment guidelines. In order to implement our non-investment grade investment strategy, HPS may also, from time to time and upon consultation with us, invest a portion of our non-investment grade portfolio in investment funds managed by HPS. While there is no codified limit on the portion of our non-investment grade portfolio that may be invested in funds managed by HPS, we only expect to invest additional assets from our non- investment grade portfolio in funds managed by HPS to the extent that HPS, in consultation with us, determines that such investment would provide economic, tax, regulatory or other benefits to us (for instance, such as allowing us to access a strategy that we would not have been able to efficiently access other than through investment in such a fund). To the extent that any such assets are invested directly or indirectly in funds managed by HPS, such assets invested in funds managed by HPS are part of our non-investment grade portfolio. We pay HPS performance and management fees on the assets in our non-investment grade portfolio. Such fees are calculated on the non-investment grade portfolio as a whole such that the assets, if any, invested in HPS-managed funds were to increase in value in a given period but the non-investment grade portfolio as a whole were to decrease during such period, we would not owe HPS a performance fee for such period. Similarly, if the assets, if any, invested in HPS-managed funds were to decrease in value in a given period but the non-investment grade portfolio as a whole were to increase during such period, we would owe HPS a performance fee for such period. We do not pay HPS any separate or additional fees with respect to any such assets invested in HPS-managed funds. As of December 31, 2018 and 2017, our non- investment grade portfolio held $49.8 million and $49.6 million, respectively, in an investment fund managed by HPS. As of December 31, 2016, our non-investment grade portfolio did not have any investments in funds managed by HPS. When evaluating an insurer’s financial strength and determining minimum capital requirements, rating agencies and applicable regulators typically assign capital charges to not only the underwriting portfolio but also to the different classes of investment assets held by that insurer, based on the perceived level of risk and volatility. Our non-investment grade assets are viewed as riskier than investment grade assets and thereby carry higher capital charges than those assigned to investment grade assets, and therefore we may be required to hold more capital than similarly-sized traditional insurers and reinsurers, and it is possible that, for certain atypical, non-investment grade assets, we might receive minimal or no regulatory capital credit. While our strategy involves a greater degree of investment risk than is typical for traditional insurers and reinsurers, in our overall enterprise risk management framework, such increased investment risk is balanced with the more predictable timing of claims payments inherent in our underwriting portfolio, especially in relation to the lesser amount of catastrophe exposure we assume, as compared with the amount of such catastrophe risk assumed by many of our insurance and reinsurance peers. Our having a mid- to long-tail underwriting portfolio reduces, but does not entirely eliminate, the risk of needing to sell investment assets into an inopportune market cycle in order to generate cash for claims payments. 14 In undertaking this strategy, based on the interest rate and/or credit spread environment as of any given quarter-end, we may periodically be required to absorb mark-to-market movements in our asset valuation on our financial statements. Our model is designed to create relatively stable and predictable cash flows from both underwriting and interest income to meet insurance liabilities, which should allow us to avoid being forced to sell assets at inopportune times. The following chart shows the composition of our non-investment grade portfolio as of December 31, 2018: Total: $1,882.6 million Our investment guidelines permit HPS to utilize leverage in managing assets of Watford Re and Watford Trust (but not WICE, WSIC or WIC). Any such leverage, expressed as the excess of the value of the long investments of the portfolio of Watford Re or Watford Trust (valued using the methodologies set forth in Watford Re’s or Watford Trust’s investment management agreement with HPS, as applicable, and referred to as the Long Market Value), as applicable, over the net asset value of the portfolio as a percentage of the net asset value of the portfolio, is generally not to exceed 80%. See “Certain relationships and related party transactions-Agreements with HPS-Investment management agreements.” Leverage may take a variety of forms, including borrowings to purchase additional assets, trading on margin total return swaps and other derivatives, and the use of inherently leveraged instruments. Depending upon the extent of the leverage utilized for our non-investment grade portfolio, the net value of our investment assets will increase or decrease at a greater rate than if leverage were not utilized. The following chart shows the use of borrowings in our non-investment grade portfolio since 2014 and the Credit Suisse High Yield Index’s Spread-to-Worst since 2014. The spread-to-worst of the index is defined as the weighted average spread-to-worst of the bonds included in the index, where the spread-to-worst for each bond is the difference between the yield-to-worst for that bond and the yield of a U.S. Treasury security with a comparable maturity. The yield-to-worst for each bond is determined by computing the yield for that bond at all possible principal repayment dates, including the maturity date and each redemption date. The minimum of these calculated yields is the yield-to-worst, provided that, by definition, the yield must be above the yield of a U.S. Treasury security with a maturity date comparable to the bond’s yield-to-worst principal repayment date. 15 In the period since our inception, the credit-focused investment market experienced both a widening and then a tightening of credit spreads. As shown on the chart below, HPS, on our behalf, increased the deployment of assets into our credit-focused strategy through borrowings from our credit facility during the period in which credit spreads widened and then contracted the deployment of assets accordingly when credit spreads tightened. As demonstrated by the “Non-Investment Grade Portfolio Borrowing Ratio” chart below, our usage of borrowings to purchase additional assets in the non-investment grade portfolio increased as the Credit Suisse High Yield Index’s Spread-to-Worst widened, reflecting HPS’s view that these periods presented more attractive investment opportunities. When credit spreads later tightened, HPS, on our behalf, sold assets and we used the proceeds to repay borrowings from the credit facility. In the chart above, the term “Borrowing Ratio” represents borrowings to purchase investments divided by the market value of the non-investment grade portfolio net of these borrowings. From time to time, HPS takes short positions, and hedges or leverages the portfolio exposure through derivative instruments or otherwise. The chart above does not reflect the value of short positions or leverage inherent in derivative positions, and thus may not be fully reflective of the market exposure of the portfolio at any given time. 16 The charts below compare our return on our non-investment grade portfolio to the benchmarks of the Credit Suisse High Yield Index and Leveraged Loan Index performance. Because our non-investment grade portfolio contains both high yield bonds and leveraged loans, we show a comparison of our non-investment grade portfolio returns to a 50/50 blend of the Credit Suisse High Yield Index and Leveraged Loan Index. Notwithstanding this comparison, the actual relative percentage composition of our non-investment grade portfolio is not designed to be a 50/50 allocation between high yield bonds and leveraged loans and it is unlikely that the composition of our non-investment grade portfolio will ever equal that metric. CS HY Index ....................................................................................... CS LL Index ........................................................................................ 50/50 LL/HY ....................................................................................... ....................................................................................... Watford (1) 16.4% 16.2% 16.4% 20.4% 3.2% 3.2% 3.2% 4.0% 3.0% 1.6% 2.2% 2.2% From Inception Through December 31, 2018 Returns Annualized (2) Volatility (3) (1) Represents Watford’s net investment return on its HPS managed, non-investment grade portfolio. Net investment return in calculated as net investment income divided by average net invested assets from the non-investment grade portfolio. Net invested 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. (2) Annualized return calculated as (1+ ITD Return)^(1/4.75 years)-1 (3) Volatility is calculated as the standard deviation of the quarterly returns over the period from inception through December 31, 2018. Our non-investment grade portfolio may purchase or short-sell securities without an offsetting position in a related security based on HPS’s determination that a particular security is undervalued or overvalued. Our non-investment grade portfolio may engage in interest rate hedging using swaps, treasuries, interest rate futures or other derivative instruments. Additionally, our non-investment grade portfolio may employ single name and index credit derivatives in an attempt to hedge credit exposure. HPS combines a disciplined investment approach with a substantial platform for transaction sourcing. Through this platform, HPS’s investment professionals seek to identify and invest in a select number of investment opportunities. HPS is required to adhere to our non-investment grade portfolio’s investment 17 guidelines and provides us with regular non-investment grade portfolio risk and performance updates, and provides a risk and performance review to our board of directors on a quarterly basis. HPS’s investment process is driven by a rigorous investment screening and selection process, with the stated objective of generating attractive risk-adjusted returns comprising current interest income, trading gains and capital appreciation, with an emphasis on capital preservation. As part of HPS’s investment process, HPS manages our non-investment grade portfolio in accordance with the non-investment grade investment guidelines. HPS’s investment process emphasizes fundamental analysis and due diligence by seeking to evaluate potential investments based upon review and analysis of available public and private information including: (i) historical financial information; (ii) financial projections; (iii) business, sector and industry diligence; and (iv) legal analysis of the company and investment documentation. When possible, HPS seeks to achieve robust asset coverage in its investments. Since our inception in 2014, starting with our initial $1.13 billion capital raise, HPS has methodically deployed the assets that we have allocated to our non-investment grade portfolio as market opportunities arose. As a result, until our non-investment grade allocation of our initial capital and underwriting float was fully deployed by HPS, our historical investment income was not reflective of a fully invested non-investment grade portfolio. The following chart depicts the deployment of the portion of our assets allocated to this non-investment grade investment strategy, including a breakout of the amount of borrowings related to purchases of non-investment grade investments in this portfolio and the commensurate increase in net interest income during the period of higher asset deployment into our credit-focused strategy. In the chart below and throughout this prospectus, in connection with our non-investment grade portfolio, the term “net non-investment grade assets” are our total invested assets allocated to our non-investment grade investment strategy less borrowings to purchase such investments, and “net interest income” is interest income net of management fees paid to HPS and borrowing costs. 18 The investments in our non-investment grade portfolio in 2014 were predominantly leveraged loans, based on HPS’s then-current view of the relative value of those assets versus bonds. Since that time, the proportion in bonds has grown to approximately one-half of the non-investment grade portfolio as of December 31, 2018, which is in line with our investment targets. The following chart shows the size and composition of our non-investment grade portfolio since the commencement of portfolio operations in 2014. The table below provides the compensation to HPS incurred for the years ended December 31, 2018, 2017 and 2016. Year Ended December 31, 2018 2017 2016 ($ in thousands) Investment management fees and performance fees to HPS ..................... $ 15,878 $ 35,732 $ 40,392 Investment grade portfolio In conducting our underwriting business, we maintain a portion of our assets in investment grade securities and cash. The size of our investment grade portfolio and the amount we hold in cash will vary over time based on the business we write. We hold a certain amount of investment grade securities and short-term investments, largely to satisfy regulatory requirements for our U.S. insurance subsidiaries or to post as collateral for certain of Watford Re’s clients for commercial reasons or to obtain regulatory credit for the reinsurance they purchase. As of December 31, 2018, approximately 4.8% of our investment grade portfolio was held in our U.S. subsidiaries, 91.8% was posted as collateral and the remaining 3.4% were discretionary investments. Our investment grade portfolio is primarily managed by AIM, with certain accounts managed by other Investment Managers, including HPS, and generally holds corporate credits assets, government bonds, and asset and mortgage-backed securities. Each of AIM, HPS and our other Investment Managers manage its respective allocation of our investment grade portfolio pursuant to investment management agreements that it has entered into with Watford Re and each of our operating subsidiaries. For a discussion of our agreements with AIM, see “Certain relationships and related party transactions-Agreements with Arch- 19 Investment management agreements.” Subject to our investment guidelines for this portfolio, AIM, HPS and our other Investment Managers make all applicable investment decisions on our behalf. As of December 31, 2018, we had $2,738.4 million of invested assets, with $855.8 million in our investment grade portfolio, of which $669.8 million were investment grade assets managed by AIM. The following chart describes the composition of our investment grade portfolio as of December 31, 2018: The table below provides the compensation to AIM for the years ended December 31, 2018, 2017 and 2016. Total: $855.8 million Investment management fees to AIM ......................................................... $ 1,176 $ 624 $ 236 Year Ended December 31, 2018 2017 2016 ($ in thousands) Industry overview Background Insurance and reinsurance companies derive substantially all of their revenues from net premiums earned, interest income and net gains and losses from investment securities. Gross premiums written represent amounts, net of acquisition costs, received from policyholders (in insurance) and ceding companies (in reinsurance). Net premiums earned represent the portion of net premiums (gross premiums written less premiums ceded for reinsurance purchased from third parties) which are recognized as revenue over the period of time that coverage is provided (i.e., ratably over the life of the policy). In underwriting operations, “float” arises when premiums are received before losses and other expenses are paid and is an interval that sometimes extends over many years. During that time, the insurer invests the premiums, earns interest income and may generate capital gains and losses. The type of coverage and source of premiums are often classified based on how long an insurer may have between the policy period and when losses are settled under the policy. The length of time between receiving premiums and paying out claims, commonly referred to as the “tail,” can significantly affect how profitable float can be. Long-tail losses pay out over longer periods of time, providing the insurance or reinsurance company the opportunity to generate significant investment earnings. Short-tail losses pay out over shorter periods of time, providing the insurance or reinsurance company with a reduced opportunity to generate investment earnings. As of December 31, 2018, the modeled duration of our claims reserves was approximately 4.8 years. The broader P&C insurance and reinsurance market 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 20 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 that insurance need, leading to a “hard” market during which insurance prices generally rise and policy terms and conditions become more favorable to the insurer. Reinsurance Reinsurance is an arrangement in which a reinsurance company agrees to indemnify an insurance company, the “cedant,” against all or a portion of the insurance exposures underwritten by the cedant under one or more insurance underlying contracts. Reinsurance does not discharge the cedant from its liability to policyholders; rather, it reimburses the cedant for covered losses. Reinsurance can provide a cedant with several benefits, including a reduction in its net liability on individual exposures or classes of exposures or a reduction in operating leverage as measured by the ratio of net premiums and reserves to capital. Reinsurance also provides a cedant with additional underwriting capacity by permitting it to accept larger exposures and write more business than otherwise would be acceptable to policyholders or regulators relative to the cedant’s financial resources. Cedants can use reinsurance to manage their overall risk profile or to create additional underwriting capacity, allowing them to accept larger risks or to write more business than would otherwise be possible, absent an increase in their capital or surplus. Reinsurers may also purchase reinsurance. Such transactions are termed “retrocessions” with the ceding (purchasing) reinsurer being the “retrocedant” and the assuming (selling) reinsurer the “retrocessionaire.” Other than terminology, reinsurance and retrocession operate in a similar manner. According to A.M. Best, non-life net premiums written in the global reinsurance market has grown by 15.1% to $153 billion from 2012 to 2017. As indicated in the chart below, reinsurance industry capital has increased in recent years primarily due to favorable loss reserve development and the lack of major catastrophe events recently. Source: Aon Benfield Analytics Given the increase in dedicated reinsurance capital and the slower increase in reinsurance net premiums written, the global reinsurance market has seen a decrease in projected underwriting profitability. This represents an advantage for total return insurers such as us who have an increased potential to generate higher returns from investment income than traditional reinsurers. 21 Insurance P&C insurance companies provide insurance coverage under a policy in exchange for premiums paid by the customer. An insurance policy is a contract between the insurance company and the insured under which the insurance company agrees to pay for losses suffered by the insured, or a third-party claimant, that are covered under the insurance contract. Property insurance, which covers the insured for losses to the insured’s property, is generally considered to be short-tailed. Casualty insurance, which covers the insured against liability claims by third parties, is generally considered to be medium- to long-tailed. In 2017, global P&C direct premiums written totaled approximately $2.23 trillion and according to A.M. Best, the U.S. P&C insurance industry is the largest P&C market in the world by premium volume. In 2017, the U.S. P&C insurance market generated $642 billion, or approximately 29% of P&C direct premiums written worldwide. Source: Prepared by management based on information obtained from A.M. Best. The U.S. P&C insurance industry is further subdivided between the standard lines market (also referred to as the admitted market) and the non-standard lines market (also referred to as the non-admitted, excess-and- surplus lines or E&S market). Admitted insurers are those that hold licenses to write the particular lines (types) of insurance coverage in each state in which they write business, and they thereby are subject to each such state’s regulatory authority. In contrast, E&S insurers receive broad permission to write excess-and- surplus lines business from the regulator in each state in which they write business, but are subject to certain rules that govern the E&S market, such as no admitted insurer being willing to write the coverage on equivalent terms. In 2017, E&S direct premiums written in the U.S. P&C insurance market totaled approximately $45 billion. This market functions as a supplemental market that covers hard-to-place, higher-risk and unique classes of business that do not fit standard lines insurers’ underwriting guidelines. Unlike admitted insurers, E&S insurers are subject to only limited rate and form regulations by the state insurance regulators. E&S insurance companies may negotiate price and coverage on a risk-by-risk basis whereas standard lines insurance carriers are subject to various regulations, including rate and policy form filings, which limit price and coverage flexibility. This allows the unique qualities of the underlying risk to be fully evaluated and underwritten and provides the E&S insurer with greater flexibility to customize pricing and terms and conditions to meet the needs of the insured. Competition in the E&S market tends to focus less on price than in the standard lines 22 insurance market and more on other value-based considerations such as availability, terms of coverage, customer service and underwriting expertise. Because of these characteristics, the E&S market is attractive to us and provides us with flexibility in product design where we feel that our integrated strategy gives us a competitive advantage in devising client solutions. Competition Insurers and reinsurers generally compete on the basis of many factors, including premium charges, general reputation, perceived financial strength, terms and conditions of the products offered, general service level, speed of claims payment, experience in the particular line of insurance to be written and ratings assigned by independent rating agencies. Watford Re, as well as each of our other operating subsidiaries, carries a financial strength rating of “A-” (Excellent) from A.M. Best and “A” from KBRA. The insurance and reinsurance industry is highly competitive. We compete with major U.S. and non-U.S. insurers and reinsurers, many of which have greater financial, marketing and management resources than we do, as well as other potential providers of capital willing to assume insurance or reinsurance risk. We also compete with new companies that continue to be formed to enter the insurance and reinsurance markets. In addition, continued consolidation within the industry will further enhance the already competitive underwriting environment. These consolidated entities may use their enhanced market power and broader capital base to negotiate price reductions for products and services that compete with ours and we may experience rate declines and possibly write less business. In our underwriting business, we compete with insurers that provide specialty P&C lines of insurance and reinsurance, including, among others: Aspen Insurance Holdings Limited, AXIS Capital Holdings Limited, Berkshire Hathaway, Inc., Chubb Limited, Everest Re Group Ltd., Fairfax Financial Holdings Limited, Greenlight Capital Re, Ltd., Hannover Rückversicherung AG, Lloyd’s, Markel Corporation, Munich Re Group, PartnerRe Ltd., RenaissanceRe Holdings Ltd., Third Point Reinsurance Ltd., Transatlantic Reinsurance Company and AXA XL Ltd. See “Risk factors-Risks related to our insurance and reinsurance business-We operate in a highly competitive environment and we may not be able to compete successfully in our industry.” Employees In accordance with our strategy to maintain an efficient operational structure with minimal fixed expenses, we have chosen to operate largely through experienced service partners, each of which is paid on a variable cost basis and which are monitored by our senior management team. As of December 31, 2018, we had ten full-time employees, eight of whom were based in Bermuda, one of whom was based in the United States and one of whom was based in Europe. In addition, pursuant to our services agreements with Arch, as of December 31, 2018, there were thirty-one designated employees of both Arch and us who were provided to us on a non-exclusive basis to perform various services in connection with our insurance and reinsurance operations (including six that were designated as officers of WSIC and/or WIC and, in such capacities, negotiate and bind reinsurance, execute documentation and perform other related functions for WSIC and/or WIC, as applicable). We believe that our employee relations are good. None of our employees are subject to collective bargaining agreements and we are not aware of any current efforts to implement such agreements. Facilities Our headquarters is located in leased office space that we maintain at Waterloo House in Hamilton, Bermuda. This lease runs through September 2, 2023 and we have the option to renew it for up to an additional ten years. We also maintain an office for our U.S.-based insurance subsidiaries in Morristown, New Jersey. Our Gibraltar insurance subsidiary currently operates from a shared office arrangement. We believe this office space will be sufficient for us to conduct our operations for the foreseeable future. Information technology Pursuant to our services agreements with Arch, Arch is responsible for the connectivity and maintenance of our information technology systems in Bermuda, the United States and Europe. These are the same systems that Arch utilizes for its own operations, accounting and to service its underwriting portfolios. Arch maintains the secure information technology environment, including secure Internet connections and electronic data transmission. 23 Such information technology and application systems are an important part of our underwriting process and our ability to compete successfully. We license the majority of our systems and data from third parties. Arch’s information technology team constantly monitors the system for breaches or failures, including those resulting from a cyberattack on us or our business partners and service providers. We use our information technology systems to process, transmit, store and protect our electronic information, financial data and proprietary models that we utilize in our business and for the communications between our employees and our business, banking and investment partners. Arch has established and implemented security measures, controls and procedures that it believes are appropriate to safeguard its and our information technology systems and to prevent unauthorized access to such systems and any data processed or stored in such systems, and our system is periodically evaluated and tested by expert third parties for the adequacy of such systems, controls and procedures. In addition, we have established, and continue to augment, a business continuity plan which is designed to ensure that we are able to maintain all aspects of our key business processes functioning in the midst of certain disruptive events, including any disruptions to or breaches of our information technology systems. Our business continuity plan has been tested and evaluated for adequacy. Legal proceedings There is no litigation currently pending or, to the knowledge of management, contemplated against us or any of our officers or directors in their capacity as such. Available information Watford Holdings files annual, quarterly and current reports and other information with the SEC. The SEC maintains an internet website (www.sec.gov) that contains reports, proxy and information statements and other information regarding registrants that file electronically with the SEC, including us. You may also access, free of charge, our reports filed with the SEC (for example, our Quarterly Reports on Form 10-Q and our Current Reports on Form 8-K and any amendments to those forms) through the “Investors” portion of our Internet website (www.watfordre.com). Reports filed with or furnished to the SEC will be available as soon as reasonably practicable after they are filed with or furnished to the SEC. 24 Our corporate structure The following chart presents a summary overview of our corporate structure. Regulation Bermuda insurance regulation The Insurance Act, pursuant to which the BMA regulates Watford Re, provides that no person shall carry on insurance or reinsurance business in or from within Bermuda, unless registered under the Insurance Act by the BMA. The Insurance Act does not distinguish between insurers and reinsurers: companies are registered under the Insurance Act as “insurers.” The Insurance Act uses the defined term “insurance business” to include reinsurance. The BMA is required by the Insurance Act to determine whether the applicant is a fit and proper body to be engaged in the insurance or reinsurance business and, in particular, whether it has, or has available to it, adequate knowledge and expertise. The registration of an applicant as an insurer is subject to its complying with the terms of its registration and such other conditions as the BMA may impose at any time. The Insurance Act imposes solvency and liquidity standards on Bermuda insurance and reinsurance companies, as well as auditing and reporting requirements. The Insurance Act also grants to the BMA powers to supervise, investigate and intervene in the affairs of insurance and reinsurance companies. Certain significant aspects of the Bermuda insurance and reinsurance regulatory framework are set forth below. 25 Classification of insurers The Insurance Act distinguishes between insurers and reinsurers carrying on long-term business, insurers and reinsurers carrying on general business and insurers and reinsurers carrying on special purpose business. There are six classifications of insurers and reinsurers carrying on general business, ranging from Class 1 insurers (pure captives subject to the lightest regulation) to Class 4 insurers (large commercial carriers subject to the most stringent regulation). Watford Re is licensed as a Class 4 insurer in Bermuda and is regulated as such under the Insurance Act. Classification as a Class 4 insurer A body corporate is registrable as a Class 4 insurer where (i) it has at the time of its application for registration, or will have before it carries on insurance or reinsurance business, a total statutory capital and surplus of not less than U.S. $100 million; and (ii) it intends to carry on general insurance and/or reinsurance business, including excess liability business or property catastrophe reinsurance business. Minimum paid up share capital Class 4 insurers are required to maintain fully paid-up share capital of at least U.S. $1 million. Principal office and principal representative As a Class 4 insurer, Watford Re is required to maintain a head and a principal office in Bermuda and to appoint and maintain a principal representative in Bermuda. For the purposes of the Insurance Act, the principal office of Watford Re is located at Waterloo House, 1st Floor, 100 Pitts Bay Road, Pembroke HM 08, Bermuda. Watford Re’s principal representative is Robert Hawley, the Chief Financial Officer of Watford Re. Without a reason acceptable to the BMA, a Class 4 insurer may not terminate the appointment of its principal representative, and the principal representative may not cease to act as such, unless 30 days’ notice in writing to the BMA is given of the intention to do so. It is the duty of the principal representative to forthwith notify the BMA where the principal representative reaches the view that there is a likelihood of the Class 4 insurer becoming insolvent, or on it coming to the knowledge of the principal representative, or the principal representative has reasonable grounds for believing that a reportable “event” has occurred. Examples of a reportable “event” include a failure by the Class 4 insurer to comply substantially with a condition imposed upon it by the BMA relating to a solvency margin or a liquidity or other ratio, a significant loss reasonably likely to cause the Class 4 insurer to fail to comply with its enhanced capital requirement (discussed below) and the occurrence of a “material change” (as such term is defined under the Insurance Act) in its business operations. Within 14 days of such notification to the BMA, the principal representative must furnish the BMA with a written report setting out all the particulars of the case that are available to the principal representative. Where there has been a significant loss which is reasonably likely to cause the Class 4 insurer to fail to comply with its enhanced capital requirement, the principal representative must also furnish the BMA with a capital and solvency return reflecting an enhanced capital requirement prepared using post-loss data. The principal representative must provide this within 45 days of notifying the BMA regarding the loss. Furthermore, where a notification has been made to the BMA regarding a material change, the principal representative has 30 days from the date of such notification to furnish the BMA with unaudited interim statutory financial statements in relation to such period as the BMA may require, together with a general business solvency certificate in respect of those statements. Head office As a Class 4 insurer, Watford Re is required to maintain its head office in Bermuda and its insurance business must be directed and managed from Bermuda. In determining whether Watford Re satisfies this requirement, the BMA shall consider, among other things, the following factors: (i) where the underwriting, risk management and operational decision making of Watford Re occurs; (ii) whether the presence of senior executives who are responsible for, and involved in, the decision making related to the insurance business of Watford Re are located in Bermuda; and (iii) where meetings of the board of directors of Watford Re occur. In making its determination, the BMA may also have regard to: (i) the location where management of Watford Re meets to effect policy decisions of Watford Re; (ii) the residence of the officers, insurance 26 managers or employees of Watford Re; and (iii) the residence of one or more directors of Watford Re in Bermuda. This provision does not apply to an insurer that has a permit to conduct business in Bermuda under the Companies Act or the Non-Resident Insurance Undertakings Act 1967. Loss reserve specialist As a Class 4 insurer, Watford Re is required to appoint an individual approved by the BMA to be its loss reserve specialist. In order to qualify as an approved loss reserve specialist, the applicant must be an individual qualified to provide an opinion in accordance with the requirements of the Insurance Act and the BMA must be satisfied that the individual is fit and proper to hold such an appointment. A Class 4 insurer is required to submit annually an opinion of its approved loss reserve specialist with its capital and solvency return. The loss reserve specialist’s opinion must state, among other things, whether or not the aggregate amount of technical provisions shown in the statutory economic balance sheet as at the end of the relevant financial year: (i) meets the requirements of the Insurance Act and (ii) makes reasonable provision for the total technical provisions of the insurer or reinsurer under the terms of its insurance or reinsurance contracts and agreements. Annual financial statements Watford Re is required to prepare and submit, on an annual basis, audited GAAP and statutory financial statements, as defined below. The Insurance Act prescribes rules for the preparation and substance of statutory financial statements (which include, in statutory form, a balance sheet, an income statement, a statement of capital and surplus and notes thereto). The statutory financial statements include detailed information and analysis regarding premiums, claims, reinsurance and investments of the insurer or reinsurer. In addition, Watford Re is also required to prepare and submit to the BMA financial statements which have been prepared under generally accepted accounting principles or international financial reporting standards, or GAAP financial statements. Watford Re’s annual GAAP financial statements and the auditor’s report thereon, and the statutory financial statements are required to be filed with the BMA within four months from the end of the relevant financial year (unless specifically extended with the approval of the BMA). The statutory financial statements do not form a part of the public records maintained by the BMA, but the GAAP financial statements are available for public inspection. Declaration of compliance At the time of filing its statutory financial statements, a Class 4 insurer is also required to deliver to the BMA a declaration of compliance, in such form and with such content as may be prescribed by the BMA, declaring whether or not the Class 4 insurer has, with respect to the preceding financial year: (i) complied with all requirements of the minimum criteria applicable to it; (ii) complied with the minimum margin of solvency as at its financial year end; (iii) complied with the applicable enhanced capital requirements as at its financial year end; (iv) complied with applicable conditions, directions and restrictions on, or approvals granted to, the Class 4 insurer; and (v) complied with the minimum liquidity ratio as at its financial year end. The declaration of compliance is required to be signed by two directors of the Class 4 insurer and if the Class 4 insurer has failed to comply with any of the requirements referenced in (i) through (v) above, the Class 4 insurer will be required to provide the BMA with particulars of such failure in writing. A Class 4 insurer shall be liable to a civil penalty by way of a fine for failure to comply with a duty imposed on it in connection with the delivery of the declaration of compliance. Annual statutory financial return and annual capital and solvency return As a Class 4 insurer, Watford Re is required to file with the BMA a statutory financial return no later than four months after its financial year end (unless specifically extended with the approval of the BMA). The statutory financial return of a Class 4 insurer shall consist of: (i) an insurer information sheet; (ii) an auditor’s report; (iii) the statutory financial statements; and (iv) notes to the statutory financial statements. The insurer information sheet shall state, among other matters: (i) whether the general purpose financial statements of Watford Re for the relevant year have been audited and an unqualified opinion issued; (ii) the minimum margin of solvency applying to Watford Re and whether such margin was met; (iii) whether or not the minimum liquidity ratio applying to Watford Re for the relevant year was met; and (iv) whether or not Watford Re has complied with every condition attached to its certificate of registration. The insurer 27 information sheet shall state if any of the questions identified in items (ii), (iii) or (iv) above is answered in the negative, whether or not Watford Re has taken corrective action in any case and, where Watford Re has taken such action, describe the action in an attached statement. The directors are required to certify whether the minimum solvency margin has been met, and the independent approved auditor is required to state whether in its opinion it was reasonable for the directors to make this certification. Where an insurer’s accounts have been audited for any purpose other than compliance with the Insurance Act, a statement to that effect must be filed with the statutory financial return. In addition, each year Watford Re is required to file with the BMA a capital and solvency return along with its annual statutory financial return. The prescribed form of capital and solvency return comprises Watford Re’s Bermuda Solvency Capital Requirement, or BSCR, model or an approved internal capital model in lieu thereof (more fully described below), a schedule of fixed income and equity investments by BSCR rating, a schedule of funds held by ceding reinsurers in segregated accounts/trusts by BSCR rating, a schedule of net loss and loss expense provisions by line of business, a schedule of geographic diversification of net loss and loss expense provisions, a schedule of premiums written by line of business, a schedule of geographic diversification of net premiums written by line of business, a schedule of risk management, a schedule of fixed income securities, a schedule of commercial insurer’s solvency self-assessment, a schedule of catastrophe risk return, a schedule of loss triangles or reconciliation of net loss reserves, a schedule of eligible capital, a statutory economic balance sheet, the loss reserve specialist’s opinion, a schedule of regulated non-insurance financial operating entities, a schedule of solvency, a schedule of particulars of ceded reinsurance, a schedule of cash and cash equivalent counterparty analysis, a schedule of currency risk and a schedule of concentration risk. Neither the statutory financial return nor the capital and solvency return is available for public inspection. Quarterly financial return As a Class 4 insurer, Watford Re is required to prepare and file quarterly financial returns with the BMA on or before the last day of the months of May, August and November of each year. The quarterly financial returns consist of: (i) quarterly unaudited financial statements for each financial quarter (which must minimally include a balance sheet and income statement and must also be recent and not reflect a financial position that exceeds two months); (ii) a list and details of material intra-group transactions that Watford Re is a party to and Watford Re’s risk concentrations that have materialized since the most recent quarterly or annual financial returns, details surrounding all intra-group reinsurance and retrocession arrangements and other intra-group risk transfer insurance business arrangements that have materialized since the most recent quarterly or annual financial returns; and (iii) details of the ten largest exposures to unaffiliated counterparties and any other unaffiliated counterparty exposures exceeding 10% of Watford Re’s statutory capital and surplus. Public disclosures Pursuant to recent amendments to the Insurance Act all commercial insurers, reinsurers, insurance groups and reinsurance groups are required to prepare and file with the BMA, and also publish on their website, a financial condition report. The BMA has discretion to approve modifications and exemptions to the public disclosure rules, on application by the insurer or reinsurer if, among other things, the BMA is satisfied that the disclosure of certain information will result in a competitive disadvantage or compromise confidentiality obligations of the insurer or reinsurer. Independent approved auditor A Class 4 insurer must appoint an independent auditor who will audit and report on the Class 4 insurer’s GAAP financial statements and provide audit assurance that its statutory financial statements were derived from its GAAP financial statements, each of which are required to be filed annually with the BMA. Non-insurance business No Class 4 insurer may engage in non-insurance business, unless that non-insurance business is ancillary to its core business. Non-insurance business means any business other than insurance or reinsurance business and includes carrying on investment business, managing an investment fund as operator, carrying on business as a fund administrator, carrying on banking business, underwriting debt or securities or otherwise engaging in 28 investment banking, engaging in commercial or industrial activities and carrying on the business of management, sales or leasing of real property. Minimum solvency margin and enhanced capital requirements The Insurance Act provides that the value of the statutory assets of an insurer must exceed the value of its statutory liabilities by an amount greater than its prescribed minimum solvency margin, or MSM. The MSM that must be maintained by a Class 4 insurer with respect to its general business is the greater of (i) $100 million or (ii) 50% of net premiums written (with a credit for reinsurance ceded not exceeding 25% of gross premiums) or (iii) 15% of net loss and loss expense provisions and other insurance reserves or (iv) 25% of the ECR as reported at the end of the relevant year. Class 4 insurers are also required to maintain available statutory economic capital and surplus at a level equal to or in excess of its ECR which is established by reference to either the BSCR model or an approved internal capital model. The BSCR model is a risk-based capital model which provides a method for determining an insurer’s capital requirements (statutory economic capital and surplus) by taking into account the risk characteristics of different aspects of Watford Re’s business. The BSCR formula establishes capital requirements for ten categories of risk: fixed income investment risk, equity investment risk, interest rate/liquidity risk, currency risk, concentration risk, premium risk, reserve risk, credit risk, catastrophe risk and operational risk. For each category, the capital requirement is determined by applying factors to asset, premium, reserve, creditor, probable maximum loss and operation items, with higher factors applied to items with greater underlying risk and lower factors for less risky items. While not specifically referred to in the Insurance Act (or required thereunder), the BMA has also established a target capital level, or TCL, for each Class 4 insurer equal to 120% of its ECR. The TCL serves as an early warning tool for the BMA and failure to maintain statutory capital at least equal to the TCL will likely result in increased regulatory oversight. Any Class 4 insurer which at any time fails to meet its MSM requirements must, upon becoming aware of such failure, immediately notify the BMA and, within 14 days thereafter, file a written report with the BMA containing particulars of the circumstances that gave rise to the failure and setting out its plan detailing specific actions to be taken and the expected timeframe in which Watford Re intends to rectify the failure. Any Class 4 insurer which at any time fails to meet its applicable enhanced capital requirement shall upon becoming aware of that failure, or of having reason to believe that such a failure has occurred, immediately notify the BMA in writing and within 14 days of such notification file with the BMA a written report containing particulars of the circumstances leading to the failure; and a plan detailing the manner, specific actions to be taken and time within which Watford Re intends to rectify the failure and within 45 days of becoming aware of that failure, or of having reason to believe that such a failure has occurred, furnish the BMA with: (i) unaudited statutory economic balance sheets and unaudited interim statutory financial statements prepared in accordance with GAAP covering such period as the BMA may require; (ii) the opinion of a loss reserve specialist in relation to the total general business insurance technical provisions as set out in the economic balance sheet, where applicable; (iii) a general business solvency certificate in respect of the financial statements; and (iv) a capital and solvency return reflecting an enhanced capital requirement prepared using post-failure data where applicable. Eligible capital To enable the BMA to better assess the quality of the Class 4 insurer’s capital resources, a Class 4 insurer is required to disclose the makeup of its capital in accordance with the “3-tiered eligible capital system.” Under this system, all of the Class 4 insurer’s capital instruments will be classified as either basic or ancillary capital which in turn will be classified into one of three tiers based on their “loss absorbency” characteristics. Highest quality capital will be classified Tier 1 Capital and lesser quality capital will be classified as either Tier 2 Capital or Tier 3 Capital. Under this regime, up to certain specified percentages of Tier 1, Tier 2 and Tier 3 Capital may be used to support the Class 4 insurer’s MSM, ECR and TCL. The characteristics of the capital instruments that must be satisfied to qualify as Tier 1, Tier 2 and Tier 3 Capital are set out in the Insurance (Eligible Capital) Rules 2012, and amendments thereto. Under these rules, Tier 1, Tier 2 and Tier 3 Capital may, until January 1, 2026, include capital instruments that do not satisfy the 29 requirement that the instrument be non-redeemable or settled only with the issuance of an instrument of equal or higher quality upon a breach, or if it would cause a breach, of the ECR. Minimum liquidity ratio The Insurance Act provides a minimum liquidity ratio for general business insurers and reinsurers. A Class 4 insurer engaged in general business is required to maintain the value of its relevant assets at not less than 75% of the amount of its relevant liabilities. Relevant assets include cash and time deposits, quoted investments, unquoted bonds and debentures, first liens on real estate, investment income due and accrued, accounts and premiums receivable, reinsurance balances receivable, funds held by ceding reinsurers and any other assets which the BMA, on application in any particular case made to it with reasons, accepts in that case. Certain categories of assets which, unless specifically permitted by the BMA, do not automatically qualify as relevant assets, such as unquoted equity securities, investments in and advances to affiliates and real estate and collateral loans. The relevant liabilities include total general business insurance and reinsurance reserves and total other liabilities less deferred income tax and letters of credit and guarantees. Code of conduct The Insurance Code of Conduct, or the Insurance Code prescribes the duties, standards, procedures and sound business principles which must be complied with by all insurers and reinsurers registered under the Insurance Act. Failure to comply with the requirements of the Insurance Code will be taken into account by the BMA in determining whether an insurer or reinsurer is conducting its business in a sound and prudent manner as prescribed by the Insurance Act, may result in the BMA exercising its powers of intervention and investigation (see below) and will be a factor in calculating the operational risk charge under the insurer or reinsurer’s BSCR or approved internal model. Restrictions on dividends and distributions A Class 4 insurer is prohibited from declaring or paying a dividend if it is in breach of its MSM, ECR or minimum liquidity ratio or if the declaration or payment of such dividend would cause such a breach. Where a Class 4 insurer fails to meet its MSM or minimum liquidity ratio on the last day of any financial year, it will be prohibited from declaring or paying any dividends during the next financial year without the approval of the BMA. In addition, a Class 4 insurer is prohibited from declaring or paying in any financial year dividends of more than 25% of its total statutory capital and surplus (as shown on its previous financial year’s statutory balance sheet), unless it files (at least seven days before payment of such dividends) with the BMA an affidavit signed by at least two directors (one of whom must be a Bermuda-resident director if any of the Class 4 insurer’s directors are resident in Bermuda) and the principal representative stating that it will continue to meet its solvency margin and minimum liquidity ratio. Where such an affidavit is filed, it shall be available for public inspection at the offices of the BMA. Reduction of capital A Class 4 insurer may not reduce its total statutory capital by 15% or more, as set out in its previous year’s financial statements, unless it has received the prior approval of the BMA. Total statutory capital consists of the insurer’s paid in share capital and its contributed surplus (sometimes called additional paid in capital) and any other fixed capital designated by the BMA as statutory capital (such as letters of credit). A Class 4 insurer seeking to reduce its statutory capital by 15% or more, as set out in its previous year’s financial statements, is also required to submit an affidavit signed by at least two directors (one of whom must be a Bermuda-resident director if any of the Class 4 insurer’s directors are resident in Bermuda) and the principal representative stating that the proposed reduction will not cause it to fail its relevant margins and such other information as the BMA may require. Where such an affidavit is filed, it shall be available for public inspection at the offices of the BMA. 30 Supervision, investigation and intervention The BMA may, by notice in writing served on a registered person or a designated insurer or reinsurer, require the registered person or designated insurer or reinsurer to provide such information and/or documentation as the BMA may reasonably require with respect to matters that are likely to be material to the performance of its supervisory functions under the Insurance Act. In addition, it may require the auditor, underwriter, accountant or any other person with relevant professional skill of such registered person or a designated insurer or reinsurer to prepare a report on any aspect pertaining thereto. In the case of a report, the person so appointed shall immediately give the BMA written notice of any fact or matter of which he becomes aware or which indicates to him that any condition attaching to his registration under the Insurance Act is not or has not, or may not be or may not have been fulfilled and that such matters are likely to be material to the performance of its functions under the Insurance Act. If it appears to the BMA to be desirable in the interests of the clients of a registered person or relevant insurance or reinsurance group, the BMA may also exercise these powers in relation to subsidiaries, parent companies and other affiliates of the registered person or designated insurer or reinsurer. If the BMA deems it necessary to protect the interests of the policyholders or potential policyholders of an insurer, reinsurer, insurance group or reinsurance group, it may appoint one or more competent persons to investigate and report on the nature, conduct or state of the insurer, reinsurer, insurance group or reinsurance group’s business, or any aspect thereof, or the ownership or control of the insurer, reinsurer, insurance group or reinsurance group. If the person so appointed thinks it necessary for the purposes of his investigation, he may also investigate the business of any person who is or has been, at any relevant time, a member of the insurance group or reinsurance group or of a partnership of which the person being investigated is a member. In this regard, it shall be the duty of every person who is or was a controller, officer, employee, agent, banker, auditor, accountant, barrister, attorney or insurance manager to produce to the person appointed such documentation as he may reasonably require for the purpose of the investigation, and to attend and answer questions relevant to the investigation and to otherwise provide such assistance as may be necessary in connection therewith. Where the BMA suspects that a person has failed to properly register under the Insurance Act or that a registered person or designated insurer or reinsurer has failed to comply with a requirement of the Insurance Act or that a person is not, or is no longer, a fit and proper person to perform functions in relation to a regulated activity, it may, by notice in writing, carry out an investigation into such person (or any other person connected thereto). In connection therewith, the BMA may require every person who is or was a controller, officer, employee, agent, banker, auditor, accountant, barrister, attorney or insurance manager to make a report and produce such documents in his care, custody and control and to attend before the BMA to answer questions relevant to the BMA’s investigation and to take such actions as the BMA may direct. The BMA may also enter any premises for the purposes of carrying out its investigation and may petition the court for a warrant if: (i) it believes a person has failed to comply with a notice served on him; (ii) there are reasonable grounds for suspecting the incompleteness of any information or documentation produced in response to such notice; or (iii) that its directions will not be complied with or that any relevant documents would be removed, tampered with or destroyed. If it appears to the BMA that the business of the registered insurer or reinsurer is being conducted in a way that there is a significant risk of the insurer or reinsurer becoming insolvent or unable to meet its obligations to its policyholders, or that the insurer or reinsurer is in breach of the Insurance Act or any conditions imposed upon its registration, or the minimum criteria stipulated in the Insurance Act is not or has not been fulfilled in respect of a registered insurer or reinsurer, or that a person has become a controller without providing the BMA with the appropriate notice or in contravention of a notice of objection, or the registered insurer or reinsurer is in breach of its ECR, the BMA may issue such directions as it deems desirable for safeguarding the interests of the policyholders or potential policyholders of the insurer, reinsurer, insurance group or reinsurance group. The BMA may, among other things, direct an insurer or reinsurer: (i) not to take on any new insurance or reinsurance business; (ii) not to vary any insurance or reinsurance contract if the effect would be to increase its liabilities; (iii) not to make certain investments; (iv) to realize certain investments; (v) to maintain or transfer to the custody of a specified bank, certain assets; (vi) not to declare or pay any dividends or other distributions or to restrict the making of such payments; (vii) to limit its premium income; (viii) not to enter into any specified transaction with any specified persons or persons of a specified class; (ix) to provide such written particulars relating to the financial circumstances of the insurer or reinsurer as the BMA thinks fit; (x) to obtain the opinion of a loss reserve specialist and to submit it to the BMA; and (xi) to remove a controller or officer. 31 Fit and proper controller The BMA maintains supervision over the controllers of all registered insurers and reinsurers in Bermuda. A controller includes: (i) the managing director of the registered insurer, reinsurer or its parent company; (ii) the chief executive of the registered insurer, reinsurer, or of its parent company; (iii) a 10%, 20%, 33% or 50% shareholder controller; and (iv) any person in accordance with whose directions or instructions the directors of the registered insurer, reinsurer, or of its parent company are accustomed to act. The definition of shareholder controller is set out in the Insurance Act, but generally refers to: (i) a person who holds 10% or more of the shares carrying rights to vote at a shareholders’ meeting of the registered insurer, reinsurer, or its parent company; (ii) a person who is entitled to exercise 10% or more of the voting power at any shareholders’ meeting of such registered insurer, reinsurer, or its parent company; or (iii) a person who is able to exercise significant influence over the management of the registered insurer, reinsurer, or its parent company by virtue of its shareholding or its entitlement to exercise, or control the exercise of, the voting power at any shareholders’ meeting. A shareholder controller that owns 10% or more, but less than 20% of the shares as described above is defined as a 10% shareholder controller. A shareholder controller that owns 20% or more, but less than 33% of the shares as described above is defined as a 20% shareholder controller. A shareholder controller that owns 33% or more but less than 50% of the shares as described above is defined as a 33% shareholder controller. A shareholder controller that owns 50% or more of the shares as described above is defined as a 50% shareholder controller. As our shares are currently not traded on a recognized stock exchange (i.e., private companies), the Insurance Act prohibits any person from becoming a controller of any description, unless he or she has first served on the BMA notice, in writing, stating that he or she intends to become such a controller and the BMA has either, before the end of 45 days following the date of notification, provided notice to the proposed controller that it does not object to his or her becoming such a controller or the full 45 days has elapsed without the BMA filing an objection. A shareholder controller of such insurer or reinsurer shall not reduce or dispose of its holdings such that it will cease to be a 50%, 33%, 20% or 10% shareholder unless that shareholder controller has served on the BMA a notice in writing that it intends to do so. Any person who contravenes the Insurance Act by failing to give notice or knowingly becoming a controller of any description before the required 45 days has elapsed, or disposing of shares and as a result ceasing to be a shareholder controller without notifying the BMA of their intention to do so, is guilty of an offense and liable to a fine of U.S. $25,000 on summary conviction. Once our shares are traded on a recognized stock exchange, which includes the Nasdaq Global Select Market, any person who becomes a 10%, 20%, 33% or 50% shareholder controller of us shall be required, within 45 days, to notify the BMA in writing that he or she has become such a controller. A shareholder controller is also required to serve notice in writing on the BMA within 45 days of reducing or disposing of shares such that it ceases to be a 50%, 33%, 20% or 10% shareholder controller. Any person who fails to give any such notice is guilty of an offense and shall be liable on summary conviction to a fine of U.S. $25,000. The BMA may file a notice of objection to any person who has become a controller of any description where it appears that such person is not or is no longer, a fit and proper person to be a controller of the registered insurer or reinsurer. Before issuing a notice of objection, the BMA is required to serve upon the person concerned a preliminary written notice stating the BMA’s intention to issue formal notice of objection and the reasons for which it appears that the person is not or no longer considered a fit and proper person. Upon receipt of the preliminary written notice, the person served may, within 28 days, file written representations with the BMA, which shall be taken into account by the BMA in making their final determination. Any person who continues to be a controller of any description after having received a notice of objection shall be guilty of an offense and shall be liable on summary conviction to a fine of U.S. $25,000 (and a continuing fine of U.S. $500 per day for each day that the offense is continuing) or, if convicted on indictment, to a fine of U.S. $100,000 or two years in prison or both. Notification of material changes All registered insurers and reinsurers are required to give notice to the BMA of their intention to effect a material change within the meaning of the Insurance Act. For the purposes of the Insurance Act, the following changes are material: (i) the transfer or acquisition of insurance or reinsurance business being part of a scheme falling within, or any transaction relating to a scheme of arrangement under, Section 25 of the 32 Insurance Act or Section 99 of the Companies Act; (ii) the amalgamation with or acquisition of another firm; (iii) engaging in unrelated business that is retail business; (iv) the acquisition of a controlling interest in an undertaking that is engaged in non-insurance or non-reinsurance business which offers services and products to persons who are not affiliates of the insurer or reinsurer; (v) outsourcing all or substantially all of the company’s actuarial, risk management compliance and internal audit functions; (vi) outsourcing all or a material part of an insurer or reinsurer’s underwriting activity; (vii) the transfer other than by way of reinsurance of all or substantially all of a line of business; (viii) the expansion into a material new line of business; (ix) the sale of an insurer or reinsurer; and (x) outsourcing the role of the chief executive or senior executive performing the duties of underwriting, actuarial, risk management, compliance, internal audit, finance or investment matters. No registered insurer or reinsurer shall take any steps to give effect to a material change, unless it has first served notice on the BMA that it intends to effect such material change and before the end of 30 days, either the BMA has notified such company in writing that it has no objection to such change or that period has lapsed without the BMA having issued a notice of objection. Before issuing a notice of objection, the BMA is required to serve upon the person concerned a preliminary written notice stating the BMA’s intention to issue a formal notice of objection. Upon receipt of the preliminary written notice, the person served may, within 28 days, file written representations with the BMA which shall be taken into account by the BMA in making their final determination. Notification by registered person of change of controllers and officers Watford Re, as a Class 4 insurer, is required to give written notice to the BMA of the fact that a person has become, or ceased to be, a controller or officer of the Class 4 insurer within 45 days of becoming aware of such fact. An officer in relation to a registered insurer or reinsurer means a director, chief executive or senior executive performing duties of underwriting, actuarial, risk management, compliance, internal audit, finance or investment matters. Group supervision The BMA may, in respect of an insurance group, determine whether it is appropriate for it to act as its group supervisor. An insurance group is defined as a group of companies that conducts insurance business. The Authority may make such determination where it ascertains that: (i) the group is headed by a “specified insurer” (that is to say, it is headed by either a Class 3A, Class 3B or Class 4 general business insurer or a Class C, Class D or Class E long-term insurer or another class of insurer designated by order of the BMA); (ii) where the insurance group is not headed by a “specified insurer,” where it is headed by a parent company which is incorporated in Bermuda; or (iii) where the parent company of the group is not a Bermuda company, in circumstances where the BMA is satisfied that the insurance group is directed and managed from Bermuda or the insurer with the largest balance sheet total is a specified insurer. Where the BMA determines that it should act as the group supervisor, it shall designate a specified insurer that is a member of the insurance group to be the designated insurer, or the Designated Insurer, and it shall give to the Designated Insurer and other applicable insurance regulatory authority written notice of its intention to act as group supervisor. Before the BMA makes a final determination whether or not to act as group supervisor, it shall take into account any written representations made by the Designated Insurer submitted within such period as is specified in the notice. The BMA may exclude any company that is a member of an insurance group from group supervision on the application of the Designated Insurer, or on its own initiative, provided the BMA is satisfied that: (i) the company is situated in a country or territory where there are legal impediments to cooperation and exchange of information; (ii) the financial operations of the company have a negligible impact on insurance group operations; or (iii) the inclusion of the company would be inappropriate with respect to the objectives of group supervision. The BMA may, on its own initiative or on the application of the relevant Designated Insurer, include within group supervision a company that is a member of the group that is not on the Register of Group Particulars (described below) if it is satisfied the financial operations of the company in question may have a material impact on the insurance group’s operations and its inclusion would be appropriate having regard to the objectives of group supervision. 33 Once the BMA has been designated as group supervisor, the Designated Insurer must ensure that the insurance group of which it is a member appoints: (i) an individual approved by the BMA who is qualified as a group actuary to provide an opinion on the insurance group’s insurance technical provisions in accordance with the requirements of Schedule XIV “Group Statutory Economic Balance Sheet” of the Insurance (Prudential Standards) (Insurance Group Solvency Requirement) Rules 2011; and (ii) an auditor approved by the BMA to audit the financial statements of the group. Pursuant to its powers under the Insurance Act, the BMA will maintain a register of particulars for every insurance group, or the Register of Group Particulars, for which it acts as the group supervisor, detailing the names and addresses of: (i) the Designated Insurer; (ii) each member company of the insurance group falling within the scope of group supervision; (iii) the principal representative of the insurance group in Bermuda; (iv) other competent authorities supervising other member companies of the insurance group; and (v) the insurance group auditors. The Designated Insurer must immediately notify the BMA of any changes to the above details entered on the Register of Group Particulars. As group supervisor, the BMA will perform a number of supervisory functions including: (i) coordinating the gathering and dissemination of relevant or essential information for going concerns and emergency situations, including the dissemination of information which is of importance for the supervisory task of other competent authorities; (ii) carrying out supervisory reviews and assessments of the insurance group; (iii) carrying out assessments of the insurance group’s compliance with the rules on solvency, risk concentration, intra-group transactions and good governance procedures; (iv) planning and coordinating through regular meetings held at least annually (or by other appropriate means) with other competent authorities, supervisory activities in respect of the insurance group, both as a going concern and in emergency situations; (v) coordinating enforcement actions that may need to be taken against the insurance group or any of its members; and (vi) planning and coordinating meetings of colleges of supervisors in order to facilitate the carrying out of the functions described above. The BMA may, for the purposes of group supervision, make rules applying to Designated Insurers which take into account any activities of the insurance group of which they are members or of other members of the insurance group. Such rules may make provision for the assessment of the financial situation of the insurance group; the solvency position of the insurance group (including the imposition of prudential standards in relation to enhanced capital requirements, capital and solvency returns, insurance reserves and eligible capital that must be complied with by the Designated Insurers); the system of governance and risk management of the insurance group; intra-group transactions and risk concentrations; and supervisory reporting and disclosure in respect of the insurance group. Watford Re was designated by the BMA as a Designated Insurer on May 5, 2017 and as such we are currently subject to group supervision. Disclosure of information In addition to powers under the Insurance Act to investigate the affairs of an insurer or reinsurer, the BMA may require certain information from an insurer or reinsurer (or certain other persons) to be produced to the BMA. Further, the BMA has been given powers to assist other regulatory authorities, including foreign insurance regulatory authorities, with their investigations involving insurance and reinsurance companies in Bermuda if it is satisfied that the assistance being requested is in connection with the discharge of regulatory responsibilities and that such cooperation is in the public interest. The grounds for disclosure are limited and the Insurance Act provides for sanctions for breach of the statutory duty of confidentiality. Cancellation of insurer or reinsurer’s registration An insurer or reinsurer’s registration may be canceled by the BMA on certain grounds specified in the Insurance Act. Failure by the insurer or reinsurer to comply with its obligations under the Insurance Act, or if the BMA believes that the insurer or reinsurer has not been carrying on business in accordance with sound insurance or reinsurance principles, would be such grounds. Certain other Bermuda law considerations All Bermuda exempted companies are exempt from certain Bermuda laws restricting the percentage of share capital that may be held by non-Bermudians. However, exempted companies may not participate in certain business transactions, including: (i) the acquisition or holding of land in Bermuda except that required for their business held by way of lease or tenancy for a term not exceeding 50 years or, with the consent of the 34 Minister of Economic Development granted in his discretion, land by way of lease or tenancy for a term not exceeding 21 years in order to provide accommodation or recreational facilities for its officers and employees; (ii) the taking of mortgages on land in Bermuda to secure an amount in excess of B.D.$50,000 without the consent of the relevant Ministers; (iii) the acquisition of any bonds or debentures secured by any land in Bermuda, other bonds or debentures issued by the Bermuda Government or a public authority; or (iv) the carrying on of business of any kind in Bermuda, except in furtherance of their business carried on outside Bermuda or under license granted by the Minister of Economic Development. Generally, it is not permitted without a special license granted by the Minister to insure or reinsure Bermuda domestic risks or risks of persons of, in or based in Bermuda. All Bermuda companies must comply with the provisions of the Companies Act regulating the payment of dividends and making distributions from contributed surplus. A company may not declare or pay a dividend, or make a distribution out of contributed surplus, if there are reasonable grounds for believing that (i) it is, or would after the payment be, unable to pay its liabilities as they become due; or (ii) the realizable value of its assets would thereby be less than its liabilities. United States insurance regulation General In common with other insurers, our U.S.-based subsidiaries are subject to extensive governmental regulation and supervision in the various states and jurisdictions in which they are domiciled and licensed and/or approved to conduct business. The laws and regulations of the state of domicile have the most significant impact on operations. This regulation and supervision is designed to protect policyholders rather than investors. Generally, regulatory authorities have broad regulatory powers over such matters as licenses, standards of solvency, premium rates, policy forms, marketing practices, claims practices, investments, security deposits, methods of accounting, form and content of financial statements, reserves and provisions for unearned premiums, unpaid losses and loss adjustment expenses, reinsurance, minimum capital and surplus requirements, dividends and other distributions to shareholders, periodic examinations and annual and other report filings. In addition, transactions among affiliates, including reinsurance agreements or arrangements, as well as certain third-party transactions, require prior regulatory approval from, or prior notice to and no disapproval by, the applicable regulator under certain circumstances. Certain insurance regulatory requirements are highlighted below. In addition, regulatory authorities conduct periodic financial, claims and market conduct examinations. Increased federal or state regulatory scrutiny could lead to new legal precedents, new regulations, new practices, or regulatory actions or investigations, which could adversely affect our financial condition and operating results. Credit for reinsurance Except for certain mandated provisions that must be included in order for a ceding company to obtain credit for reinsurance ceded, the terms and conditions of reinsurance agreements generally are not subject to regulation by any governmental authority. This contrasts with admitted primary insurance policies and agreements, the rates and terms of which generally are regulated by state insurance regulators. Certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, or the Dodd- Frank Act, provide that only the state in which a primary insurer is domiciled may regulate the financial statement credit for reinsurance taken by that primary insurer. A primary insurer ordinarily will enter into a reinsurance agreement only if it can obtain credit for the reinsurance ceded on its U.S. statutory-basis financial statements. In general, credit for reinsurance is allowed in the following circumstances: if the reinsurer is licensed in the state in which the primary insurer is domiciled; if the reinsurer is an “accredited” or otherwise approved reinsurer in the state in which the primary insurer is domiciled; in some instances, if the reinsurer (i) is domiciled in a state that is deemed to have substantially similar credit for reinsurance standards as the state in which the primary insurer is domiciled and (ii) meets certain financial requirements; or if none of the above applies, to the extent that the reinsurance obligations of the reinsurer are collateralized appropriately, typically through the posting of a letter of credit for the benefit of the primary insurer or the deposit of assets into a trust fund established for the benefit of the primary insurer. 35 WIC is an admitted insurer in 50 states and the District of Columbia. WSIC is eligible to issue insurance on an excess and surplus lines basis in 50 states and the District of Columbia. Watford Re does not expect to become licensed, accredited or so approved in any U.S. jurisdiction. Holding company acts All states have enacted legislation that regulates insurance holding company systems. These regulations generally provide that each insurance company in the system is required to register with the insurance department of its state of domicile and furnish information concerning the operations of companies within the holding company system which may materially affect the operations, management or financial condition of the insurers within the system. All transactions within a holding company system affecting insurers must be fair and reasonable. Notice to the state insurance departments is required prior to the consummation of certain material transactions between an insurer and any entity in its holding company system. In addition, certain of such transactions cannot be consummated without the applicable insurance department’s prior approval, or its failure to disapprove after receiving notice. The holding company acts also prohibit any person from directly or indirectly acquiring control of a U.S. insurance company unless that person has filed an application with specified information with the insurance company’s domiciliary commissioner and has obtained the commissioner’s prior approval. Under most states’ statutes, including New Jersey (the state of domicile of our U.S. insurance subsidiaries), acquiring 10% or more of the voting securities of an insurance company or its parent company is presumptively considered an acquisition of control of the insurance company, although such presumption may be rebutted, as was the case for us, with Arch filing a disclaimer of control in connection with WSIC and WIC. Accordingly, any person or entity that acquires, directly or indirectly, 10% or more of our voting securities without the prior approval of the commissioner will be in violation of these laws and may be subject to injunctive action requiring the disposition or seizure of those securities by the commissioner or prohibiting the voting of those securities, or to other actions that may be taken by the commissioner. In 2010, the National Association of Insurance Commissioners, or the NAIC, adopted amendments to the Insurance Holding Company System Regulatory Act and Regulation, which, among other changes, introduce the concept of “enterprise risk” within an insurance holding company system. If and when the amendments are adopted by a particular state, the amended Insurance Holding Company System Regulatory Act and Regulation would impose more extensive informational requirements on parents and other affiliates of licensed insurers or reinsurers with the purpose of protecting them from enterprise risk, including requiring an annual enterprise risk report by the ultimate controlling person identifying the material risks within the insurance holding company system that could pose enterprise risk to the licensed companies. The amended Insurance Holding Company System Regulatory Act also requires any controlling person of a U.S. insurance company seeking to divest its controlling interest in the insurance company to file with the commissioner a confidential notice of the proposed divestiture at least 30 days prior to the cessation of control; after receipt of the notice, the commissioner shall determine those instances in which the parties seeking to divest or to acquire a controlling interest will be required to file for or obtain approval of the transaction. The amended Insurance Holding Company System Regulatory Act and Regulation must be adopted by the individual states for the new requirements to apply to U.S. domestic insurers and reinsurers. To date, every state and the District of Columbia have enacted legislation adopting the amended Insurance Holding Company System Regulatory Act in some form. Enterprise risk The NAIC has increased its focus on risks within an insurer’s holding company system that may pose enterprise risk to the insurer. “Enterprise risk” is defined as any activity, circumstance, event or series of events involving one or more affiliates of an insurer that, if not remedied promptly, is likely to have a material adverse effect upon the financial condition or the liquidity of the insurer or its insurance holding company system as a whole. As noted above, in 2010, the NAIC adopted amendments to its Model Insurance Holding Company System Regulatory Act and Regulation, which include, among other amendments, a requirement for the ultimate controlling person to file an enterprise risk report annually. In 2012, the NAIC adopted the Risk Management and Own Risk and Solvency Assessment, or ORSA, Model Act, which requires domestic insurers to maintain a risk management framework and establishes a legal requirement for domestic insurers to conduct an ORSA in accordance with the NAIC’s ORSA Guidance Manual. The ORSA Model Act provides that domestic insurers, or their insurance group, must regularly conduct an ORSA consistent with a process comparable to the ORSA Guidance Manual process. The ORSA Model Act also provides that, no more than once a year, an insurer’s domiciliary regulator may request that an insurer submit an ORSA summary report, or any combination of reports that together contain the information described in the ORSA Guidance Manual, with respect to the insurer and/or the insurance group of which it is a member. If and when the 36 ORSA Model Act is adopted by an individual state, the state may impose additional internal review and regulatory filing requirements on licensed insurers and their parent companies. Regulation of dividends and other payments from insurance subsidiaries The ability of an insurer to pay dividends or make other distributions is subject to insurance regulatory limitations of the insurance company’s state of domicile. Generally, such laws limit the payment of dividends or other distributions above a specified level. Dividends or other distributions in excess of such thresholds are “extraordinary” and are subject to prior regulatory approval. Such dividends or distributions may be subject to applicable withholding or other taxes. See “Management’s discussion and analysis of financial condition and results of operations-Financial condition, liquidity and capital resources-Liquidity and capital resources” and Note 20 - “Statutory information” of the notes accompanying our financial statements. Insurance regulatory information system ratios The NAIC Insurance Regulatory Information System, or the IRIS, was developed by a committee of state insurance regulators and is intended primarily to assist state insurance departments in executing their statutory mandates to oversee the financial condition of insurance companies operating in their respective states. IRIS identifies 13 property/casualty industry ratios (referred to as IRIS ratios) and specifies usual ranges and identifies unusual values for each ratio. Departure from the usual values of the IRIS ratios can lead to inquiries from individual state insurance commissioners as to certain aspects of an insurer’s business. Accreditation The NAIC has instituted its Financial Regulation Accreditation Standards Program, or FRASP, in response to federal initiatives to regulate the business of insurance. FRASP provides a set of standards designed to establish effective state regulation of the financial condition of insurance companies. Under FRASP, a state must adopt certain laws and regulations, institute required regulatory practices and procedures, and have adequate personnel to enforce such items in order to become an “accredited” state. If a state is not accredited, other states may not accept certain financial examination reports of insurers prepared solely by the regulatory agency in such unaccredited state. New Jersey, the state in which our insurance subsidiaries are domiciled, is an accredited state. Risk-based capital requirements In order to enhance the regulation of insurer solvency, the NAIC adopted in December 1993 a formula and model law to implement risk-based capital requirements for property and casualty insurance companies. These risk-based capital requirements are designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policyholder obligations. The risk-based capital model for property and casualty insurance companies measures three major areas of risk facing property and casualty insurers: underwriting, which encompasses the risk of adverse loss developments and inadequate pricing; declines in asset values arising from credit risk; and declines in asset values arising from investment risks. An insurer will be subject to varying degrees of regulatory action depending on how its statutory surplus compares to its risk-based capital calculation. For equity investments in an insurance company affiliate, the risk-based capital requirements for the equity securities of such affiliate would generally be our U.S.-based subsidiaries’ proportionate share of the affiliate’s risk-based capital requirement. Under the approved formula, an insurer’s total adjusted capital is compared to its authorized control level risk-based capital. If this ratio is above a minimum threshold, no company or regulatory action is necessary. Below this threshold are four distinct action levels at which a regulator can intervene with increasing degrees of authority over an insurer as the ratio of surplus to risk-based capital requirement decreases. The four action levels include: insurer is required to submit a plan for corrective action; insurer is subject to examination, analysis and specific corrective action; regulators may place insurer under regulatory control; and regulators are required to place insurer under regulatory control. Each of our U.S. subsidiaries’ surplus (as calculated for statutory purposes) is above the risk-based capital thresholds that would require either company or regulatory action. Guaranty funds and assigned risk plans Most states require all admitted insurance companies to participate in their respective guaranty funds which cover certain claims against insolvent insurers. Solvent insurers licensed in these states are required to cover 37 the losses paid on behalf of insolvent insurers by the guaranty funds and are generally subject to annual assessments in the states by the guaranty funds to cover these losses. Participation in state-assigned risk plans may take the form of reinsuring a portion of a pool of policies or the direct issuance of policies to insureds. The calculation of an insurer’s participation in these plans is usually based on the amount of premium for that type of coverage that was written by the insurer on a voluntary basis. Assigned risk pools tend to produce losses which result in assessments to insurers writing the same lines on a voluntary basis. Federal regulation Although state regulation is the dominant form of regulation for insurance and reinsurance business, the federal government in recent years has shown some concern over the adequacy of state regulation. It is not possible to predict the future impact of any potential federal regulations or other possible laws or regulations on our U.S.-based subsidiaries’ capital and operations, and such laws or regulations could materially adversely affect their business. In addition, a number of federal laws affect and apply to the insurance industry, including various privacy laws and the economic and trade sanctions implemented by the Office of Foreign Assets Control, or OFAC. OFAC maintains and enforces economic sanctions against certain foreign countries and groups and prohibits U.S. persons from engaging in certain transactions with certain persons or entities. OFAC has imposed civil penalties on persons, including insurance and reinsurance companies, arising from violations of its economic sanctions program. The Dodd-Frank Wall Street Reform and Consumer Protection Act The Dodd-Frank Act created the Federal Insurance Office, or FIO, within the Department of Treasury, which is not a federal regulator or supervisor of insurance, but monitors the insurance industry for systemic risk, administers the Terrorism Risk Insurance Program Reauthorization Act of 2015, or TRIPRA, consults with the states regarding insurance matters and develops federal policy on aspects of international insurance matters. In addition, FIO is authorized to assist the Treasury Secretary in negotiating “covered agreements” between the U.S. and one or more foreign governments or regulatory authorities that address insurance prudential measures. Where a state law is inconsistent with a “covered agreement” and provides less favorable treatment to foreign insurers than U.S. companies, the FIO Director may preempt conflicting state law. In 2013, the FIO issued two reports relating to the insurance industry, one on modernization of the insurance regulatory system and one on the impact of Part II of the Nonadmitted and Reinsurance Reform Act of 2010. In December 2014, the FIO issued a report on the vital role that the global reinsurance market plays in supporting insurance in the United States. The impact that these reports will have on the regulation of insurance, if any, is yet to be determined. The Dodd-Frank Act also created a uniform system for non- admitted insurance premium tax payments based on the home state of the policyholder and provides for single state regulation for financial solvency and credit for reinsurance as discussed above. The Dodd-Frank Act established the Consumer Finance Protection Bureau, or the CFPB, to regulate the offering and provision of consumer financial products and services under federal law. Pursuant to the Dodd- Frank Act, the CFPB is charged with rulemaking and enforcement with respect to enumerated consumer laws. The Dodd-Frank Act also granted to the CFPB certain supervisory powers with respect to “covered persons” and “service providers,” as defined by the Dodd-Frank Act. Terrorism Risk Insurance Program Reauthorization Act of 2015 The Terrorism Risk Insurance Act of 2002 was amended and extended again by TRIPRA through December 31, 2020. TRIPRA provides a federal backstop for insurance-related losses resulting from certain acts of terrorism on U.S. soil or against certain U.S. air carriers, vessels or foreign missions. Under TRIPRA, all U.S.-based property and casualty insurers are required to make terrorism insurance coverage available in specified commercial property and casualty insurance lines. Under TRIPRA, the federal government will pay 85% of covered losses after (i) aggregate industry insured losses resulting from the act of terrorism exceeds a statutorily prescribed program trigger, and (ii) an insurer’s losses exceed a deductible determined by a statutorily prescribed formula, up to a combined annual aggregate limit for the federal government and all insurers of $100 billion. The program trigger for calendar year 2015 is $100 million and will increase by $20 million per year until it becomes $200 million in 2020. Beginning January 1, 2016, the 85% federal share will decrease by 1% per year until it becomes 80% in 2020. If an act (or acts) of terrorism result in covered losses exceeding the $100 billion annual limit, insurers with losses exceeding their deductibles will not be responsible for additional losses. An insurer’s deductible for each year is based on the insurer’s (together with those of its affiliates) direct commercial earned premiums for property and casualty insurance, excluding certain lines of business such as commercial auto, surety, professional liability and earthquake lines of 38 business, for the prior calendar year multiplied by a specified percentage. The specified percentage for 2015 through 2020 is 20%. Our U.S.-based property and casualty insurers, WIC and WSIC, are subject to TRIPRA. The Gramm-Leach-Bliley Act The Gramm-Leach-Bliley Act of 1999, or the GLBA, which implements fundamental changes in the regulation of the financial services industry in the United States, was enacted on November 12, 1999. The GLBA permits mergers that combine commercial banks, insurers and securities firms under one holding company, a “financial holding company.” Bank holding companies and other entities that qualify and elect to be treated as financial holding companies may engage in activities, and acquire companies engaged in activities, that are “financial” in nature or “incidental” or “complementary” to such financial activities. Such financial activities include acting as principal, agent or broker in the underwriting and sale of life, property, casualty and other forms of insurance and annuities. Until the passage of the GLBA, the Glass-Steagall Act of 1933 had limited the ability of banks to engage in securities-related businesses, and the Bank Holding Company Act of 1956 had restricted banks from being affiliated with insurers. Since passage of the GLBA, among other things, bank holding companies may acquire insurers, and insurance holding companies may acquire banks. The ability of banks to affiliate with insurers may affect our U.S. subsidiaries’ product lines by substantially increasing the number, size and financial strength of potential competitors. The GLBA also imposes privacy requirements on financial institutions, such as insurance companies, including obligations to protect and safeguard consumers’ non-public personal information and records, and limitations on the re-use of such information. Federal regulatory agencies have issued Interagency Guidelines Establishing Information Security Standards, or “Security Guidelines,” and interagency regulations regarding financial privacy, or “Privacy Rule,” implementing sections of GLBA. The Security Guidelines establish standards relating to administrative, technical, and physical safeguards to ensure the security, confidentiality, integrity, and the proper disposal of consumer information. The Privacy Rule limits a financial institution’s disclosure of non-public personal information to unaffiliated third parties unless certain notice requirements are met and the consumer does not elect to prevent or “opt out” of the disclosure. The Privacy Rule also requires that privacy notices provided to customers and consumers describe the financial institutions’ policies and practices to protect the confidentiality and security of the information. Many states have enacted legislation implementing GLBA and establishing information security regulation. Many states have enacted privacy and data security laws which impose compliance obligations beyond GLBA, including obligations to protect social security numbers and provide notification in the event that a security breach results in a reasonable belief that unauthorized persons may have obtained access to consumer non-public information. Legislative and regulatory proposals From time to time, various regulatory and legislative changes have been, and will be, proposed in the insurance and reinsurance industry. Among the proposals that have been considered are the possible introduction of federal regulation in addition to, or in lieu of, the current system of state regulation of insurers and the NAIC. In addition, there are a variety of proposals being considered by various state legislatures. Two ongoing areas of work at the NAIC are model rules relating to corporate governance and consideration of enhanced methods of group supervision. Gibraltar insurance regulation General The Gibraltar Financial Services Commission, or the GFSC, regulates insurance and reinsurance companies, firms carrying out insurance mediation activities and insurance managers operating in Gibraltar. Insurance and reinsurance companies operate principally under the Financial Services (Insurance Companies) Act 1987 and, since January 1, 2016, also under the Financial Services (Insurance Companies) (Solvency II Directive) Act 2015. Insurance intermediaries and insurance managers operate principally under the Financial Services (Investment & Fiduciary Services) Act 1989. In addition, insurance companies, intermediaries and managers are subject to a range of further laws and regulations. On July 28, 2015, WICE was licensed by the GFSC. It holds permissions to write the following classes and is authorized to do business in the following territories: • United Kingdom: 3 (Land Vehicles), 10 (Motor Vehicle Liability); 39 • France: 1 (Accident), 3 (Land Vehicles), 8 (Fire and Natural Forces), 9 (Damage to Property), 10 (Motor Vehicle Liability), 13 (General Liability); and • Ireland: 1 (Accident), 3 (Land Vehicles), 8 (Fire and Natural Forces), 9 (Damage to Property), 10 (Motor Vehicle Liability), 13 (General Liability). The GFSC’s mission statement states that its mission is “to provide financial services regulation in an effective and efficient manner in order to promote good business, protect the public from financial loss and enhance Gibraltar’s reputation as a quality financial centre.” Underpinning this mission statement, the GFSC’s regulatory objectives are the promotion of market confidence, the reduction of systemic risk, the promotion of public awareness, the protection of the good reputation of Gibraltar, the protection of consumers and the reduction of financial crime. The GFSC is responsible both for supervising the application of prudential standards and the conduct of firms across the Gibraltar financial services sector. This includes, but is not limited to banks, insurance companies, insurance intermediaries, e-money issuers, payment service institutions, investment firms, fund service providers, funds, fiduciary service providers and auditors. Gibraltar financial service firms, including insurance and reinsurance companies, which passport their services into another EU member state are also subject to the conduct and general good provision in that member state, as set out by the host state regulator. Financial resources WICE is required to have adequate financial assets and to file quarterly returns to the GFSC. WICE adopts the Standard Formula as postulated under Solvency II to calculate its regulatory solvency capital requirement, or SCR. In addition to this, WICE is required to carry out its own risk and solvency assessment at least annually, taking into account its specific risk profile and risk appetite to formulate an internal view of the appropriate level of capital. The calculation of the SCR takes account of market risk, insurance risk (underwriting and reserving), counterparty risk and operational risk. The ORSA also takes account of other risks facing the business, such as liquidity risk and group risk. The GFSC requires insurance and reinsurance companies to maintain an appropriate buffer above the SCR, but this is not prescriptive. The buffer is expected to be appropriate to the risk profile and type of business written. WICE maintains a level of capital which is above both the SCR and the internally derived view of capital required. Financial services compensation scheme The Financial Services Compensation Scheme, or FSCS, is a scheme established under FSMA to compensate eligible policyholders of insurance and reinsurance companies who may become insolvent. The FSCS is funded by the levies that it has the power to impose on all insurers and reinsurers. As a motor insurer writing into the U.K. market, WICE contributes to the FSCS. Motor insurance bureau The Motor Insurance Bureau in the United Kingdom, or MIB, and the Motor Insurance Bureau Ireland, or MIBI, provide compensation where an individual is injured by an uninsured driver. As an insurance and reinsurance company writing motor business into the U.K. and Ireland, WICE is a member of both the MIB and the MIBI and pays the appropriate levies. Additional restrictions When granting a license, the GFSC issues a Notice of Requirements, or NOR, which imposes further restrictions on a licensee over and above those set out in legislation. The key restrictions applicable to WICE include the following: 40 Restriction on business to be written WICE is required to obtain prior written approval of the GFSC if it plans to make any significant change to the business that it writes. Restrictions on transactions with connected parties WICE is required to obtain prior written consent from the GFSC if it enters into certain transactions with connected parties. This includes: (i) agreements which will result in payments in excess of $40,000; (ii) the acquisition of property in excess of $40,000; (iii) other property-related arrangements including, but not limited to, mortgages, charges and leases above $40,000; (iv) undertaking any liability to meet an obligation of a connected party; (v) loans to connected parties exceeding $40,000; and (vi) entering into or varying a reinsurance agreement with a connected party without giving the GFSC 14 days prior written notice. Changes to WICE’s operations WICE must inform the GFSC of any significant change in its insurance or reinsurance arrangements, a change in the name of its bankers or the address of the branch where the account is held, or a change in its auditors. Provision of information WICE must send to the GFSC, within 14 days, copies of insurance or reinsurance agreements, agreements for the provision of insurance management services or changes to agreements and new or revised agreements with investment managers. Restriction on dividends WICE is required to notify the GFSC of any proposal to declare or pay a dividend and is required to provide relevant financial information which has been considered by its board of directors in considering this proposal. WICE is not permitted to pay any such dividend within 14 days of such notice to the GFSC. In order to obtain regulatory approval for the payment of a dividend, WICE must demonstrate that it will continue to meet its SCR and its internal view of capital following the payment of such dividend. Other matters The NOR imposes a requirement on WICE to comply with certain other matters: • A business plan must be submitted prior to December 1 of each financial year; • WICE must obtain an annual independent actuarial review of loss reserves; • WICE must provide the GFSC with a copy of any management report provided by its auditors within two weeks of receipt; • WICE must submit to the GFSC copies of board of director and committee minutes and board of directors and committee packs on a quarterly basis once the meetings have been held; and • WICE must hold quarterly meetings of its board of directors. European Union considerations Through its authorization in Gibraltar, which is a British Overseas Territory of the U.K. and therefore able to benefit from certain rights available to Member States of the EU, WICE’s authorization is recognized throughout the European Economic Area, subject only to certain notification and application requirements. This authorization enables WICE to provide services or to establish a branch in any other Member State of the EU, where such entity will be subject to the insurance regulations of each such Member State with respect to the conduct of its business in such Member State, but remain subject only to the financial, prudential and operational supervision by the GFSC. The framework for the passporting of services and the establishment of branches in Member States of the EU was generally set forth, and remains subject to, directives adopted by the Council, the legislative body of the European Union, which directives are then implemented in each Member State. WICE currently passports under the Freedom of Services provisions into the United Kingdom, France and Ireland. 41 The recent U.K. referendum in favor of an exit from the European Union, commonly referred to as “Brexit,” may adversely impact our European operations by limiting or removing WICE’s current ability to flexibly transact insurance business across the borders of European Union members. Alternative avenues to distribute our insurance products in Europe exist but may prove to be more costly and/or less economical, and a reduction in premium writings from Europe would have an adverse effect on our business, financial condition and results of operations. 42 Item 2. Market Price of and Dividends on the Registrant's Common Equity Market information Our common shares began trading on the Nasdaq Global Select Market on March 28, 2019 under the symbol “WTRE.” Prior to the listing of our common shares on the Nasdaq Global Select Market, there was no public market for our common shares. On September 6, 2019, the last practicable date, the last reported sale price of our common shares was $24.24 per share and there were 59 registered holders of common shares. This number does not include shareholders for whom our common shares were held in a “nominee” or “street” name. Dividends We do not expect to declare or pay dividends on our common shares for the foreseeable future. We intend to retain all of our future earnings, if any, generated by our operations for the development and growth of our business. Additionally, we are subject to Bermuda legal constraints that may affect our ability to pay dividends on our common shares and make other payments. Under the Bermuda Companies Act, we may not declare or pay a dividend if there are reasonable grounds for believing that we are, or would after the payment be, unable to pay our liabilities as they become due or that the realizable value of our assets would thereafter be less than the aggregate of our liabilities. We are also currently restricted in our ability to pay dividends pursuant to the terms of our existing indebtedness unless we meet certain conditions, financial and otherwise. In addition, certain of our subsidiaries are currently restricted in their ability to pay dividends to us pursuant to applicable insurance regulatory requirements. Any decision to pay dividends in the future will be made at the discretion of our board of directors and depends on our financial condition, results of operations, capital requirements and other factors that our board of directors deems relevant. 43 Item 3. Selected Financial and Other Information The tables below present summary financial and operating data as of and for the periods indicated. The following information is only a summary and should be read in conjunction with “Management’s discussion and analysis of financial condition and results of operations” and our consolidated financial statements and the accompanying notes included elsewhere in this prospectus. The consolidated balance sheet data as of December 31, 2018, 2017 and 2016, and the consolidated income statement data for the years ended December 31, 2018, 2017 and 2016, have been derived from our audited consolidated financial statements. These historical results are not necessarily indicative of the results that may be expected for any future period. Selected statement of operations data: Year Ended December 31, 2018 2017 2016 ($ in thousands) Gross premiums written ..................................................................................................... $735,015 $600,304 $535,094 Net premiums written ........................................................................................................ Net premiums earned ......................................................................................................... Net interest income ............................................................................................................ Net investment income (loss) ............................................................................................. Total revenues ..................................................................................................................... Net income (loss) before preferred dividends ................................................................... Preferred dividends ............................................................................................................ 604,175 578,862 107,533 (6,349) 575,235 (34,883) (19,633) Net income (loss) available to common shareholders ....................................................... $(54,516) 553,117 531,726 86,523 72,738 607,644 10,741 (19,633) $(8,892) 513,788 467,970 89,818 146,396 618,112 146,734 (19,634) $127,100 Other data: Underwriting income (loss) (1) ........................................................................................... $(25,840) Adjusted underwriting income (loss) (2) ........................................................................... (19,009) $(66,576) (59,745) $(8,300) (1,624) Net interest income return on average net assets under management (3) ..................... Non-investment grade portfolio (3) ............................................................................. Investment grade portfolio (3) ..................................................................................... Net investment income return on average total investments (4) ..................................... Non-investment grade portfolio (4) ............................................................................. Investment grade portfolio (4) ..................................................................................... Net investment income return on average net assets under management (3) ............... Non-investment grade portfolio (3) ............................................................................. Investment grade portfolio (3) ..................................................................................... 5.4 % 7.0 % 1.9 % (0.2)% (0.1)% 0.9 % (0.3)% (0.2)% 0.9 % 4.9 % 6.3 % 1.1 % 3.2 % 4.5 % (0.1)% 4.1 % 5.8 % (0.1)% 6.3 % 8.5 % 0.4 % 8.0 % 10.2 % (0.4)% 10.3 % 14.2 % (0.4)% Basic and diluted earnings (loss) per share (5) .................................................................. $ (2.40) $ (0.39) $ 5.60 Return on average equity (6) ............................................................................................. (5.7)% (0.9)% 14.3 % (1) Underwriting income (loss) is a non-U.S. GAAP financial measure and is calculated as net premiums earned, less loss and loss adjustment expenses, acquisition expenses and general and administrative expenses. Refer to “Management’s discussion and analysis of financial condition and results of operations-Reconciliation of non-U.S. GAAP financial measures” for a reconciliation of underwriting income (loss) to net income (loss) available to common shareholders. (2) Adjusted underwriting income (loss) is a non-U.S. GAAP financial measure and is calculated as underwriting income (loss), plus other underwriting income (loss) and excluding certain corporate expenses. Refer to “Management’s discussion and analysis of financial condition and results of operations-Reconciliation of non-U.S. GAAP financial measures” for a reconciliation of adjusted underwriting income to underwriting income (loss). (3) Net interest income return on average net assets under management and net investment income return on average net assets under management are calculated by dividing net interest income, and net investment income (loss), respectively, by average net assets under management. Net assets under management 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 twelve month period, average net assets under management 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 under management calculation. The separate components of these returns (non-investment grade portfolio and investment grade portfolio) are non-U.S. GAAP financial measures. Refer to “Management’s discussion and analysis of financial 44 condition and results of operations-Reconciliation of non-U.S. GAAP financial measures” for a reconciliation of these components of our net interest income return on average net assets under management and net investment income return on average net assets under management. (4) Net investment income return on average total investments is calculated by dividing net investment income by average total investments per the balance sheet. For the twelve month period, 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 “Management’s discussion and analysis of financial condition and results of operations-Reconciliation of non- U.S. GAAP financial measures” for a reconciliation of these components of our net investment income return on average total investments. (5) Earnings (loss) per share is based on the weighted average number of common shares outstanding during the period. The weighted average number of common shares excludes shares issuable upon the exercise of the warrants currently held by Arch and HPS. These warrants are exercisable at any time following the listing of our common shares on the Nasdaq Global Select Market for an aggregate of 975,503 and 729,188 common shares, respectively. The exercise price of the warrants is determined at the date of exercise based on a formula that is premised on investors in our original private placement achieving a target return of 15%; as of December 31, 2018, the exercise price was $77.94 per share. The warrants expire on March 31, 2020. For more information, see “Certain relationships and related party transactions-Our original private placement-Warrants.” (6) Return on average equity represents net income (loss) expressed as a percentage of average common shareholders’ equity during the period. For the twelve month period, the average common shareholders’ equity is calculated as the average of the beginning and ending common shareholders’ equity of each quarterly period. Selected balance sheet data: December 31, 2018 2017 2016 ($ in thousands) Total investments .................................................................................................................... $ 2,738,367 $ 2,496,215 $ 1,923,549 Net assets under management (1) ......................................................................................... 2,019,348 1,924,809 1,606,952 Premiums receivable ............................................................................................................... 227,301 Cash and cash equivalents ...................................................................................................... 63,529 177,492 54,503 189,911 74,893 Total Assets .............................................................................................................................. 3,372,856 3,014,583 2,382,750 Reserves for losses and loss adjustment expenses ................................................................. 1,032,760 Unearned premiums ............................................................................................................... Revolving credit agreement borrowings ............................................................................... 390,114 693,917 798,262 330,644 549,165 510,809 293,480 258,861 Total liabilities ......................................................................................................................... 2,262,256 1,846,079 1,205,126 Contingently redeemable preferred shares .......................................................................... Total shareholders’ equity ...................................................................................................... 220,992 889,608 220,622 947,882 220,253 957,371 Book value per share data: Book value per share - basic and diluted (2) ......................................................................... $ 39.22 $ 41.79 $ 42.21 Growth in basic and diluted book value per share (3) .......................................................... (6.1)% (1.0)% 15.3% Weighted average common shares outstanding basic and diluted ..................................... 22,682,875 22,682,875 22,682,875 (1) Net assets under management 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. (2) Basic and diluted book value per share is calculated by dividing shareholder’s equity by the number of issued and outstanding shares at period end. (3) Growth in basic and diluted book value per share is calculated as the percentage change in value of beginning and ending basic and diluted book value per share over the reporting period. Underwriting and other ratios: Year Ended December 31, 2018 2017 2016 ($ in thousands, except for share and per share data) ........................................................................................................... Loss ratio (1) Acquisition expense ratio (2) ................................................................................. General and administrative expense ratio (3) ....................................................... Combined ratio (4) ................................................................................................. 76.2% 24.4% 3.9% 82.1% 26.5% 4.0% 68.7% 29.2% 3.8% 104.5% 112.6% 101.7% Adjusted loss ratio (5) ............................................................................................ Adjusted acquisition expense ratio (5) .................................................................. Adjusted general and administrative expense ratio (5) ....................................... Adjusted combined ratio (5) .................................................................................. 75.9% 24.3% 3.1% 81.6% 26.3% 3.3% 68.2% 29.0% 3.2% 103.3% 111.2% 100.4% (1) Loss ratio is calculated by dividing loss and loss adjustment expenses by net premiums earned. 45 (2) Acquisition expense ratio is calculated by dividing acquisition expenses by net premiums earned. (3) General and administrative expense ratio is calculated by dividing general and administrative expenses by net premiums earned. (4) Combined ratio is calculated by dividing the sum of loss and loss adjustment expenses, acquisition expenses and general and administrative expenses by net premiums earned, or equivalently, by adding the loss ratio, acquisition expense ratio and general and administrative expense ratio. (5) Adjusted combined ratio is a non-U.S. GAAP financial measure and is calculated by dividing the sum of loss and loss adjustment expenses, acquisition expenses and general and administrative expenses, excluding the effects of certain corporate expenses, by the sum of net premiums earned and other underwriting income (loss). Adjusted loss ratio, adjusted acquisition expense ratio and adjusted general and administrative expense ratio are components of our adjusted combined ratio. Adjusted loss ratio is calculated by dividing loss and loss adjustment expenses by the sum of net premiums earned and other underwriting income (loss). Adjusted acquisition expense ratio is calculated by dividing acquisition expenses by the sum of net premiums earned and other underwriting income (loss). Adjusted general and administrative expense ratio is calculated by dividing general and administrative expenses, excluding the effects of certain corporate expenses, by the sum of net premiums earned and other underwriting income (loss). Refer to “Management’s discussion and analysis of financial condition and results of operations- Reconciliation of non-U.S. GAAP financial measures” for a reconciliation of our adjusted combined ratio to our combined ratio, as well as related reconciliations of our adjusted loss ratio, adjusted acquisition expense ratio and adjusted general and administrative expense ratio to our loss ratio, acquisition expense ratio and general and administrative expense ratio, respectively. 46 Item 4. Management’s discussion and analysis of financial condition and results of operations The following discussion and analysis contains forward-looking statements which involve inherent risks and uncertainties. All statements other than statements of historical fact are forward-looking statements. These statements are based on our current assessment of risks and uncertainties. Actual results may differ materially from those expressed or implied in these statements 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 in this prospectus, including the sections entitled “Cautionary note regarding forward-looking statements” and “Risk factors.” This discussion and analysis should be read in conjunction with our audited consolidated financial statements and notes thereto included elsewhere in this prospectus. Tabular amounts are in U.S. dollars in thousands, except share amounts, unless otherwise noted. Overview We are a global P&C insurance and reinsurance company with approximately $1.1 billion in total capital as of December 31, 2018, comprised of $0.2 billion of contingently redeemable preference shares and $0.9 billion 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 comprising primarily non-investment grade corporate credit assets, managed by HPS. In addition, we have a services arrangement with AIM to manage our investment grade portfolio. While we are positioned to provide a full range of P&C lines, we focus on writing specialty lines of business. We believe that our experienced management team, our relationship with Arch and our strong capital base have enabled us to successfully compete and establish a meaningful presence in the insurance and reinsurance markets in which we participate. We seek to generate an attractive return on average equity across the relevant insurance and investment cycles. We opportunistically seek to underwrite new lines that fit our return profile while maintaining a disciplined underwriting approach. Current outlook The current insurance and reinsurance market environment is extremely competitive and reflects a prolonged period of low prices and continued pressure to broaden terms and conditions, though the 2017 and 2018 catastrophe events seem to have somewhat dampened the downward pricing pressure. While the insurance and reinsurance market historically has been subject to pricing and capacity cycles, the overall market has not experienced true cyclicality in the period since our inception of operations in 2014. Over the past several years, the industry has witnessed a gradual rate softening in response to a surplus of industry capital and a number of years of benign catastrophe activity, and this market dynamic has led to reduced underwriting profitability. However, due to the hurricane, wildfire and earthquake activity over the past two years, pricing on certain product lines appears to be firming and becoming more attractive on a risk-adjusted basis. Against this backdrop, we are selectively growing our business in areas that we believe present attractive opportunities. In this market environment, our Bermuda reinsurance platform has maintained its premium volume while reshaping its portfolio in response to market conditions. We have developed a portfolio with concentrations in professional liability, multiline, workers compensation, and motor product lines through reinsurance cedants on a worldwide basis and retrocessions of Arch. We continue to deploy resources opportunistically in product lines that meet our risk and return profile. Our insurance underwriting platforms in the United States and Europe are growing. In Europe, WICE began writing P&C insurance in December 2015, concentrating on personal lines but also writing commercial casualty lines accessed through specialized insurance agents known as program administrators and coinsurance relationships, and, in 2017 and 2018, WICE contributed meaningful premium volume to our portfolio. 47 In the United States, we began writing excess and surplus lines through our non-admitted carrier, WSIC, in April 2016. In August 2016, we gained access to the larger admitted insurance market in the United States, through the acquisition of WIC, further expanding our U.S. insurance capabilities. We are growing our U.S. insurance business through a select group of program administrators and, in 2018, WSIC and WIC also each contributed meaningful premium volume to our portfolio. Arch, our underwriting manager, continuously monitors the broad reinsurance and insurance markets for opportunities. Specifically, Arch monitors opportunities that provide attractive risk-adjusted returns with a particular focus on product lines, such as European motor insurance, which may have previously experienced adverse results, that have benefited from an increase in premium rates, and thus provide a reasonable basis to increase activity in those markets. Similarly, by reason of the soft market pricing in the property catastrophe product line, we have purposely written less premium in that line of business versus what we had originally projected. Following the severe 2017 and 2018 Atlantic hurricanes, earthquake activity and U.S. wildfires, the property catastrophe market pricing and terms and conditions have improved marginally but not enough to entice us to provide more capacity. While these several recent actions demonstrate purposeful increases or decreases in underwriting activity in response to market dynamics, it is also important to recognize that certain product lines are written for the diversification effect they provide. When facing soft phases of the insurance and/or reinsurance cycles, we continue to have the ability to generate higher returns from investment income through our relationship with HPS. For example, during the latter half of 2015 as the insurance and reinsurance markets continued their multi-year softening, credit spreads widened and were viewed by HPS as providing an attractive risk-adjusted return, and consequently we increased borrowings to purchase additional non-investment grade investments. When credit spreads later tightened, assets were sold and the proceeds were used to repay borrowings. In managing our business, we are mindful that changing climate and economic conditions could have a material impact on the frequency and severity of claims and, therefore, could negatively impact our underwriting results. In addition, volatility in the financial markets could cause fluctuations in investment returns, reported net income and shareholders’ equity. We consider the potential impact of economic trends in our insurance and reinsurance loss reserve estimation process and in determining our investment strategies, with a continued focus on meeting our obligations to our insureds. Our outsourced business model We have engaged Arch and HPS to perform certain services for us that are essential to the results of our operations, and have entered into long-term, renewable contracts with each in order to ensure continued access to these services. For our underwriting operations, Arch provides underwriting services including sourcing and evaluating underwriting opportunities as well as related services such as claims-handling, loss control, exposure management, portfolio management, modeling, statistical, actuarial, and administrative support services, in each case, subject to our underwriting and operational guidelines and the oversight of our senior management and board of directors. With regard to our investments, HPS manages our non- investment grade portfolio while AIM manages the largest portion of our investment grade portfolio, in each case subject to compliance with our investment guidelines and the oversight of our senior management and board of directors. We outsource these functions in order to cost-effectively leverage the respective expertise and strong market positions of our trusted partners. Through our association with Arch, we access Arch’s worldwide platform on a variable cost basis, thus avoiding the fixed expense of maintaining a multi-line platform for our underwriting operations. Similarly, we believe that the terms of service and structure of the compensation we pay to HPS and AIM provide benefits to us both in terms of cost-effective access to the expertise required to execute our investment strategy and in aligning interests. Natural catastrophe risk While we are more casualty-focused and assume less catastrophe exposure than many of our peers, we do underwrite a limited amount of natural catastrophe risk in order to balance and diversify our underwriting portfolio. We carefully monitor our natural catastrophe risk globally for all perils and regions where we believe our underwriting portfolio might have significant exposure. Limited operating history and comparability of results We were incorporated in July 2013 and completed our initial funding and began underwriting business in the first quarter of 2014. Our initial underwriting activities focused on writing reinsurance. In 2015, we began our 48 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 return on average net assets under management, net investment income (loss), net investment income return on average total investments, net investment income return on average net assets under management, book value per share, growth in book value per share and return on average equity. The table below shows the key performance indicators for the years ended December 31, 2018, 2017 and 2016, and descriptions of each financial measure shown follow the table: Key underwriting metrics: Year Ended December 31, 2018 2017 2016 ($ in thousands, except percentages and share amounts) Underwriting income (loss) .............................................................................. $ (25,840) Combined ratio ................................................................................................ Adjusted underwriting income (loss) .............................................................. $ (19,009) Adjusted combined ratio ................................................................................. 103.3 % 104.5 % Key investment return metrics: Net interest income ......................................................................................... $ 107,533 Net interest income return on average net assets under management (1)... Non-investment grade portfolio (1) ........................................................... Investment grade portfolio (1) ................................................................... Net investment income (loss) ........................................................................... $ Net investment income return on average total investments (2) .................. Non-investment grade portfolio (2) ........................................................... Investment grade portfolio (2) ................................................................... (6,349) 5.4 % 7.0 % 1.9 % (0.2)% (0.1)% 0.9 % Net investment income return on average net assets under management ................................................................................................................ (1) Non-investment grade portfolio (1) ........................................................... Investment grade portfolio (1) ................................................................... (0.3)% (0.2)% 0.9 % $ (66,576) 112.6 % $ (59,745) $ $ (8,300) 101.7 % (1,624) 111.2 % 100.4 % $ 86,523 $ 89,818 4.9 % 6.3 % 1.1 % 6.3 % 8.5 % 0.4 % $ 72,738 $ 146,396 3.2 % 4.5 % (0.1)% 4.1 % 5.8 % (0.1)% 8.0 % 10.2 % (0.4)% 10.3 % 14.2 % (0.4)% Key shareholders’ value creation metrics: Book value per share - basic and diluted (2) ................................................... $ Growth in basic and diluted book value per share (3) ................................... Return on average equity (4) ........................................................................... 39.22 $ 41.79 $ 42.21 (6.1)% (5.7)% (1.0)% (0.9)% 15.3 % 14.3 % (1) Net interest income return on average net assets under management and net investment income return on average net assets under management are calculated by dividing net interest income, and net investment income (loss), respectively, by average net assets under management. Net assets under management 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 twelve month period, average net assets under management 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 under management 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 return on average net assets under management and net investment income return on average net assets under management. (2) Net investment income return on average total investments is calculated by dividing net investment income by average total investments per the balance sheet. For the twelve month period, average total investments is calculated using the averages of each quarterly period. However, for 49 the investment grade portfolio component of these returns, the impact of revolving credit agreement borrowings is not subtracted from net investment income. The separate components of these returns (non-investment grade portfolio and investment grade portfolio) are non-U.S. GAAP financial measures. Refer to “-Reconciliation of non-U.S. GAAP financial measures” for a reconciliation of these components of our net investment income return on average total investments. (3) Growth in basic and diluted book value per share is calculated as the percentage change in value of beginning and ending basic and diluted book value per share over the reporting period. (4) Return on average equity represents net income (loss) expressed as a percentage of average common shareholders’ equity during the period. For the twelve month period, the average common shareholders’ equity is calculated as the average of the beginning and ending common shareholders’ equity of each quarterly period. Underwriting income (loss) Underwriting income (loss) is a non-U.S. GAAP financial measure. We define underwriting income (loss) as net premiums earned less loss and loss adjustment expenses, acquisition expenses and general and administrative expenses. Underwriting income (loss) is one of the ways we evaluate the performance of our underwriting segment, and does not include other underwriting income (loss), net investment income (loss), net foreign exchange gains (losses), income tax expenses and preferred dividends. Although these items are an integral part of our operations, with the exception of other underwriting income (loss) they are independent of the underwriting process and result, in large part, from general economic and financial market conditions. We include other underwriting income (loss) in our adjusted underwriting income (loss), as described in more detail below. See “-Reconciliation of non-U.S. GAAP financial measures” for a reconciliation of underwriting income to net income (loss) available to common shareholders. Combined ratio The combined ratio is calculated as the sum of loss and loss adjustment expenses, acquisition expenses and general and administrative expenses, divided by net premiums earned, or equivalently, as the sum of the loss ratio, acquisition expense ratio and general and administrative expense ratio. The combined ratio is a measure of underwriting profitability but does not include other underwriting income or net investment income earned on underwriting cash flows. Adjusted underwriting income (loss) Adjusted underwriting income (loss) is a non-U.S. GAAP financial measure. We define adjusted underwriting income (loss) as underwriting income (loss) plus other underwriting income (loss) less certain corporate expenses. Adjusted underwriting income (loss) is one of the ways we evaluate the performance of our underwriting segment. We include other underwriting income (loss), as our underwriting strategy allows us to enter into government-sponsored enterprise credit-risk sharing transactions. Certain corporate expenses are generally comprised of non-recurring costs of the holding company, such as costs associated with the initial setup of subsidiaries, as well as costs associated with the ongoing operations of the holding company such as salaries of certain executives. See “-Reconciliation of non-U.S. GAAP financial measures” for a reconciliation of adjusted underwriting income to net income (loss) available to common shareholders. Adjusted combined ratio Adjusted combined ratio is a non-U.S. GAAP financial measure. The adjusted combined ratio is calculated as the sum of loss and loss adjustment expenses, acquisition expenses and general and administrative expenses less certain corporate expenses, divided by the sum of net premiums earned and other underwriting income (loss). This ratio is a measure of our underwriting and operational profitability but does not include certain corporate expenses, or net investment income earned on underwriting cash flows. Certain corporate expenses are generally comprised of non-recurring costs of the holding company, such as costs associated with the initial setup of subsidiaries, as well as costs associated with the ongoing operations of the holding company such as salaries of certain executives. See “-Reconciliation of non-U.S. GAAP financial measures” for a reconciliation of our adjusted combined ratio to our combined ratio. 50 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 and net investment income (loss) for the years ended December 31, 2018, 2017 and 2016 were comprised of the following: Year Ended December 31, 2018 2017 2016 Interest income ................................................................................................... $ 152,916 Investment management fees - related parties ................................................ Borrowings and miscellaneous other investment expenses ............................. Net interest income ............................................................................................ Net realized gains (losses) .................................................................................. Net unrealized gains (losses) .............................................................................. Investment performance fees - related parties ................................................. Net investment income (loss) ............................................................................. $ 107,533 (109,046) (28,377) (17,006) (4,788) (6,349) (48) ($ in thousands) $ 125,463 $ 122,378 (21,451) (17,489) 86,523 722 398 (14,905) (16,563) (15,997) 89,818 (24,483) 105,126 (24,065) $ 72,738 $ 146,396 Net interest income return on average net assets under management (1) ..... Non-investment grade portfolio (1) ........................................................... Investment grade portfolio (1) ................................................................... Net investment income return on average total investments (2) ..................... Non-investment grade portfolio (2) .............................................................. Investment grade portfolio (2) ...................................................................... Net investment income return on average net assets under management(1) Non-investment grade portfolio (1) .............................................................. Investment grade portfolio (1) ...................................................................... 5.4 % 7.0 % 1.9 % (0.2)% (0.1)% 0.9 % (0.3)% (0.2)% 0.9 % 4.9 % 6.3 % 1.1 % 3.2 % 4.5 % (0.1)% 4.1 % 5.8 % (0.1)% 6.3 % 8.5 % 0.4 % 8.0 % 10.2 % (0.4)% 10.3 % 14.2 % (0.4)% (1) Net interest income return on average net assets under management and net investment income return on average net assets under management are calculated by dividing net interest income, and net investment income (loss), respectively, by average net assets under management. Net assets under management 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 twelve month period, average net assets under management 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 under management 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 return on average net assets under management and net investment income return on average net assets under management. (2) Net investment income return on average total investments is calculated by dividing net investment income by average total investments per the balance sheet. For the twelve month period, 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. Net interest income return on average net assets under management Net interest income return on average net assets under management is calculated by dividing net interest income by average net assets under management. Net assets under management 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 return on average net assets under management is a key indicator by which we measure the performance of our Investment Managers. 51 Net investment income return on average total investments Net investment income return on average total investments is calculated by dividing net investment income (loss) by average total investments per the balance sheet. Net investment income return on average total investments is a key indicator by which we measure the performance of our Investment Managers. Net investment income return on average net assets under management Net investment income return on average net assets under management is calculated by dividing net investment income (loss) by average net assets under management. Net assets under management 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 under management is a key indicator by which we measure the performance of our Investment Managers. Non-investment grade portfolio and investment grade portfolio components of our certain 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 return on average net assets under management, net investment income return on average total investments and net investment income return on average net assets under management. In the calculation of the investment grade portfolio component of our net interest income return on average net assets under management and net investment income return on average net assets under management, the impact of the revolving credit agreement borrowings is not subtracted from net interest income, net investment income (loss) or the net assets under management 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 net interest income return on average net assets under management, net investment income return on average total investments and net investment income return on average net assets under management. Growth in basic and diluted book value per share Basic and diluted book value per share is calculated by dividing common shareholders’ equity by the number of issued and outstanding shares at the end of each reporting period. We calculate growth in basic and diluted book value per share as the percentage change in value of beginning and ending basic and diluted book value per share over the reporting period. We measure our long-term financial success by our ability to compound growth in basic and diluted book value per share at an attractive rate of return. We believe that long-term growth in basic and diluted book value per share is the most comprehensive measure of our success because it includes all underwriting, operating and investing results. Return on average equity Return on average equity is net income (loss) expressed as a percentage of average common shareholders’ equity during the period and is used to measure profitability. Our goal is to generate an attractive long-term return on our common shareholders’ equity. Comment on non-U.S. GAAP financial measures Throughout this prospectus, 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 users of financial information to compare our performance with our industry peer group. See “-Reconciliation of non-U.S. GAAP financial measures” for reconciliations of our non-U.S. GAAP financial measures. 52 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; • investment related expenses; and • general and administrative expenses. 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. 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 under management. 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. If this reduced fee structure had been in place as of January 1, 2015, we estimate that it would have reduced the aggregate fees we paid HPS during 2017 and 2016 by approximately $10.3 million and $4.9 million. 53 We have also recently engaged HPS to manage a portion of our investment grade portfolio as a recently- created separate managed account. As this separate managed account is funded, we will pay HPS a management fee equal to 0.60% per annum on the assets 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 statement of income, and as management fees are accrued and paid to HPS in connection with its management of a portion of our investment grade portfolio, we will include such fees therein as well. We include interest and other expenses on borrowings in “borrowing and miscellaneous other investment expenses” in our consolidated statement of income. The HPS non-investment grade portfolio performance fee, if applicable, is shown on a separate line in our consolidated statement of income. For more information regarding the calculation of these fees, as well as the fee structure and fees to HPS related to its management of our non- investment grade portfolio prior to the reduction on January 1, 2018, see “Certain relationships and related party transactions-Agreements with HPS-Investment management agreements” and “Certain relationships and related party transactions-Agreements with Arch-Investment management agreements.” 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. 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 certain operating expenses related to corporate activities referred to as certain corporate expenses. Certain corporate expenses are generally comprised of non-recurring costs of the holding company, such as costs associated with the initial setup of subsidiaries, as well as costs associated with the ongoing operations of the holding company such as salaries of certain executives (refer to “- Reconciliation of non-U.S. GAAP financial measures” for a discussion about certain corporate expenses). Consolidated results - for years ended December 31, 2018, 2017 and 2016 The following table summarizes our results of operations for the years ended December 31, 2018, 2017 and 2016: Year Ended December 31, 2018 % Change 2017 % Change 2016 (130,840) 604,175 Gross premiums written ............................. $ 735,015 Gross premiums ceded ................................ Net premiums written ................................ Net premiums earned ................................. Loss and loss adjustment expenses ............ Acquisition expenses .................................. General and administrative expenses (1)... Underwriting income (loss) (2) ................... Other underwriting income (loss) .............. Interest income ........................................... 152,916 578,862 2,722 (141,136) (441,255) (25,840) (22,311) Investment management fees - related parties .................................................... Borrowing and miscellaneous other investment expenses ............................... Net interest income .................................... (17,006) (28,377) 107,533 ($ in thousands) 22.4 % $ 600,304 12.2 % 535,094 (47,187) 553,117 531,726 (436,402) (140,726) (21,174) (66,576) 3,180 125,463 (21,451) (17,489) 86,523 9.2 % 8.9 % 61.2 % 54 7.7 % 13.6 % (702.1)% (21,306) 513,788 467,970 (321,581) (136,733) (17,956) (8,300) 3,746 122,378 (16,563) (15,997) 89,818 Realized and unrealized gain (loss) on investments ............................................ (113,834) Investment performance fees - related parties .................................................... Net investment income (loss) ..................... Net foreign exchange gains (losses) ........... Non-recurring direct listing expenses ........ Income tax expense .................................... Net income (loss) before preferred dividends ................................................ Preferred dividends .................................... (48) (6,349) 3,611 (9,000) (27) (34,883) (19,633) 1,120 (14,905) 72,738 1,420 — (21) 10,741 (19,633) 80,643 (24,065) 146,396 4,893 — (1) 146,734 (19,634) Net income (loss) available to common shareholders .......................................... $ (54,516) (513.1)% $ (8,892) (107.0)% $ 127,100 Net interest income return on average net assets under management (3) ........ Non-investment grade portfolio (3) ...... Investment grade portfolio (3) .............. Net investment income return on average total investments (4) ............................. Non-investment grade portfolio (4) ...... Investment grade portfolio (4) .............. Net investment income return on average net assets under management (3) ........ Non-investment grade portfolio (3) ...... Investment grade portfolio (3) .............. 5.4 % 7.0 % 1.9 % (0.2)% (0.1)% 0.9 % (0.3)% (0.2)% 0.9 % 4.9 % 6.3 % 1.1 % 3.2 % 4.5 % (0.1)% 4.1 % 5.8 % (0.1)% 6.3 % 8.5 % 0.4 % 8.0 % 10.2 % (0.4)% 10.3 % 14.2 % (0.4)% Year Ended December 31, 2018 % Point Change 2017 % Point Change 2016 ($ in thousands) Loss ratio ..................................................... Acquisition expense ratio ........................... General & administrative expense ratio .... Combined ratio ........................................... 76.2 % 24.4 % 3.9 % 104.5 % (5.9)% (2.1)% (0.1)% (8.1)% 82.1 % 26.5 % 4.0 % 13.4 % (2.7)% 0.2 % 68.7% 29.2% 3.8% 112.6 % 10.9 % 101.7% Adjusted underwriting income (loss)(2)..... $ (19,009) Adjusted combined ratio (2) ...................... Return on average equity (5) ..................... 103.3 % (5.7)% $ (59,745) $ (1,624) (7.9)% 111.2 % 10.8 % (0.9)% 100.4% 14.3% (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) Net interest income return on average net assets under management and net investment income return on average net assets under management are calculated by dividing net interest income, and net investment income (loss), respectively, by average net assets under management. Net assets under management 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 twelve month period, average net assets under management 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 under management 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 return on average net assets under management and net investment income return on average net assets under management. (4) Net investment income return on average total investments is calculated by dividing net investment income by average total investments per the balance sheet. For the twelve month period, 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. 55 (5) Return on average equity represents net income (loss) expressed as a percentage of average common shareholders’ equity during the period. The average common shareholders’ equity is calculated as the average of the beginning and ending common shareholders’ equity of each quarterly period. 2018 versus 2017: The net loss attributable to common shareholders was $54.5 million for the year ended December 31, 2018, compared to a net loss of $8.9 million for the year ended December 31, 2017. The 2018 net loss was driven by a decrease in net investment income and non-recurring direct listing expenses of $9.0 million related to legal, advisory and accounting expenses associated with the initial listing of our common shares on the Nasdaq Global Select Market, offset in part by an improved underwriting result. During 2018, net investment income decreased by $79.1 million, to a loss of $6.3 million. The net investment loss was primarily due to an increase in net realized and unrealized losses of $115.0 million, compared to 2017. The 2018 investment loss was driven by the impact of widening credit spreads and rising interest rates on the market value of our investment portfolio, resulting in net unrealized losses of $109.0 million. Importantly, 2018 net interest income, which is a primary driver of long-term book value growth, increased 24.0%, from $86.5 million in 2017 to $107.5 million. The 2018 underwriting loss of $25.8 million was primarily the result of $19.0 million of property catastrophe losses due to the California wildfires, Hurricanes Michael and Florence, Typhoon Jebi, and other 2018 global catastrophe events. 2017 versus 2016: The net loss attributable to common shareholders was $8.9 million for the year ended December 31, 2017, compared to a net income of $127.1 million for the year ended December 31, 2016. The decrease in net income was driven by a higher underwriting loss and a decrease in net investment income as compared to 2016. The 2017 underwriting loss of $66.6 million was primarily driven by catastrophe losses and prior-period loss reserve development. During 2017, net investment income decreased by $73.7 million, or 50.3%, to $72.7 million. Our 2017 net interest income of $86.5 million was relatively flat compared to the prior year; however, net realized and unrealized gains were substantially lower compared to 2016, primarily as a result of a more stable credit spread environment in the non-investment grade market. 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. 56 Gross premiums written Gross premiums written for the years ended December 31, 2018, 2017 and 2016 were as follows: Year Ended December 31, 2018 2017 2016 Amount % Amount % Amount % Casualty reinsurance ..................... $ Other specialty reinsurance .......... Property catastrophe reinsurance 274,661 196,170 10,424 Insurance programs and coinsurance ............................... Total ............................................... $ 253,760 735,015 ($ in thousands) 37.4% $ 284,481 47.4% $ 331,127 26.7% 1.4% 169,100 12,740 28.2% 2.1% 125,404 11,756 61.9% 23.4% 2.2% 34.5% 133,983 22.3% 66,807 12.5% 100.0% $ 600,304 100.0% $ 535,094 100.0% 2018 versus 2017: Gross premiums written were $735.0 million for the year ended December 31, 2018 compared to $600.3 million for the year ended December 31, 2017, an increase of $134.7 million, or 22.4%. Our 2018 premium growth was primarily due to the continued expansion of our U.S. and European insurance programs and coinsurance, while our reinsurance portfolio grew 3.2%. Within reinsurance, we grew our other specialty business by 16.0% and reduced our casualty business by 3.5%, which was reflective of our view of the relative market opportunities. During 2018, WICE grew its insurance gross premiums written by $66.1 million, or 57.2%, to $181.7 million. In addition, during 2018, WSIC and WIC collectively grew their insurance programs' gross premiums written by $53.7 million, or 291%, to $72.1 million. 2017 versus 2016: Gross premiums written were $600.3 million for the year ended December 31, 2017 compared to $535.1 million for the year ended December 31, 2016, an increase of $65.2 million, or 12.2%. Our 2017 premium growth was due to the continued expansion of our U.S. and European insurance programs and coinsurance while our reinsurance portfolio remained stable overall. However, within reinsurance, we grew our other specialty business by 34.8% and reduced our casualty business by 14.1%, which was reflective of our view of the relative market opportunities. During 2017, WICE grew its insurance gross premiums written by $58.0 million, or 100.9%, to $115.5 million. In addition, during 2017, WSIC and WIC collectively grew their insurance programs' gross premiums written by $9.0 million, or 96.8%, to $18.3 million. Premiums ceded Premiums ceded were $130.8 million, or 17.8% of gross premiums written for the year ended December 31, 2018, compared to $47.2 million, or 7.9%, and $21.3 million, or 4.0%, for the years ended December 31, 2017 and 2016, respectively. The increase in premiums ceded was primarily related to one WICE insurance program with significant third-party quota share reinsurance protection. Additionally, premiums ceded to Arch increased, primarily related to our WICE, WSIC and WIC outward quota share retrocession agreements, reflecting the gross premiums written growth in these platforms. See “Certain relationships and related party transactions-Agreements with Arch-Reinsurance and retrocession agreements-Outward quota share retrocession and reinsurance agreements.” 57 Net premiums written Net premiums written for the years ended December 31, 2018, 2017 and 2016 were as follows: Year Ended December 31, 2018 2017 2016 Amount % Amount % Amount % Casualty reinsurance ..................... $ Other specialty reinsurance .......... Property catastrophe reinsurance 273,048 181,096 10,193 Insurance programs and coinsurance ............................... Total ............................................... $ 139,838 604,175 ($ in thousands) 45.2% $ 281,783 50.9% $ 329,149 30.0% 1.7% 155,666 12,455 28.1% 2.3% 117,267 11,463 64.1% 22.8% 2.2% 23.1% 103,213 18.7% 55,909 10.9% 100.0% $ 553,117 100.0% $ 513,788 100.0% 2018 versus 2017: Net premiums written were $604.2 million for the year ended December 31, 2018 compared to $553.1 million for the year ended December 31, 2017, an increase of $51.1 million or 9.2%. Our 2018 premium growth was primarily due to the continued expansion of our U.S. and European insurance programs and coinsurance while our reinsurance portfolio grew 3.2%. Within reinsurance, we grew our other specialty business by 16.3% and reduced our casualty business by 3.1%, which was reflective of our view of the relative market opportunities. During 2018, WSIC and WIC collectively grew their insurance programs' net premiums written by $36.5 million or 310% to $48.2 million. 2017 versus 2016: Net premiums written were $553.1 million for the year ended December 31, 2017 compared to $513.8 million for the year ended December 31, 2016, an increase of $39.3 million, or 7.6%. Our 2017 premium growth was due to the continued expansion of our U.S. and European insurance programs and coinsurance while our reinsurance portfolio remained stable overall. However, within reinsurance, we grew our other specialty business by 32.7% and reduced our casualty business by 14.4%, which was reflective of our view of the relative market opportunities. During 2017, WICE grew its insurance net premiums written by $41.3 million, or 82.2% to $91.5 million. In addition, during 2017, WSIC and WIC collectively grew their insurance programs' net premiums written by $6.1 million or 107% to $11.8 million, after cessions to Arch of $6.5 million. Net premiums earned Net premiums earned for the years ended December 31, 2018, 2017 and 2016 were as follows: Year Ended December 31, 2018 2017 2016 Amount % Amount % Amount % Casualty reinsurance ..................... $ Other specialty reinsurance .......... Property catastrophe reinsurance 278,656 162,691 10,998 Insurance programs and coinsurance ............................... Total ............................................... $ 126,517 578,862 ($ in thousands) 48.1% $ 308,526 58.0% $ 320,769 28.1% 1.9% 134,855 12,690 25.4% 2.4% 101,435 11,421 68.5% 21.7% 2.4% 21.9% 75,655 14.2% 34,345 7.4% 100.0% $ 531,726 100.0% $ 467,970 100.0% 2018 versus 2017: Net premiums earned were $578.9 million for the year ended December 31, 2018, compared to $531.7 million for the year ended December 31, 2017, an increase of $47.1 million or 8.9% over the prior year. The growth in the 2018 earned premium was due to the aggregate effect of earned premium recognition relating to net premiums written in 2018 and prior periods, as well as the growth of the WICE, WSIC and WIC platforms. 2017 versus 2016: Net premiums earned were $531.7 million for the year ended December 31, 2017, compared to $468.0 million for the year ended December 31, 2016, an increase of $63.8 million or 13.6% over 58 the prior year. The growth in the 2017 earned premium was due to the aggregate effect of earned premium recognition relating to premiums written in both 2017 and prior periods, as well as the growth of the WICE and WSIC platforms. Loss ratio The following table shows the components of our loss and loss adjustment expenses for the years ended December 31, 2018, 2017 and 2016: Year Ended December 31, 2018 2017 2016 Loss and Loss Adjustment Expenses % of Earned Premiums Loss and Loss Adjustment Expenses % of Earned Premiums Loss and Loss Adjustment Expenses % of Earned Premiums Current year ..................................... $ Prior year development (favorable)/adverse ..................... Loss and loss adjustment expenses . $ 443,482 76.6 % $ 399,530 75.2% $ 318,523 68.0% ($ in thousands) (2,227) 441,255 (0.4)% 36,872 6.9% 3,058 76.2 % $ 436,402 82.1% $ 321,581 0.7% 68.7% 2018 versus 2017: Our loss ratio was 76.2% for the year ended December 31, 2018, compared to 82.1% for the year ended December 31, 2017. The 2018 loss ratio was impacted by $19.0 million of property catastrophe losses primarily related to the 2018 California wildfires, Hurricanes Michael and Florence, and Typhoon Jebi versus $33.2 million of property catastrophe losses in 2017 emanating primarily from Hurricanes Harvey, Irma and Maria and the 2017 California wildfires. The 2018 loss ratio benefited from net favorable prior year loss reserve development of $2.2 million primarily driven by property catastrophe and other specialty lines of business. This contrasts with $36.9 million of net unfavorable loss reserve development in 2017, as described in detail below. 2017 versus 2016: Our loss ratio was 82.1% for the year ended December 31, 2017, compared to 68.7% for the year ended December 31, 2016. The increase in the 2017 loss ratio was driven by property catastrophe losses of $33.2 million and a net increase of $36.9 million in loss reserves related to prior periods. The net unfavorable prior year development was driven by casualty reinsurance and other specialty reinsurance contracts. Casualty reinsurance experienced net unfavorable development of $12.6 million on our U.K. Motor excess-of-loss portfolio primarily due to the U.K. Ministry of Justice’s reduction of the discount rate known as the “Ogden” rate, used to determine the present value of future medical costs and lost earnings when determining lump-sum court awards. The Ogden rate was reduced from 2.5% to negative 0.75%, and this change resulted in claims development in 2017 being higher than expected. Casualty reinsurance experienced an additional net unfavorable development of $21.2 million, driven by adverse development on certain multi-line and professional liability contracts. Other specialty reinsurance experienced net unfavorable development of $5.2 million primarily due to worse than expected emergence on nonstandard and U.K. motor quota share contracts. The remaining lines had net favorable prior year development of $2.2 million due to better than expected emergence of reported losses. Acquisition expense ratio 2018 versus 2017: Our acquisition expense ratio was 24.4% for the year ended December 31, 2018, a reduction of 2.1% from the prior year ended December 31, 2017. The lower acquisition expense ratio was largely driven by an increased percentage of insurance net premiums earned and a greater percentage of premiums earned on certain contracts with higher loss ratios and corresponding lower acquisition expenses. 2017 versus 2016: Our acquisition expense ratio was 26.5% for the year ended December 31, 2017, a reduction of 2.7% from the prior year ended December 31, 2016. The lower acquisition expense ratio was largely driven by a change in mix of business and a reduction in accrued ceding commissions on certain contracts that incurred adverse development during the year. 59 General and administrative expense ratio 2018 versus 2017: Our general and administrative expense ratio was 3.9% for the year ended December 31, 2018, compared to 4.0% for the year ended December 31, 2017. While the general and administrative expense ratio remained consistent with the prior year, increases in expenses reimbursable to Arch and professional fees were offset by a reduction in fees pertaining to letters of credit outstanding. Starting mid-2017, we altered our strategy for meeting collateral requirements by posting collateral into trusts more frequently than utilizing letters of credit, and therefore the amount of letters of credit outstanding decreased. 2017 versus 2016: Our general and administrative expense ratio was 4.0% for the year ended December 31, 2017, compared to 3.8% for the year ended December 31, 2016. The increase in the general and administrative expense ratio was primarily driven by increased corporate expenses and additional employee expenses resulting from the growth and expansion of our U.S. and European insurance programs and coinsurance line. Combined ratio 2018 versus 2017: Our combined ratio was 104.5% for the year ended December 31, 2018, compared to 112.6% and 101.7% for the year ended December 31, 2017 and 2016, respectively. In 2018, there was a 5.9 point decrease in the loss ratio and a 2.1 point decrease in acquisition expense ratio versus the prior period, as described above. 2017 versus 2016: In 2017, the 13.4 point increase in the loss ratio and 0.2 point increase in the general and administrative expense ratio was partially offset by the 2.7 point decrease in acquisition expense ratio versus the prior period, as described above. 60 Investing results The following table summarizes the components of total investment income: Year Ended December 31, 2018 2017 2016 ($ in thousands) $ 125,463 $ 122,378 (21,451) (16,563) Interest income .................................................................. $ 152,916 Investment management fees - related parties ............... (17,006) Borrowing and miscellaneous other investment expenses ........................................................................ Net interest income ........................................................... Net realized gains (losses) ................................................. Net unrealized gains (losses) ............................................. Investment performance fees - related parties ................ Net investment income (loss) ............................................ $ (28,377) 107,533 (4,788) (109,046) (17,489) 86,523 722 398 (48) (14,905) (15,997) 89,818 (24,483) 105,126 (24,065) (6,349) $ 72,738 $ 146,396 Net interest income return on average net assets under management (1) ............................................................ Non-investment grade portfolio (1) ............................. Investment grade portfolio (1) ..................................... Net investment income return on average total investments (2) .............................................................. Non-investment grade portfolio (2) ............................. Investment grade portfolio (2) ..................................... Net investment income return on average net assets under management (1) ................................................. Non-investment grade portfolio (1) ............................. Investment grade portfolio (1) ..................................... 5.4 % 7.0 % 1.9 % (0.2)% (0.1)% 0.9 % (0.3)% (0.2)% 0.9 % 4.9 % 6.3 % 1.1 % 3.2 % 4.5 % (0.1)% 4.1 % 5.8 % (0.1)% 6.3 % 8.5 % 0.4 % 8.0 % 10.2 % (0.4)% 10.3 % 14.2 % (0.4)% (1) Net interest income return on average net assets under management and net investment income return on average net assets under management are calculated by dividing net interest income, and net investment income (loss), respectively, by average net assets under management. Net assets under management 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 twelve month period, average net assets under management 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 under management 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 return on average net assets under management and net investment income return on average net assets under management. (2) Net investment income return on average total investments is calculated by dividing net investment income by average total investments per the balance sheet. For the twelve month period, 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. 2018 versus 2017: Net investment loss was $6.3 million for the year ended December 31, 2018 compared to net investment income of $72.7 million for the year ended December 31, 2017, a decrease of $79.1 million. The 2018 net investment income return on average net assets under management was (0.3)% as compared to 4.1% for the prior year. In 2018, net interest income benefited from an increase in the average net assets under management. The 2018 net interest yield was 5.4% versus 4.9% in 2017, which was reflective of a change in the composition of our investment portfolios and a higher LIBOR reference rate for floating rate assets. The reduction in net investment income was driven by net unrealized losses of $109.0 million, primarily in the non-investment grade portfolio. Investment performance fees decreased by $14.9 million commensurate with our overall lower net investment income. 2017 versus 2016: Net investment income was $72.7 million for the year ended December 31, 2017 compared to net investment income of $146.4 million for the year ended December 31, 2016, a decrease of $73.7 61 million or 50.3%. The 2017 net investment income return on average net assets under management was 4.1% as compared to 10.3% for the prior year. In contrast to 2016, which saw significant tightening in credit spreads generating sizable unrealized gains, the lower 2017 investment return was largely attributable to credit spreads remaining relatively stable. In 2017, net interest income benefited slightly from an increase in the average net assets under management base. The 2017 net interest yield was 4.9% versus 6.3% in 2016, which was reflective of tightened credit spreads in our non-investment grade portfolio as well as an increase in our allocation to our lower-yielding investment grade portfolio for regulatory and other commercial reasons. Investment performance fees decreased by $9.2 million commensurate with our overall lower net investment income. Non-recurring direct listing expense During 2018, we expensed non-recurring direct listing costs of $9.0 million related to legal, advisory and accounting expenses associated with the initial listing of our common shares on the Nasdaq Global Select Market. Growth in basic and diluted book value per share 2018 versus 2017: Basic and diluted book value per common share was $39.22 as of December 31, 2018, compared to $41.79 per share as of December 31, 2017, a decrease of $2.57 or 6.1%. The reduction in basic and diluted book value per share was driven by a net investment loss of $6.3 million, an underwriting loss of $25.8 million, and non-recurring direct listing expenses of $9.0 million incurred during the year. 2017 versus 2016: Basic and diluted book value per common share was $41.79 as of December 31, 2017, compared to $42.21 per share as of December 31, 2016, a decrease of $0.42 or 1.0%. The reduction in basic and diluted book value per share was driven by an underwriting loss of $66.6 million and a reduction in net investment income of $73.7 million, or 50.3%, to $72.7 million, compared to 2016. Return on average equity 2018 versus 2017: Our return on average equity was (5.7)% for the year ended December 31, 2018, compared to (0.9)% for the year ended December 31, 2017. The reduction in return on average equity was driven by a net investment loss of $6.3 million, an underwriting loss of $25.8 million, and non-recurring direct listing costs of $9.0 million expensed during the year. 2017 versus 2016: Our return on average equity was (0.9)% for the year ended December 31, 2017, compared to 14.3% for the year ended December 31, 2016. The reduction in return on average equity was driven by a 2017 underwriting loss of $66.6 million and reduction in net investment income of $73.7 million, or 50.3%, to $72.7 million as compared to 2016. 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 return on average net assets under management, and net investment income return on average net assets under management and on average total investments, respectively) are non-U.S. GAAP financial measures. We use these measures, together with the GAAP financial statements, to provide information that assists with analyzing our performance. As a result, certain income and expense items are excluded from these measures in an effort to allow an effective analysis. With respect to expenses, we do not view certain operating expenses related to corporate activities, referred to as certain corporate expenses, as part of our underwriting activities. These expenses are generally comprised of non-recurring costs of the holding company, such as costs associated with the initial setup of subsidiaries, as well as costs associated with the ongoing operations of the holding company such as salaries of certain executives. The following are descriptions of each of the non-U.S. GAAP financial measures used by us. Underwriting income (loss) is useful in evaluating our underwriting performance, without regard to other underwriting income (losses), net investment income (losses), net foreign exchange gains (losses), income tax expenses and preferred dividends. 62 Adjusted underwriting income (loss) is useful in evaluating our underwriting performance, without regard to net investment income (losses), net foreign exchange gains (losses), income tax expenses, preferred 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 return on average net assets under management, and net investment income return on average net assets under management and on average total investments, respectively) are useful in evaluating our investment performance. The non-investment grade portfolio component of these investment returns reflect the performance of our investment strategy under HPS, which includes the use of leverage. The investment grade portfolio component of these investment returns reflect the performance of the investment portfolios that predominantly support our underwriting collateral. We use underwriting income (loss), adjusted underwriting income (loss) and the adjusted combined ratio and the separate components of our returns (non-investment grade portfolio and investment grade portfolio) as internal performance measures in the management of our operations because we believe they give us and users of our financial information useful insight into our results of operations and our underlying business performance. Underwriting income (loss) and adjusted underwriting (income) loss should not be viewed as a substitute for net income (loss) calculated in accordance with U.S. GAAP, and our adjusted combined ratio should not be viewed as a substitute for our combined ratio. Furthermore, other companies may define these measures differently. Reconciliation of underwriting income (loss) and adjusted underwriting income (loss) Underwriting income (loss) reconciles to net income (loss) available to common shareholders, and adjusted underwriting income (loss) reconciles to underwriting income (loss) for the years ending December 31, 2018, 2017 and 2016 as follows: Net income (loss) available to common shareholders ................................. $ Preferred dividends ...................................................................................... Net income (loss) before dividends .............................................................. Income tax expense ...................................................................................... Net foreign exchange (gains) losses ............................................................ Non-recurring direct listing expenses .......................................................... Net investment (income) loss ....................................................................... Other underwriting (income) loss ................................................................ Underwriting income (loss) .......................................................................... Certain corporate expenses .......................................................................... Other underwriting income (loss) ................................................................ Adjusted underwriting income (loss) ........................................................... $ Year Ended December 31, 2018 2017 2016 ($ in thousands) (54,516) $ (8,892) $ 127,100 19,633 (34,883) 27 (3,611) 9,000 6,349 (2,722) (25,840) 4,109 2,722 19,633 10,741 21 (1,420) — (72,738) (3,180) (66,576) 3,651 3,180 19,634 146,734 1 (4,893) — (146,396) (3,746) (8,300) 2,930 3,746 (19,009) $ (59,745) $ (1,624) 63 Reconciliation of the adjusted combined ratio The adjusted combined ratio reconciles to the combined ratio for the years ending December 31, 2018, 2017 and 2016 as follows: 2018 Amount Adjustment As Adjusted Year ended December 31, 2017 2016 Amount Adjustment ($ in thousands) As Adjusted Amount Adjustment As Adjusted Losses and loss adjustment expenses ......... $ 441,255 Acquisition expenses ................................... General & administrative expenses (1) ....... Net premiums earned (1)(2) ........................ 141,136 578,862 22,311 $ — $ 441,255 $ 436,402 $ — $ 436,402 $ 321,581 $ — $ 321,581 — 141,136 140,726 — 140,726 136,733 (4,109) 2,722 18,202 21,174 581,584 531,726 (3,651) 3,180 17,523 17,956 534,906 467,970 — (2,930) 3,746 136,733 15,026 471,716 Loss ratio ..................................................... Acquisition expense ratio ........................... General & administrative expense ratio (1) ............................................................. Combined ratio ........................................... Adjusted loss ratio ....................................... Adjusted acquisition expense ratio ............ Adjusted general & administrative expense ratio ......................................... Adjusted combined ratio ............................ 76.2% 24.4% 3.9% 104.5% 82.1% 26.5% 4.0% 112.6% 75.9% 24.3% 3.1% 103.3% 68.7% 29.2% 3.8% 101.7% 81.6% 26.3% 3.3% 111.2% 68.2% 29.0% 3.2% 100.4% (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. 64 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 years ending December 31, 2018, 2017 and 2016 are as follows: Year Ended December 31, 2018 Year Ended December 31, 2017 Year Ended December 31, 2016 Non- Investment Grade Investment Grade Cost of U/W Collateral (3) Non- Investment Grade Investment Grade Total Cost of U/W Collateral (3) Non- Investment Grade Total Investment Grade Total ($ in thousands) Interest income ................................................... $ 135,847 $ 17,069 $ Investment management fees - related parties (15,818) (1,188) — — $ 152,916 $ 118,263 $ 7,200 $ (17,006) (20,827) (624) — — $ 125,463 $ 120,461 $ 1,917 $ 122,378 (21,451) (16,327) (236) (16,563) Borrowing and miscellaneous other investment expenses.................................... (16,994) Net interest income ............................................ 103,035 (375) 15,506 (11,008) (11,008) (28,377) 107,533 (14,816) 82,620 (287) 6,289 (2,386) (2,386) (17,489) (15,888) 86,523 88,246 (109) 1,572 Realized and unrealized gains (losses) on investments .................................................. (105,376) (8,458) Investment performance fees - related parties. (48) — — — (113,834) 8,018 (6,898) (48) (14,905) — — — 1,120 83,761 (3,118) (14,905) (24,065) — (15,997) 89,818 80,643 (24,065) Net investment income (loss) ............................. $ (2,389) $ 7,048 $ (11,008) $ (6,349) $ 75,733 $ (609) Average total investments (1)............................ $1,851,650 $812,186 $ — $2,663,836 $1,701,162 $547,307 $ $ (2,386) $ 72,738 $ 147,942 $ (1,546) $ 146,396 — $2,248,469 $1,445,451 $388,488 $1,833,939 Average net assets under management (2) ...... $1,472,297 $814,154 $(287,765) $1,998,686 $1,314,708 $548,797 $(91,407) $1,772,098 $1,038,432 $388,791 $1,427,223 Net interest income return on average net assets under management (2)..................... Net investment income return on average total investments (1).................................... Net investment income return on average net assets under management (2)..................... 7.0 % (0.1)% 1.9% 0.9% 5.4 % 6.3% 1.1 % 4.9% 8.5% 0.4 % (0.2)% 4.5% (0.1)% 3.2% 10.2% (0.4)% 6.3% 8.0% (0.2)% 0.9% (3.8)% (0.3)% 5.8% (0.1)% (2.6)% 4.1% 14.2% (0.4)% 10.3% (1) Net investment income return on average total investments is calculated by dividing net investment income by average total investments per the balance sheet. For the twelve month period, 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. (2) Net interest income return on average net assets under management and net investment income return on average net assets under management are calculated by dividing net interest income, and net investment income (loss), respectively, by average net assets under management. For the non-investment grade component of investment returns and total investment returns, net assets under management 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 under management calculation. (3) The cost of underwriting capital 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. 65 As of December 31, 2018 As of December 31, 2017 As of December 31, 2016 Non- Investment Grade Investment Grade Cost of U/ W Collateral Non- Investment Grade Investment Grade Cost of U/ W Collateral Non- Investment Grade Total Total Investment Grade Total ($ in thousands) Average total investments - YTD .................................. $ 1,851,650 $ 812,186 $ — $ 2,663,836 $ 1,701,162 $ 547,307 $ — $ 2,248,469 $ 1,445,451 $ 388,488 $ 1,833,939 Average net assets under management - YTD............. 1,472,297 814,154 (287,765) 1,998,686 1,314,708 548,797 (91,407) 1,772,098 1,038,432 388,791 1,427,223 Total investments ........................................................... $ 1,882,591 $ 855,776 $ — $ 2,738,367 $ 1,752,056 $ 744,159 $ — $ 2,496,215 $ 1,490,729 $ 432,820 $ 1,923,549 Accrued Investment Income .......................................... Receivable for Securities Sold........................................ Less: Payable for Securities Purchased .......................... Less: Payable for Securities Sold Short.......................... 15,000 23,820 60,142 8,928 Less: Revolving credit agreement borrowings ............. 386,430 4,461 687 — — — — — — — 19,461 24,507 60,142 8,928 15,034 36,355 42,501 34,375 307,487 693,917 295,749 3,227 19 — — — — — — — 18,261 36,374 42,501 34,375 16,308 1,326 42,922 33,157 253,416 549,165 258,861 709 — — — — 17,017 1,326 42,922 33,157 258,861 Net assets under management ..................................... $ 1,465,911 $ 860,924 $ (307,487) $ 2,019,348 $ 1,430,820 $ 747,405 $ (253,416) $ 1,924,809 $ 1,173,423 $ 433,529 $ 1,606,952 66 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 December 31, 2018. Actual results will differ from these estimates and such differences may be material. We believe that the following critical accounting policies affect significant estimates used in the preparation of our consolidated financial statements. Reserves for losses and loss adjustment expenses We are required by applicable insurance laws and regulations and U.S. GAAP to establish reserves for losses and loss adjustment expenses, or “loss reserves,” that arise from the business we underwrite. Loss reserves are balance sheet liabilities representing estimates of future amounts required to pay losses and loss adjustment expenses for insured or reinsured events which have occurred at or before the balance sheet date. Loss reserves do not reflect contingency reserve allowances to account for future loss occurrences. Losses arising from future events will be estimated and recognized at the time the losses are incurred and could be substantial. We do not currently discount our reserves for losses and loss adjustment expenses in our financial statement presentation. Loss reserves are comprised of (1) case reserves for claims reported, (2) additional case reserves, or ACRs, and (3) reserves for estimated loss and loss adjustment expenses that have been incurred by insureds and reinsureds, but not yet reported to the insurer or reinsurer, including unknown future developments on loss and loss adjustment expenses which are known to the insurer or reinsurer, or IBNR, reserves. Loss reserves are established to provide for loss adjustment expenses and represent the estimated expense of settling claims, including legal and other fees and the general expenses of administering the claims adjustment process. Periodically, adjustments to the reported or case reserves may be made as additional information regarding the claims is reported or payments are made. IBNR reserves are established to provide for incurred claims which have not yet been reported at the balance sheet date as well as to adjust for any projected variance in case reserving. Actuaries estimate ultimate losses and loss adjustment expenses using various generally accepted actuarial methods applied to known losses and other relevant information. Like case reserves, IBNR reserves are adjusted as additional information becomes known or payments are made. The process of estimating reserves involves a considerable degree of judgment by management and, as of any given date, is inherently uncertain. Estimates of ultimate losses and loss adjustment expenses are generally determined by extrapolation of claim emergence and settlement patterns observed in the past that can reasonably be expected to persist into the future. In forecasting ultimate losses and loss adjustment expenses with respect to any line of business, past experience with respect to that line of business is the primary resource, developed through both industry and company experience, but cannot be relied upon in isolation. Uncertainties in estimating ultimate losses and loss adjustment expenses are magnified by the time lag between when a claim actually occurs and when it is reported and settled. This time lag is sometimes referred to as the “claim-tail.” The claim-tail for most property coverages is typically short (usually several months up to a few years). The claim-tail for certain professional liability, executive assurance and health care coverages, which are generally written on a claims- made basis, is typically longer than property coverages but shorter than casualty lines. The claim-tail for liability/casualty coverages, such as general liability, products liability, multiple peril coverage and workers’ compensation, may be especially long as claims are often reported and ultimately paid or settled years, or even decades, after the related loss events occur. During the claims reporting and settlement period, additional facts regarding coverages written in prior accident years, as well as about actual claims and trends, may become known and, as a result, management may adjust its reserves. If management determines that an adjustment is appropriate, the adjustment is recorded in the accounting period in which such determination is made in accordance with U.S. GAAP. Accordingly, if loss reserves need to be increased or 67 decreased in the future from amounts currently established, future results of operations would be negatively or positively impacted, respectively. In addition, the inherent uncertainties of estimating such reserves are even greater for our reinsurance lines of business, due primarily to the following factors: (1) the claim-tail for reinsurers is generally longer because claims are first reported to the ceding company and then to the reinsurer through one or more intermediaries, (2) the reliance on premium estimates, where reports have not been received from the ceding company, in the reserving process, (3) the potential for writing a number of reinsurance contracts with different ceding companies with the same exposure to a single loss event, (4) the diversity of loss development patterns among different types of reinsurance contracts, (5) the necessary reliance on the ceding companies for information regarding reported claims and (6) the differing reserving practices among ceding companies. In determining ultimate losses and loss adjustment expenses, the cost to indemnify claimants, provide needed legal defense and other services for insureds and administer the investigation and adjustment of claims are considered. These claim costs are influenced by many factors that change over time, such as expanded coverage definitions as a result of new court decisions, inflation in costs to repair or replace damaged property, inflation in the cost of medical services and legislated changes in statutory benefits, as well as by the particular, unique facts that pertain to each claim. As a result, the rate at which claims arose in the past and the costs to settle them may not always be representative of what will occur in the future. The factors influencing changes in claim costs are often difficult to isolate or quantify and developments in paid and incurred losses are frequently subject to multiple and conflicting interpretations. Changes in coverage terms or claims-handling practices may also cause future experience and/or development patterns to vary from the past. A key objective of actuaries in developing estimates of ultimate losses and loss adjustment expenses, and resulting IBNR reserves, is to identify aberrations and systemic changes occurring within historical experience and accurately adjust for them so that the future can be projected reliably. Pricing actuaries devote considerable effort to understanding and analyzing a ceding company and program administrator’s operations and loss history during the underwriting of the business, using a combination of ceding company, program administrator, and industry statistics. Such statistics normally include historical premium and loss data by class of business, individual claim information for larger claims, distributions of insurance limits provided, loss reporting and payment patterns, and rate change history. Because of the factors previously discussed, this process requires the substantial use of informed judgment and is inherently uncertain. As mentioned above, with regard to reinsurance, there can be a considerable time lag from the time a claim is reported to a ceding company to the time it is reported to the reinsurer. The lag can be several years in some cases and may be attributed to a number of reasons; including the time it takes to investigate a claim, delays associated with the litigation process, the deterioration in a claimant’s physical condition many years after an accident occurs, the case reserving approach of the ceding company, etc. In the reserving process, we assume that such lags are predictable, on average, over time and therefore the lags are contemplated in the loss reporting patterns used in their actuarial methods. This means that reserves for our reinsurance lines of business must rely on estimates for a longer period of time than for our insurance lines of business. Backlogs in the recording of assumed reinsurance can also complicate the accuracy of loss reserve estimation. As of December 31, 2018, there were no significant backlogs related to the processing of assumed reinsurance information for our reinsurance lines of business. Although loss reserves are initially determined based on underwriting and pricing analysis, we apply several generally accepted actuarial methods, as discussed below, on a quarterly basis. Each quarter, as part of the reserving process, actuaries at our operations reaffirm that the assumptions used in the reserving process continue to form a sound basis for projection of liabilities. If actual loss activity differs substantially from expectations based on historical information, an adjustment to loss reserves may be supported. Estimated loss reserves for more mature underwriting years are based more on actual loss activity and historical patterns than on the initial assumptions based on pricing indications. More recent underwriting years rely more heavily on internal pricing assumptions. We place more or less reliance on a particular actuarial method based on the facts and circumstances at the time the estimates of loss reserves are made. These methods generally fall into one of the following categories or are hybrids of one or more of the following categories: • Expected loss methods: these methods are based on the assumption that ultimate losses vary proportionately with premiums. Expected loss and loss adjustment expense ratios are typically developed based upon the information derived by underwriters and actuaries during the initial pricing of the business, 68 supplemented by industry data available from organizations, such as statistical bureaus and consulting firms, where appropriate. These ratios consider, among other things, rate changes and changes in terms and conditions that have been observed in the market. Expected loss methods are useful for estimating ultimate losses and loss adjustment expenses in the early years of long-tailed lines of business, when little or no paid or incurred loss information is available, and is commonly applied when limited loss experience exists for a company. • Historical incurred loss development methods: these methods assume that the ratio of losses in one period to losses in an earlier period will remain constant in the future. These methods use incurred losses (i.e., the sum of cumulative historical loss payments plus outstanding case reserves) over discrete periods of time to estimate future losses. Historical incurred loss development methods may be preferable to historical paid loss development methods because they explicitly take into account open cases and the claims adjusters’ evaluations of the cost to settle all known claims. However, historical incurred loss development methods necessarily assume that case reserving practices are consistently applied over time. Therefore, when there have been significant changes in how case reserves are established, using incurred loss data to project ultimate losses may be less reliable than other methods. • Historical paid loss development methods: these methods, like historical incurred loss development methods, assume that the ratio of losses in one period to losses in an earlier period will remain constant. These methods use historical loss payments over discrete periods of time to estimate future losses and necessarily assume that factors that have affected paid losses in the past, such as inflation or the effects of litigation, will remain constant in the future. Because historical paid loss development methods do not use incurred losses to estimate ultimate losses, they may be more reliable than the other methods that use incurred losses in situations where there are significant changes in how incurred losses are established by a company’s claims adjusters. However, historical paid loss development methods are more leveraged (meaning that small changes in payments have a larger impact on estimates of ultimate losses) than actuarial methods that use incurred losses because cumulative loss payments take much longer to equal the expected ultimate losses than cumulative incurred amounts. In addition, and for similar reasons, historical paid loss development methods are often slow to react to situations when new or different factors arise than those that have affected paid losses in the past. • Adjusted historical paid and incurred loss development methods: these methods take traditional historical paid and incurred loss development methods and adjust them for the estimated impact of changes from historical levels in factors such as inflation, the speed of claim payments or the adequacy of case reserves. Adjusted historical paid and incurred loss development methods are often more reliable methods of predicting ultimate losses in periods of significant change, provided the actuaries can develop methods to reasonably quantify the impact of changes. As such, these methods utilize more judgment than historical paid and incurred loss development methods. • Bornhuetter-Ferguson, or B-F, paid and incurred loss methods: these methods utilize actual paid and incurred losses and expected patterns of paid and incurred losses, taking the initial expected ultimate losses into account to determine an estimate of expected ultimate losses. The B-F paid and incurred loss methods are useful when there are few reported claims and a relatively less stable pattern of reported losses. • Additional analysis: other methodologies are often used in the reserving process for specific types of claims or events, such as catastrophic or other specific major events. These include vendor catastrophe models, which are typically used in the estimation of loss reserves at the early stage of known catastrophic events before information has been reported to an insurer or reinsurer, and analysis of specific industry events, such as large lawsuits or claims. In the initial reserving process for short-tail lines, consisting of property catastrophe and other exposures, we rely on a combination of the reserving methods discussed above. For known catastrophic events, our reserving process also includes the usage of catastrophe models and a heavy reliance on analysis that includes ceding company inquiries and management judgment. The development of property losses may be: (i) unstable, especially where there is high catastrophic exposure; (ii) characterized by high severity, low frequency losses for excess and catastrophe-exposed business; and/or (iii) highly correlated across contracts. As time passes, for a given underwriting year, additional weight is given to the paid and incurred B-F loss development methods and historical paid and incurred loss development methods in the reserving process. We make a number of key assumptions in reserving for short-tail lines, including that: (i) historical paid and reported development patterns are stable; (ii) catastrophe models provide useful information about our exposure to catastrophic events that have occurred; and (iii) our underwriters’ judgment and guidance 69 received from ceding companies as to potential loss exposures may be relied on. The expected loss ratios used in the initial reserving process for our property exposures will vary over time due to changes in pricing, reinsurance structure, estimates of catastrophe losses, terms and conditions and geographical distribution. As losses in property lines are reported relatively quickly, expected loss ratios are selected for the current underwriting year incorporating the experience for earlier underwriting years, adjusted for rate changes, inflation, changes in reinsurance programs, expectations about present and future market conditions and expected attritional losses based on modeling. Due to the short-tail nature of property business, reported loss experience emerges quickly and ultimate losses are known in a comparatively short period of time. In the initial reserving process for medium-tail and long-tail lines, consisting of casualty, other specialty, and other exposures, we primarily rely on the expected loss method. The development of medium-tail and long- tail business may be unstable, especially if there are high severity major events, with business written on an excess of loss basis typically having a longer tail than business written on a pro rata basis. As time passes, for a given exposure, additional weight is given to the paid and incurred B-F loss development methods and historical paid and incurred loss development methods in the reserving process. We make a number of key assumptions in reserving for medium-tail and long-tail lines, including that the pricing loss ratio is the best estimate of the ultimate loss ratio at the time the contract is entered into, historical paid and reported development patterns are stable and our claims personnel and underwriters’ analysis of our exposure to major events are assumed to be our best estimate of our exposure to the known claims on those events. The expected loss ratios used in initial reserving process for medium-tail and long-tail contracts will vary over time due to changes in pricing, terms and conditions and reinsurance structure. As the credibility of historical experience for earlier underwriting years increases, the experience from these underwriting years will be used in the actuarial analysis to determine future underwriting year expected loss ratios, adjusted for changes in pricing, loss trends, terms and conditions and reinsurance structure. Our reinsurance business receives reports of claims notices from ceding companies and record case reserves based upon the amount of reserves recommended by the ceding company. Case reserves on known events may be supplemented by ACRs, which are often estimated by our reinsurance operations’ claims personnel ahead of official notification from the ceding company, or when our reinsurance operations’ judgment regarding the size or severity of the known event differs from the ceding company. In certain instances, our reinsurance operations establish ACRs even when the ceding company does not report any liability on a known event. In addition, specific claim information reported by ceding companies or obtained through claim audits can alert our reinsurance operations to emerging trends such as changing legal interpretations of coverage and liability, claims from unexpected sources or classes of business, and significant changes in the frequency or severity of individual claims. Our reinsurance business relies heavily on information reported by ceding companies, as discussed above. In order to determine the accuracy and completeness of such information, underwriters, actuaries, and claims personnel at our reinsurance operations often perform audits of ceding companies and regularly review information received from ceding companies for unusual or unexpected results. Material findings are usually discussed with the ceding companies. Our reinsurance operations sometimes encounter situations where they determine that a claim presentation from a ceding company is not in accordance with contract terms. In these situations, our reinsurance operations attempt to resolve the dispute with the ceding company. Most situations are resolved amicably and without the need for litigation or arbitration. However, in the infrequent situations where a resolution is not possible, our reinsurance operations will vigorously defend their position in such disputes. For our insurance program and coinsurance line of business, Arch’s claim personnel, under our service arrangements, determine whether to establish a case reserve for the estimated amount of the ultimate settlement of individual claims. The estimate reflects the judgment of claims personnel based on general corporate reserving practices, the experience and knowledge of such personnel regarding the nature and value of the specific type of claim and, where appropriate, advice of counsel. We contract with a number of outside third-party administrators in the claims process who, in certain cases, have limited authority to establish case reserves. The work of these administrators is reviewed and monitored by such claims personnel. 70 As of December 31, 2018, we did not make any significant changes in our methodologies or assumptions as described above. Our loss reserves, net of unpaid losses and loss adjustment expenses recoverable from reinsurers by type were as follows: December 31, 2018 2017 2016 ($ in thousands) Case Reserves ..................................................................................... $ IBNR Reserves ..................................................................................... 401,049 $ 293,464 $ 135,216 550,444 464,942 354,075 Total net reserves ............................................................................ $ 951,493 $ 758,406 $ 489,291 The loss reserves by major line of business, net of unpaid losses and loss adjustment expenses recoverable, were as follows: December 31, 2018 2017 2016 ($ in thousands) Casualty reinsurance .......................................................................... $ Other specialty reinsurance .............................................................. Property catastrophe reinsurance ..................................................... Insurance programs and coinsurance ............................................... 700,630 $ 572,775 $ 395,533 134,203 21,826 94,834 112,589 19,836 53,206 67,157 7,050 19,551 Total net reserves ............................................................................ $ 951,493 $ 758,406 $ 489,291 Potential variability in loss reserves The tables below summarize the effect of reasonably likely scenarios on the key actuarial assumptions used to estimate our loss reserves, net of unpaid losses and loss adjustment expenses recoverable, at December 31, 2018 by line of business. The scenarios shown in the tables summarize the effect of (i) changes to the expected loss ratio selections used at December 31, 2018, which represent loss ratio point increases or decreases to the expected loss ratios used, and (ii) changes to the loss development patterns used in our reserving process at December 31, 2018, which represent claims reporting that is either slower or faster than the reporting patterns used. We believe that the illustrated sensitivities are indicative of the potential variability inherent in the estimation process of those parameters. The results show the impact of varying each key actuarial assumption using the chosen sensitivity on our IBNR reserves, on a net basis and across all accident years. Each of the impacts set forth in the tables is estimated individually, without consideration for any correlation among key assumptions or among lines of business. Therefore, it would be inappropriate to take each of the amounts and add them together in an attempt to estimate total volatility. While we believe the variations in the expected loss ratios and loss development patterns presented could be reasonably expected, our own historical data regarding variability is generally limited and actual variations may be greater or less than these amounts. It is also important to note that the variations are not meant to be a “best-case” or “worst- case” series of scenarios and, therefore, it is possible that future variations in our loss reserves may be more or less than the amounts set forth above. While we believe that these are reasonably likely scenarios, we do not believe this sensitivity analysis should be considered an actual reserve range. 71 Development Pattern Increase (decrease) in loss reserves, net: Casualty Reinsurance Expected Loss Ratio ($ in thousands) 10% Lower Unchanged 10% Higher 6 Months Shorter .......................................................................................... $ Unchanged .................................................................................................... 6 Months Longer .......................................................................................... (116,751) $ (52,608) $ (81,348) (36,441) — 40,260 10,758 57,165 115,832 Other Specialty Reinsurance 5% Lower Unchanged 5% Higher 6 Months Shorter .......................................................................................... $ Unchanged .................................................................................................... 6 Months Longer .......................................................................................... (8,266) $ (96) $ (4,710) (2,377) — 2,494 4,685 6,556 10,530 Property Catastrophe Reinsurance 5% Lower Unchanged 5% Higher 6 Months Shorter .......................................................................................... $ Unchanged .................................................................................................... 6 Months Longer .......................................................................................... (1,229) $ (937) $ (380) 785 — 1,223 (646) 380 1,660 Insurance and Coinsurance 5% Lower Unchanged 5% Higher 6 Months Shorter .......................................................................................... $ Unchanged .................................................................................................... 6 Months Longer .......................................................................................... (7,217) $ (1,397) $ (5,917) (5,156) — 816 3,790 5,171 6,792 Ceded reinsurance In the normal course of business, our insurance subsidiaries may cede premium on a quota share or excess of loss basis through treaty or facultative reinsurance agreements. Our reinsurance subsidiary may also obtain reinsurance whereby another reinsurer contractually agrees to indemnify us for the ceded portion of certain reinsurance risks we had assumed. Such arrangements, where one reinsurer provides reinsurance to another reinsurer, are usually referred to as “retrocessional reinsurance” arrangements. Such arrangements reduce the effect of individual or aggregate losses to the ceding company. In our case, we also cede business to Arch, as an alignment of interest mechanism. Reinsurance recoverables are recorded as assets, predicated on the reinsurers’ ability to meet their obligations under the reinsurance agreements. If the reinsurers are unable to satisfy their obligations under the agreements, our insurance or reinsurance operations would be liable for such defaulted amounts. We have historically reinsured a portion of our exposures, paying to reinsurers a part of the premiums received on the policies we write. On a consolidated basis, ceded premiums written, as a percentage of gross premiums written for the years ended December 31, 2018, 2017 and 2016 were as follows: Year Ended December 31, 2018 2017 2016 Gross premiums ceded ................................................................................. 17.8% 7.9% 4.0% We monitor the financial condition of our reinsurers and attempt to place coverages only with substantial, financially sound carriers. If the financial condition of our reinsurers or retrocessionaires deteriorates, resulting in an impairment of their ability to make payments, we will provide for probable losses resulting from our inability to collect amounts due from such parties, as appropriate. We evaluate the creditworthiness of all the reinsurers to which we cede business. If our analysis indicates that there is significant uncertainty regarding our ability to collect amounts due from reinsurers, managing general agents, brokers and other clients, we will record a provision for doubtful accounts. See “Risk factors-Risks related to our company-We are exposed to credit risk related to our cedants and policyholders in certain of our underwriting operations.” 72 The availability and cost of reinsurance and retrocessional protection is subject to market conditions, which are beyond our control. Although we believe that our underwriting operations have been successful in obtaining adequate reinsurance and retrocessional protection, it is not certain that they will be able to continue to obtain adequate protection at cost effective levels. As a result of such market conditions and other factors, our underwriting operations may not be able to successfully mitigate risk through reinsurance and retrocessional arrangements and may lead to increased volatility in our results of operations in future periods. See “Risk factors-Risks related to our insurance and reinsurance business-The availability of reinsurance and retrocessional coverage may be limited and counterparty credit and other risks associated with our reinsurance arrangements may result in losses which could adversely affect our financial condition and results of operations.” Premium revenues and related expenses Premiums written include amounts reported by brokers, ceding companies, program administrators and coinsurers supplemented by our own estimates of premiums where reports have not been received. Premiums written include estimates; such premium estimates are derived from multiple sources which include the historical experience of the underlying business, similar business and available industry information. The determination of premium estimates requires a review of our experience with ceding companies, familiarity with each market, the timing of the reported information, an analysis and understanding of the characteristics of each line of business, and management’s judgment of the impact of various factors, including premium or loss trends, on the volume of business written and ceded to us. On an ongoing basis, our underwriters review the amounts reported by these third parties for reasonableness based on their experience and knowledge of the subject class of business, taking into account our historical experience with the brokers or ceding companies. In addition, reinsurance contracts under which we assume business generally contain specific provisions which allow us to perform audits of the ceding company to ensure compliance with the terms and conditions of the contract, including accurate and timely reporting of information. Based on a review of all available information, management establishes premium estimates where reports have not been received. Premium estimates are updated when new information is received and differences between such estimates and actual amounts are recorded in the period in which estimates are changed or the actual amounts are determined. Premiums written are recorded based on the type of contracts we write. Insurance premiums written are generally recorded at the policy inception. Premiums on our excess of loss and pro rata reinsurance contracts are estimated when the business is underwritten. For excess of loss contracts, premiums are recorded as written based on the terms of the contract. Estimates of premiums written under pro rata contracts are recorded in the period in which the underlying risks incept and are based on information provided by the brokers and the ceding companies. For multi-year reinsurance treaties which are payable in annual installments, generally, only the initial annual installment is included as premiums written at policy inception due to the ability of the reinsured to commute or cancel coverage during the term of the policy. The remaining annual installments are included as premiums written at each successive anniversary date within the multi-year term. Reinstatement premiums are recognized at the time a loss event occurs, where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms. Reinstatement premiums, if obligatory, are fully earned when recognized. The accrual of reinstatement premiums is based on an estimate of losses and loss adjustment expenses, which reflects management’s judgment, as described above in “Reserves for losses and loss adjustment expenses.” 73 The amount of reinsurance premium estimates included in premiums receivable and the amount of related acquisition expenses by line of business were as follows as of December 31, 2018: Casualty reinsurance .......................................................................... $ Other specialty reinsurance .............................................................. Property catastrophe reinsurance ..................................................... Insurance programs and coinsurance ............................................... December 31, 2018 Gross Amount Acquisition Expenses Net Amount ($ in thousands) 90,463 $ (33,882) $ 52,316 228 19,664 (10,628) (48) (4,101) 56,581 41,688 180 15,563 Total ................................................................................................. $ 162,671 $ (48,659) $ 114,012 Premium estimates are reviewed by management. Such review includes a comparison of actual reported premiums to expected ultimate premiums along with a review of the aging and collection of premium estimates. Based on management’s review, the appropriateness of the premium estimates is evaluated, and any adjustment to these estimates is recorded in the period in which it becomes known. Adjustments to premium estimates could be material and such adjustments could directly and significantly impact earnings favorably or unfavorably in the period they are determined because the estimated premium may be fully or substantially earned. A significant portion of amounts included as premiums receivable, which represent estimated premiums written, net of commissions, are not currently due based on the terms of the underlying contracts. Based on currently available information, management believes that the premium estimates included in premiums receivable will be collectible and, therefore, no provision for doubtful accounts has been recorded on the premium estimates as of December 31, 2018. Reinsurance premiums assumed, irrespective of the class of business, are generally earned on a pro rata basis over the terms of the underlying policies or reinsurance contracts. Contracts and policies written on a “losses occurring” basis cover claims that may occur during the term of the contract or policy, which is typically 12 months. Accordingly, the premium is earned evenly over the term. Contracts which are written on a “risks attaching” basis cover claims which attach to the underlying insurance policies written during the terms of such contracts. Premiums earned on such contracts usually extend beyond the original term of the reinsurance contract, typically resulting in recognition of premiums earned over a 24-month period. Insurance premiums are primarily earned on a pro rata basis over the terms of the policies, generally 12 months. Certain of our contracts include provisions that adjust premiums or acquisition expenses based upon the experience under the contracts. Premiums written and earned, as well as related acquisition expenses are recorded based upon the projected experience under such contracts. Retroactive reinsurance reimburses a ceding company for liabilities incurred as a result of past insurable events covered by the underlying policies reinsured. For retroactive contracts that meet the established criteria for reinsurance accounting, written premiums are fully earned and corresponding losses and loss expense are recognized at inception. The initial gain, if applicable, is deferred and amortized into income over an actuarially determined expected payout period. Any future loss is recognized immediately and charged against earnings. The contracts can cause significant variances in gross premiums written, net premiums written, net premiums earned, and net incurred losses in the years in which they are written. Reinsurance contracts sold not meeting the established criteria for reinsurance accounting are recorded using the deposit method. In certain instances, reinsurance contracts cover losses both on a prospective basis and on a retroactive basis and, accordingly, we bifurcate the prospective and retrospective elements of these reinsurance contracts and account for each element separately. Underwriting income generated in connection with retroactive reinsurance contracts is deferred and amortized into income over the settlement period while losses are charged to income immediately. Subsequent changes in estimated or actual cash flows under such retroactive reinsurance contracts are accounted for by adjusting the previously deferred amount to the balance that would have existed had the revised estimate been available at the inception of the reinsurance transaction, with a corresponding charge or credit to income. 74 Unearned premiums represent the portion of premiums written that is related to the estimated unexpired risk under the policy or contract, as applicable. A portion of premium payments may be refundable if the insured cancels coverage. Premium refunds reduce premiums earned in the consolidated statements of income. Generally, only unearned premiums are refundable. Acquisition expenses and other expenses related to our underwriting operations that vary with, and are directly related to, the successful acquisition or renewal of business are deferred and amortized over the period in which the premiums are earned. Deferred acquisition costs are carried at their estimated realizable value and take into account anticipated losses and loss adjustment expenses, based on historical and current experience, and anticipated investment income. In regard to unexpired policies and contracts, a premium deficiency occurs if the sum of anticipated losses and loss adjustment expenses and unamortized acquisition costs exceed unearned premiums and anticipated investment income. A premium deficiency reserve is recorded by charging any unamortized acquisition costs to expenses to the extent required in order to eliminate the deficiency. If the premium deficiency exceeds unamortized acquisition costs then a liability is accrued for the excess deficiency. No premium deficiency reserves were recorded by us the years ended December 31, 2018, 2017 and 2016. Fair value measurements 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 fashion 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 determination of the existence of an active market for our investment assets is based on whether transactions for the financial instrument occur in such market with sufficient frequency and volume to provide reliable pricing information. The independent pricing services we engage 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. In addition, pricing vendors use model processes, such as an option-adjusted spread model, to develop prepayment and interest rate scenarios. 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. When quoted prices are unavailable we use the best available pricing information, which in some cases, particularly for non-standard instruments, will be a modeled valuation provided by HPS. In such cases, HPS uses quantitative and qualitative assessments such as internally modeled values. The modeled values are based on comparisons to peer security and industry-specific market data. Any such valuations supplied by HPS are reviewed for reasonableness by our management. We review our securities measured at fair value and discuss the proper classification of such investments with our Investment Managers and others. See Note 9 - “Fair value” to our consolidated financial statements for a summary of our financial assets and liabilities measured at fair value as of December 31, 2018 by valuation hierarchy. Other-than-temporary impairments On a quarterly basis, we perform reviews of our investments to determine whether declines in fair value below the cost basis are considered other-than-temporary in accordance with applicable accounting guidance regarding the recognition and presentation of other-than-temporary impairments, or OTTIs. The process of determining whether a security is other-than-temporarily impaired requires judgment and involves analyzing many factors. These factors include: an analysis of the liquidity, business prospects and overall financial 75 condition of the issuer; the time in which there was a significant decline in value; the significance of the decline; and the analysis of specific credit events. We evaluate the unrealized losses of our equity securities by issuer and determine if we can forecast a reasonable period of time by which the fair value of the securities would increase and we would recover our cost. If we are unable to forecast a reasonable period of time in which to recover the cost of our equity securities, we record an OTTI equivalent to the entire unrealized loss. For debt securities, we separate an OTTI into two components when there are credit-related losses associated with the impaired debt security for which we assert that we do not have the intent to sell the security, and it is more likely than not that we will not be required to sell the security before recovery of its cost basis. The amount of the OTTI related to a credit loss is recognized in earnings, and the amount of the OTTI related to other factors (e.g., interest rates, market conditions, etc.) is recorded as a component of other comprehensive income or loss. The amount of the credit loss of an impaired debt security is the difference between the amortized cost and the greater of (i) the present value of expected future cash flows and (ii) the fair value of the security. In instances where no credit loss exists but it is more likely than not that we will have to sell the debt security prior to the anticipated recovery, the decline in fair value below amortized cost is recognized as an OTTI in earnings. In periods after the recognition of an OTTI on debt securities, we account for such securities as if they had been purchased on the measurement date of the OTTI at an amortized cost basis equal to the previous amortized cost basis less the OTTI recognized in earnings. For debt securities for which OTTI was recognized in earnings, the difference between the new amortized cost basis and the cash flows expected to be collected will be accreted or amortized into net investment income. As of December 31, 2018, we did not identify any OTTIs. Recent accounting pronouncements Refer to “Significant accounting policies-Recent accounting pronouncements” in our consolidated financial statements. Financial condition, liquidity and capital resources General We are a holding company whose assets primarily consist of the shares in our subsidiaries. Generally, we depend on our available cash resources, dividends or other distributions from subsidiaries to make payments, including the payment of dividends on our preference shares and operating expenses we may incur. During the year ended December 31, 2018, we received dividends of $19.3 million, respectively, from Watford Re, our Bermuda operating subsidiary. The ability of our regulated operating subsidiaries to pay dividends or make distributions is dependent on their ability to meet applicable regulatory standards. Under Bermuda law, Watford Re is required to maintain an enhanced capital requirement, or ECR, which must equal or exceed its minimum solvency margin (in other words, the amount by which the value of its general business assets must exceed its general business liabilities). Watford Re is also required to maintain a minimum liquidity ratio whereby the value of its relevant assets is not less than 75% of the amount of its relevant liabilities for general business. Watford Re is prohibited from declaring or paying any dividends during any financial year if it is not in compliance with each of its ECR, minimum solvency margin and minimum liquidity ratio. In any financial year Watford Re is prohibited from declaring or paying dividends of more than 25% of its total statutory capital and surplus (as shown on its previous financial year’s statutory balance sheet) unless it files, at least seven days before payment of such dividends, with the BMA an affidavit attesting that a dividend would not cause the company to fail to meet its relevant margins. As of December 31, 2018, as determined under Bermuda law, Watford Re had a statutory capital and surplus of $1.1 billion and Watford was in compliance with its ECR, minimum solvency margin and minimum liquidity ratio. Accordingly, Watford Re should be permitted to pay dividends of up to $278.7 million to us during 2018 without the requirement of filing such an affidavit with the BMA. In addition, Watford Re is prohibited, without prior approval of the BMA, from reducing by 15% or more its total statutory capital, as set out in its previous year’s statutory financial statements. Our U.S. and Gibraltar insurance subsidiaries are subject to similar insurance laws and regulations in the jurisdictions in which they operate. The ability of these insurance subsidiaries to pay dividends or make distributions is also dependent on their ability to meet applicable regulatory standards. 76 Furthermore, the ability of our operating subsidiaries to pay dividends to us and to intermediate subsidiaries owned by us could be constrained by our dependence on financial strength ratings from independent rating agencies. Our ratings from these agencies depend to a large extent on the capitalization levels of our operating subsidiaries. We believe that we have sufficient cash resources and available dividend capacity to pay required dividends on our preference shares, service our indebtedness and satisfy other current outstanding obligations. Financial condition Shareholders’ equity 2018 versus 2017: Total shareholders’ equity was $889.6 million as of December 31, 2018, compared to $947.9 million as of December 31, 2017, a decrease of $58.3 million or 6.1%. The reduction in shareholders’ equity was primarily driven by an underwriting loss of $25.8 million, preferred dividends of $19.6 million, non- recurring direct listing expenses of $9.0 million, net investment loss of $6.3 million and unrealized losses in our available for sale investments of $5.2 million, offset in part by a foreign exchange gain of $3.6 million, other underwriting income of $2.7 million and reclassification of net realized gains included in net income of $1.0 million. 2017 versus 2016: Total shareholders’ equity was $947.9 million as of December 31, 2017, compared to $957.4 million as of December 31, 2016, a decrease of $9.5 million or 1.0%. The reduction in shareholders’ equity was driven by an underwriting loss of $66.6 million, preferred dividends of $19.6 million and a net foreign currency translation loss of $0.6 million, offset in part by net investment income of $72.7 million, other underwriting income of $3.2 million and a foreign exchange gain of $1.4 million. 77 Investment portfolios The table below summarizes the credit quality of our total investments as of December 31, 2018, 2017 and 2016, as rated by Standard & Poor’s Financial Services, LLC, or Standard & Poor’s, Moody’s Investors Service, or Moody’s, Fitch Ratings Inc., or Fitch, or KBRA, as applicable: December 31, 2018 Fair Value AAA AA A BBB BB B CCC CC C D Not Rated ($ in thousands) Term loan investments .................................... $1,000,652 $ — $ — $ — $ — $ 57,844 $677,211 $201,116 $ 2,438 $ — $ — $ 62,043 Credit Rating (1) Fixed maturities: Corporate bonds ........................................... 654,607 3,961 58,185 100,590 63,791 15,246 174,867 203,505 U.S. government and government agency bonds ....................................................... Asset-backed securities ................................. Mortgage-backed securities ......................... Non-U.S. government and government agency bonds .......................................... Municipal government and government agency bonds .......................................... 268,675 225,983 22,161 — 268,675 — — — — 4,532 4,973 10,278 113,075 36,643 20,818 — — 944 13,336 742 136,513 5,173 122,715 8,625 8,231 6,490 715 1,026 — — — — — — — — — — — — — — — — — — 2,200 — — — — — — — — 2,962 — — 32,262 — 35,664 4,177 — — Total fixed income instruments....................... 2,316,822 20,156 455,263 121,463 190,202 110,475 872,896 404,621 2,438 2,200 2,962 134,146 Short term investments ................................... 282,132 4,450 128,015 54,970 68,853 — 25,844 — — — — — Total fixed income instruments and short term investments ....................................... Other Investments ........................................... Equities ............................................................. 2,598,954 24,606 583,278 176,433 259,055 110,475 898,740 404,621 2,438 2,200 2,962 134,146 49,762 89,651 Total ................................................................. $2,738,367 $ 24,606 $583,278 $176,433 $259,055 $ 110,475 $898,740 $404,621 $ 2,438 $ 2,200 $ 2,962 $ 134,146 (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. 78 December 31, 2017 Fair Value (1) AAA AA A BBB BB B CCC CC D Not Rated ($ in thousands) Term loan investments .......................................... $ 877,818 $ — $ — $ 42,673 $ 68,556 $ 526,183 $ 131,743 $ 4,485 $ 4,324 $ 99,854 Credit Rating Fixed maturities: Corporate bonds ................................................. 715,891 9,263 63,651 131,605 43,657 57,037 157,702 194,409 U.S. government and government agency bonds ............................................................. Asset-backed securities ....................................... 231,019 101,147 9,290 14,676 12,201 — 216,343 3,003 — — 3,419 — Non-U.S. government and government agency bonds ............................................................. 104,205 2,785 95,514 5,906 Municipal government and government agency bonds ................................................ 15,481 Total fixed income instruments ............................ 2,054,851 13,721 52,646 1,265 495 379,776 141,425 Short-term investments ......................................... 323,883 366 224,176 767 — — — — — 86,330 70,149 — 15,353 — — — — 34,155 1,027 — — — — — — — — — — — — — 5,584 52,983 — — 6,682 — — — 33,016 1,581 — — 140,946 719,067 326,152 4,485 16,590 187,434 — 21,404 — — — 7,021 Total fixed income instruments and short-term investments ...................................................... 2,378,734 53,012 603,952 142,192 156,479 140,946 740,471 326,152 4,485 16,590 194,455 Other Investments ................................................. Equities .................................................................. 49,613 67,868 Total ....................................................................... $ 2,496,215 $ 53,012 $ 603,952 $ 142,192 $ 156,479 $ 140,946 $ 740,471 $ 326,152 $ 4,485 $ 16,590 $ 194,455 (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. 79 Credit Rating December 31, 2016 Fair Value (1) AAA AA A BBB BB B CCC D Not Rated ($ in thousands) Term loan investments ..................................... $ 813,621 $ — $ — $ — $ 15,024 $ 112,298 $ 321,078 $ 222,490 $ — $ 142,731 Fixed maturities: Corporate bonds ............................................ 486,102 860 3,629 5,942 13,150 53,970 107,603 266,938 9,733 24,277 U.S. government and government agency bonds ......................................................... Asset-backed securities .................................. Non-U.S. government and government agency bonds ............................................ Municipal government and government agency bonds ................................................. Total fixed income instruments ........................ Short term investments .................................... 196,942 30,324 15,452 — 196,942 — — — 15,452 — — — 4,313 429 2,576 1,546,754 1,289 218,599 1,039 6,981 — — — — — 9,940 — 3,195 — — — — — — — — — — — — — 17,189 — 269 28,174 176,208 431,876 489,428 9,733 184,466 374,480 — — 108,662 262,291 — — — — 3,527 Total fixed income instruments and short term investments .............................................. Other Investments ............................................ Equities ............................................................. 2,315 .................................................................. $ 1,923,549 Total 1,921,234 1,289 218,599 115,643 290,465 176,208 431,876 489,428 9,733 187,993 — $ 1,289 $ 218,599 $ 115,643 $ 290,465 $ 176,208 $ 431,876 $ 489,428 $ 9,733 $ 187,993 (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. 80 The amortized cost and fair value of our term loans, fixed maturities and short-term investments summarized by contractual maturity as of December 31, 2018, 2017 and 2016 were as follows: Amortized Cost Fair Value ($ in thousands) % of Fair Value December 31, 2018 Due in one year or less ...................................................................... $ Due after one year through five years ............................................. Due after five years through ten years ............................................ Due after ten years ............................................................................ Asset-backed securities ...................................................................... Mortgage-backed securities .............................................................. 22,161 Total ................................................................................................... $ 2,707,785 $ 2,598,954 300,554 $ 1,269,540 1,322,982 823,643 233,215 225,983 776,937 300,519 23,466 3,814 3,925 December 31, 2017 Due in one year or less ...................................................................... $ Due after one year through five years ............................................. Due after five years through ten years ............................................ Due after ten years ............................................................................ Asset-backed securities ...................................................................... Mortgage-backed securities .............................................................. 9,290 Total ................................................................................................... $ 2,379,655 $ 2,378,734 339,205 $ 1,197,346 1,193,733 718,766 100,105 721,973 101,147 339,358 12,861 11,372 13,233 December 31, 2016 Due in one year or less ...................................................................... $ Due after one year through five years ............................................. Due after five years through ten years ............................................ Due after ten years ............................................................................ Asset-backed securities ...................................................................... 30,324 Total ................................................................................................... $ 1,923,938 $ 1,921,234 447,137 $ 543,407 900,587 446,743 909,235 533,666 31,547 1,266 1,260 11.6% 48.8% 29.9% 0.1% 8.7% 0.9% 100.0% 14.3% 50.2% 30.3% 0.6% 4.2% 0.4% 100.0% 23.3% 47.3% 27.8% 0.1% 1.5% 100.0% Actual maturities may differ from contractual maturities because some borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Liquidity and capital resources Cash flows 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. 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, and dividends on our contingently-redeemable 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 81 subsequent reinsurance receipts, can be significant, so their timing can influence cash flows from operating activities in any given period. Sources of liquidity include cash flows from operations, financing arrangements, or routine sales of investments. The following table summarizes our cash flows from operating, investing, and financing activities for the years ended December 31, 2018, 2017 and 2016: Year Ended December 31, 2018 2017 2016 ($ in thousands) Cash and cash equivalents provided by (used for): Operating activities ...................................................................................... $ Investing activities ........................................................................................ Financing activities ....................................................................................... Effects of exchange rate changes on foreign currency ............................... Change in cash and cash equivalents ........................................................... $ 229,314 $ 292,225 $ 275,088 (345,307) 127,768 (2,749) (577,461) 262,307 2,539 (105,997) (195,647) (7,101) 9,026 $ (20,390) $ (33,657) Results 2018 versus 2017: • Cash provided by operating activities for the year ended December 31, 2018 decreased from the same period in 2017. We continued to generate significant operating cash inflows in both 2018 and 2017, primarily driven by our premium receipts exceeding the level of our paid claims, although to a lesser extent in 2018 than in 2017. • Cash used for investing activities for the year ended December 31, 2018 was lower than in the same period for 2017, as there was less cash provided by operating activities and financing activities to fund a net increase in our investment portfolios. • Cash provided by financing activities for the year ended December 31, 2018 was lower than in the same period for 2017, which primarily driven by a reduction in incremental borrowings used to purchase investments. Results 2017 versus 2016: • Cash provided by operating activities for the year ended December 31, 2017 increased from the same period in 2017. We continued to generate significant operating cash inflows in 2017 and 2016, primarily driven by our premium receipts significantly exceeding the level of our paid claims. • Cash used for investing activities for the year ended December 31, 2017 was higher than in the same period for 2017, as we used cash provided by operating activities and financing activities to fund a net increase in our investment portfolios. • Cash provided by financing activities for the year ended December 31, 2017 was primarily driven by an increase in revolving credit agreement borrowings used to purchase investments. Our investments in certain securities may be illiquid due to contractual provisions or investment market conditions. Changes in general economic conditions could have a material adverse effect on the value and liquidity of securities in our investment portfolios. If we require significant amounts of cash on short notice in excess of anticipated cash requirements, we may have difficulty selling these investments in a timely manner or may be forced to sell or otherwise liquidate them at unfavorable values. The primary goals of our asset liability management process are to satisfy insurance liabilities and maintain sufficient liquidity to cover fluctuations in projected liability cash flows, including payment of dividends on our preference shares and other debt service obligations. We do not explicitly implement an exact cash flow match in each period. However the substantial degree by which the fair value of our investment portfolios exceeds the expected present value of the net underwriting liabilities, as well as the ongoing cash flow from premiums and contractual principal and interest payments received from our investment portfolios, provide assurance of our ability to fund the payment of claims and to service our other outstanding obligations without having to sell securities at distressed prices. We believe that, generally, the combination of premium 82 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 contingently-redeemable preference shares we issued in our initial funding, we have arranged credit facilities to support our business operations. We believe that we hold sufficient capital to allow us to take advantage of market opportunities and to maintain our financial strength ratings, as well as to comply with all applicable statutory regulations. We monitor our capital adequacy on a regular basis and will seek to adjust our capital base (up or down) according to the needs of our business. As part of our capital management program, we may seek to raise additional capital or may seek to return capital to our shareholders through share repurchases, cash dividends or other methods (or a combination of such methods). Any such determination will be at the discretion of our board of directors and will be dependent upon our profits, financial requirements and other factors, including legal restrictions, rating agency requirements and such other factors as our board of directors deems relevant. Our board of directors has authorized a share repurchase program under which, following the listing of our common shares on the Nasdaq Global Select Market, we may repurchase up to $75 million of our outstanding common shares from time to time. Any such repurchases will be in accordance with applicable laws, our organizational documents and the applicable terms of our outstanding securities. In addition, we intend to allow our common shares to trade in an independent market for what we believe to be a reasonable period of time prior to commencing any share repurchases. In particular, in connection with the listing, we intend to use our reasonable efforts to keep the registration statement of which this prospectus forms a part effective for a period of 25 days after the effectiveness of the registration statement, and we do not intend to make any share repurchases while the registration statement is effective. There can be no assurance any share repurchases will occur. Other than pursuant to this share repurchase program, at the present time, we do not expect to repurchase common shares, declare or pay dividends on our common shares or otherwise return capital to our common shareholders for the foreseeable future. The following table summarizes our consolidated capital position: December 31, 2018 December 31, 2017 December 31, 2016 Amount % of Total Capital Amount % of Total Capital Amount % of Total Capital ($ in thousands) Preferred shares .................................... $ Shareholders’ equity ............................. 889,608 Total capital ........................................... $ 1,110,600 220,992 19.9% $ 220,622 18.9% $ 220,253 80.1% 947,882 81.1% 957,371 18.7% 81.3% 100.0% $ 1,168,504 100.0% $ 1,177,624 100.0% The future capital requirements of our business will depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses. Our ability to underwrite is largely dependent upon the quality of our claims paying and financial strength ratings as evaluated by independent rating agencies. In particular, we require (1) sufficient capital to maintain our financial strength ratings, as issued by ratings agencies, at a level considered necessary by management to enable our key operating subsidiaries to compete; (2) sufficient capital to enable our underwriting subsidiaries to meet the capital adequacy tests mandated by regulatory agencies in Bermuda, the United States and other key markets; and (3) sufficient letter of credit and other credit facilities to enable Watford Re to post regulatory and commercially required letters of credit and other forms of collateral that are necessary for it to write business. To the extent that our existing capital is insufficient to fund our future operating requirements or maintain such ratings, we may need to raise additional funds through financings or limit our growth. However, we can provide no assurance that, if needed, we would be able to obtain additional funds through financing on satisfactory terms or at all. Adverse developments in the financial markets, such as disruptions, uncertainty or volatility in the capital and credit markets may result in realized and unrealized capital losses that could have a material adverse effect on our results of operations, financial position and our businesses, and may also limit our access to capital required to operate our business. If we are not able to obtain adequate capital, our business, results of operations and financial condition could be adversely affected, which could include, among other things, the following possible outcomes: (1) 83 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. The holders of our 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 preference shares on or after June 30, 2019 at the original purchase price of $25.00 per share. Dividends on our preference shares currently accrue at a fixed rate of 8.5% per annum. On June 30, 2019, dividends on our preference shares begin accruing at a floating rate. See “Description of share capital-Preference shares-8½% cumulative redeemable preference shares-Redemption of preference shares.” We are currently evaluating our refinancing options in connection with our preference shares. In addition, pursuant to the terms of the preference shareholders agreement with the holders of our preference shares, if we have not consummated an initial public offering of our preference shares in the United States or a listing of our preference shares on a U.S. national securities exchange by March 31, 2019, we have agreed to annually make an offer repurchase up to 20% of the preference shares. See “Certain relationships and related party transactions-Preference shareholders agreement.” In addition to the capital provided by the sale of common shares and preference shares, we may depend on external sources of finance to support our underwriting activities, such as bank credit facilities providing loans and/or letters of credit. As 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. See also “Risk factors-Risks related to our company-A downgrade or withdrawal of our financial strength ratings by insurance rating agencies could adversely affect the volume and quality of business presented to us and could negatively impact our relationships with clients and the sales of our products.” 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. 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. 84 When this occurs, insurance prices tend to decline and policy terms and conditions become more favorable to the insured. Conversely, there are periods when there is not enough insurance capital in the market to meet insureds’ needs, leading to a “hard” market during which insurance prices generally rise and policy terms and conditions become more favorable to the insurer. The current insurance and reinsurance market environment is extremely competitive and reflects a prolonged period of low prices and continued pressure to broaden terms and conditions, although the 2017 and 2018 global catastrophe events seem to have partially dampened this downward pricing pressure. While the insurance and reinsurance market historically has been subject to pricing and capacity cycles, the overall market has not experienced true cyclicality in the period since the inception of our operations in 2014. Over the past several years, the industry has witnessed a gradual rate softening in response to a surplus of industry capital and a number of years of benign catastrophe activity; this market dynamic has led to reduced underwriting profitability. However, due to the hurricane, wildfire and earthquake activity over the past two years, pricing on certain product lines appears to be firming and becoming more attractive on a risk-adjusted basis. There have recently, however, been certain product lines that have experienced a favorable hardening, such as European motor insurance. The rates for these particular lines have been rising as a result of several years of higher than expected losses, as well as regulatory changes impacting loss costs. As rates and commensurate risk-adjusted returns have risen, we have increased our writings in those lines. Since the formation of WICE, we have grown our European motor insurance business. Gross premiums written generated by WICE for the years ended December 31, 2018, 2017 and 2016 were $181.7.0 million, $115.5 million and $57.5 million, respectively. The majority of such premiums relate to European motor insurance. In addition, certain “new” product lines, such as mortgage reinsurance (having historically been written by captive insurers allied with primary mortgage insurers or mortgage lenders), are now more widely available due to risk transfer programs initiated over the past few years by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. We believe the pricing for mortgage reinsurance is attractive on a risk-adjusted basis and have increased our writings as a result. We target a medium- to long-term, lower volatility underwriting portfolio with tightly managed natural catastrophe exposure in order to reduce the likelihood that our capital and/or liquidity position would be adversely affected by a catastrophe event. We seek to limit our modeled net 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 December 31, 2018 our largest modeled peak peril and zone net occurrence PML was 2.4%, respectively, of our total capital. Our conscious effort to limit our catastrophe exposure is designed to lower the volatility of our overall underwriting portfolio and to provide greater certainty as to future claims-related payout patterns and timing. Our casualty-focused underwriting portfolio’s payout pattern is slower than that of most competitors due to the longer tail lines of business we write, and that slower payout pattern provides us with the potential for greater investment income on those premiums. While we seek to limit our exposure to catastrophic events to a level with which we feel comfortable 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 85 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. See “Risk factors-Risks related to our insurance and reinsurance business.” Depending on business opportunities and the mix of business that may comprise our underwriting portfolio, we may seek to adjust our self-imposed limitations on PML for catastrophe-exposed business. Contractual obligations and commitments Letter of credit and revolving credit facilities On May 16, 2018, Watford Re renewed its letter of credit facility with Lloyds Bank Plc, New York Branch. The Lloyds facility amount is $100.0 million and was renewed through to May 16, 2019. The principal purpose of the Lloyds facility is to issue, as required, evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which we have entered into reinsurance arrangements to ensure that such counterparties are permitted to take credit for reinsurance obtained from us as required under insurance regulations in the United States. The amount of letters of credit issued is driven by, among other things, the timing and payment of catastrophe losses, loss development of existing reserves, the payment pattern of such reserves, the further expansion of our business and the loss experience of such business. When issued, the letters of credit are secured by certificates of deposit or cash. In addition, the Lloyds facility also requires the maintenance of certain covenants, with which we were in compliance as of December 31, 2018, 2017 and 2016. At such dates, we had approximately $68.9 million, $70.1 million and $65.9 million respectively, in outstanding letters of credit issued from the Lloyds facility, which were secured by certificates of deposit. These collateral amounts are reflected as short-term investments in our consolidated balance sheets. On November 30, 2017, Watford Re amended and restated its $800.0 million secured credit facility with Bank of America, N.A. through Watford Trust, which had originally been entered into in June 2015. Watford Re owns all of the beneficial interests of Watford Trust. The facility expires on November 30, 2021 and is backed by a portion of Watford Re’s non-investment grade portfolio which has been transferred to Watford Trust and which continues to be managed by HPS pursuant to an investment management agreement between HPS and Watford Trust. The purpose of the facility is to provide borrowing capacity, including for the purchase of loans, securities and other assets and to distribute cash or any such loans, securities or other assets to Watford Re. Pursuant to our credit agreement, the bank assigns borrowing or letter of credit capacity (or “advance rate”) for each eligible asset type held in the trust. Under our credit agreement, advance rates range from 100% for cash and 80% for certain first-lien loans to 40% for certain small-issue unsecured bonds. Borrowings on the facility may be made at LIBOR or an alternative base rate at our option, in either case plus an applicable margin. The applicable margin varies based on the applicable base rate and, in the case of LIBOR rate borrowings, the currency in which the borrowing is denominated. In addition, the facility allows for us to issue up to $400.0 million in evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which we have entered into reinsurance arrangements. We pay a fee on each letter of credit equal to the amount available to be drawn under such letter of credit multiplied by an applicable percentage. The applicable percentage varies based on the currency in which the letter of credit is denominated. 86 The borrowings and outstanding letters from credit from the Bank of America secured credit facility were as follows: December 31, 2018 2017 2016 ($ in thousands) Borrowings to purchase investments ........................................................ $ Borrowings to purchase collateral ............................................................. Total Borrowings ........................................................................................ Outstanding letters of credit ..................................................................... 148,194 $ 187,717 $ 256,650 307,487 455,681 52,533 253,416 441,133 43,913 — 256,650 186,563 The secured credit facility contains various affirmative and negative covenants. As of December 31, 2018, December 31, 2017, and December 31, 2016, Watford Re was in compliance with all covenants contained in the Bank of America secured credit facility. Custodian bank facility As of December 31, 2018, December 31, 2017 and December 31, 2016, we borrowed $238.2 million, $108.0 million and $2.2 million from our custodian bank to purchase U.S.-denominated securities. As of December 31, 2018, the total borrowed amount of $238.2 million included $2.0 million Swiss Francs, or CHF, ($2.0 million) to purchase CHF-denominated securities. We pay interest based on 3-month LIBOR plus a margin and the borrowed amount is payable upon demand. The foreign exchange gain or loss on revaluation on the borrowed Euro denominated funds is included as a component of foreign exchange gains (losses) included in the consolidated statements of net income (loss). The custodian bank requires us to hold cash and investments in deposit with, or in an investment account with respect to the borrowed funds. As at December 31, 2018, 2017 and 2016, we were required to hold $339.1 million, $150.5 million and $3.0 million, respectively, in such deposits and investment accounts. Master confirmation of total return swap transactions On August 13, 2018, Watford Re executed a Master Confirmation of Total Return Swap Transactions, or the Master TRS, with Credit Suisse International, or CSI, under the ISDA Master Agreement between Watford Re and CSI dated as of April 24, 2014. Under the Master TRS, we can from time to time execute total return swap transactions referencing loan obligations. The purpose of the Master TRS is to allow us to obtain leveraged exposure to loan obligations in a cash efficient manner. Since each transaction will be confirmed separately, the Master TRS is uncommitted and does not have a maximum facility size. Each confirmed transaction executed under the Master TRS will expire on the earlier of (i) the repayment date of the underlying reference loan or (ii) the date specified in the confirmation, which cannot be later than 360 days after the date of the confirmation, provided that each transaction will automatically extend for a further 360 days unless certain events have occurred. Under the terms of the Master TRS, we are required to post collateral to CSI under our ISDA Credit Support Annex with CSI to support our obligations under each transaction. The collateral will comprise an initial amount, determined on a transaction-by-transaction basis, plus an amount calculated on the basis of the daily mark-to-market value of the transaction. Under each transaction, CSI will pay to us an amount equal to the amounts received by a lender of the specified principal amount under the relevant reference loan and, if the transaction is terminated before the loan is repaid, an amount based on the change in market value of the loan. We have the option to terminate any transaction at will, subject to paying a break fee, and CSI can terminate transactions if certain events occur, including the unavailability of market prices for the relevant loan, CSI being unable to hedge the relevant transaction or certain changes of law or regulation. Pledged and restricted assets For the benefit of certain Arch entities and other third parties that cede business to us, we are required to post and maintain collateral to support our potential obligations under reinsurance contracts that we write. This collateral can be in the form of either investment assets held in collateral trust accounts or letters of credit. Under our credit facilities, in order for us to have the bank issue a letter of credit to our reinsurance contract counterparty, we must post investment assets or cash as collateral to the bank. In either case, the amounts remain restricted for the duration of the term of the trust or letter of credit, as applicable. See Note 87 15 - “Commitments and contingencies-Letter of credit and revolving credit facilities” to our audited consolidated financial statements included elsewhere in this prospectus for further details. As of December 31, 2018, 2017 and 2016, we held $2.4 billion, $2.0 billion and $1.6 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 $5.5 million, $6.0 million and $6.6 million, respectively, in deposits with U.S. regulatory authorities. The following table summarizes our assets pledged as collateral for credit and letter of credit facilities and total return swap transactions, assets held in trust for underwriting transactions and regulatory deposits as of December 31, 2018, 2017 and 2016: December 31, 2018 2017 2016 ($ in thousands) Total investments pledged for BAML credit facility .................................... $ Total investments pledged for custodian bank ........................................... Total investments pledged for Lloyds credit facility .................................... Total investments pledged for Master TRS .................................................. 917,837 $ 986,126 $ 933,833 339,139 68,853 36,336 150,480 70,149 — 3,007 65,926 — Total investments held in trust as collateral for underwriting transactions and regulatory deposits ..................................................... 988,872 795,472 549,116 Contractual obligations and commitments The following table illustrates our contractual obligations and commitments by due date as of December 31, 2018, 2017 and 2016: 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) December 31, 2018 Estimated gross payments for losses and loss adjustment expenses (1)................ $ 1,032,760 $ 238,291 $ 316,166 $ 172,955 $ 305,348 Revolving credit agreement borrowings (2) .......................................................... Operating lease obligations ..................... Total ........................................................... $ 1,727,998 $ December 31, 2017 693,917 1,321 693,917 283 — 566 — 472 — — 932,491 $ 316,732 $ 173,427 $ 305,348 Estimated gross payments for losses and loss adjustment expenses (1)................ $ 798,262 $ 178,688 $ 243,788 $ 133,205 $ 242,581 Revolving credit agreement borrowings (2) .......................................................... Operating lease obligations ..................... Total ........................................................... $ 1,349,284 $ December 31, 2016 549,165 1,857 549,165 323 — 646 — 646 — 242 728,176 $ 244,434 $ 133,851 $ 242,823 Estimated gross payments for losses and loss adjustment expenses (1)................ $ Revolving credit agreement borrowings (2) .......................................................... Operating lease obligations ..................... Total ........................................................... $ 510,809 $ 124,276 $ 155,213 $ 86,764 $ 144,556 258,861 258,861 2,180 771,850 $ 323 — 646 — 646 — 565 383,460 $ 155,859 $ 87,410 $ 145,121 (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). 88 (2) 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 December 31, 2018, 2017 and 2016 totaled $86.4 million, $42.8 million, and $24.4 million, respectively. 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. 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 We have foreign currency exposure related to non-U.S. dollar denominated contracts and policies. Of our gross premiums written from inception, $1.0 billion, or 39.0%, 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 December 31, 2018, 2017 and 2016, loss and loss adjustment expense reserves included $310.2 million, $231.2 million and $100.3 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 89 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 December 31, 2018, 2017 and 2016, our total net long exposure to foreign denominated investments represented 9.5%, 7.6% and 2.0% of our total investment portfolios of $2.7 billion, $2.5 billion and $1.9 billion, respectively. The following table summarizes the net impact that a 10% increase and decrease in the value of the U.S. dollar against select foreign currencies in which we have written contracts and policies would have had on the value of our shareholders’ equity as of December 31, 2018, 2017 and 2016: (U.S. dollars in thousands, except per share data) Assets, net of insurance liabilities, denominated in foreign currencies, excluding shareholders’ equity and derivatives ....... $ Shareholders’ equity denominated in foreign currencies (1).......... Net assets denominated in foreign currencies ................................. $ Pre-tax impact of a hypothetical 10% appreciation of the U.S. dollar against foreign currencies: December 31, 2018 2017 2016 65,674 $ 47,763 $ 20,799 (23,501) (25,708) (16,081) 42,173 $ 22,055 $ 4,718 Shareholders’ equity ....................................................................... $ Book value per common share ....................................................... $ (4,217) $ (2,206) $ (0.19) $ (0.10) $ (472) (0.02) Pre-tax impact of a hypothetical 10% decline of the U.S. dollar against foreign currencies: Shareholders’ equity ....................................................................... $ Book value per common share ....................................................... $ 4,217 $ 0.19 $ 2,206 $ 0.10 $ 472 0.02 (1) Represents capital contributions held in the foreign currency of WICE. 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. 90 The following table estimates the impact that a 50 basis point and 100 basis point increase or decrease in interest rates would have on the value of our non-investment grade and investment grade portfolios as of December 31, 2018, 2017 and 2016: (U.S. dollars in millions) -100 -50 0 +50 +100 Interest Rate Shift in Basis Points December 31, 2018 Total fair value .......................................... $ Change from base ..................................... Change in unrealized value ...................... $ December 31, 2017 Total fair value .......................................... $ Change from base ..................................... Change in unrealized value ...................... $ December 31, 2016 Total fair value .......................................... $ Change from base ..................................... Change in unrealized value ...................... $ Credit spread risk 2,778 1.5% 40 2,536 1.6% 40 1,945 1.1% 21 $ $ $ $ $ $ 2,758 0.7% 20 2,517 0.8% 21 1,934 0.5% 10 $ $ $ $ $ $ 2,738 $ 2,719 —% (0.7)% — $ (19) 2,496 $ 2,475 —% (0.8)% — $ (21) 1,924 $ 1,913 —% (0.6)% — $ (11) $ $ $ $ $ $ 2,700 (1.4)% (38) 2,454 (1.7)% (42) 1,902 (1.1)% (22) We invest in credit spread sensitive assets, primarily debt assets. We consider the effect of credit spread movements on the market value of our fixed maturity investments, short-term investments, and certain of our other investments and the corresponding change in market value. As credit spreads widen, the fair value of our fixed income investments falls, and the converse is also true. Based upon historical observations, there is a low probability that credit spreads would change in the same magnitude across asset classes, industries, credit ratings, jurisdictions, and individual instruments. Accordingly, the actual effect of credit spread movements may differ materially from the amounts set forth in the following tables. The following table summarizes the effect that an immediate, parallel shift in credit spreads in a static interest rate environment would have had on our portfolios as of December 31, 2018, 2017 and 2016: (U.S. dollars in millions) -50% -10% 0 +10% +50% Percentage Shift in Credit Spreads December 31, 2018 Total fair value ....................................... $ Change from base ................................. Change in unrealized value .................. $ December 31, 2017 Total fair value ....................................... $ Change from base ................................. Change in unrealized value .................. $ December 31, 2016 Total fair value ....................................... $ Change from base ................................. Change in unrealized value .................. $ 2,930 6.6% 192 2,722 9.1% 226 2,030 5.5% 106 $ $ $ $ $ $ 91 2,778 1.4% 40 2,532 1.4% 36 1,945 1.1% 21 $ $ $ $ $ $ 2,738 $ 2,698 —% (1.5)% — $ (40) 2,496 $ 2,462 —% (1.4)% — $ (34) 1,924 $ 1,903 —% (1.1)% — $ (21) $ $ $ $ $ $ 2,539 (7.8)% (199) 2,336 (6.4)% (160) 1,818 (5.5)% (106) Credit risk Underwriting contracts and policies We are exposed to credit risk from our clients relating to premiums receivable under our contracts and policies, and the possibility that counterparties may default on their obligations to us. The risk of counterparty default is partially mitigated by the fact that any amount owed to us from an insurance or reinsurance counterparty would be netted against any losses we would pay in the future. We monitor the collectability of these premiums on a regular basis. Investments Our investment strategy is to invest primarily in the debt obligations of non-investment grade corporate issuers. We rely upon our Investment Managers to invest our funds in debt instruments that provide an attractive risk-adjusted return, but the value we ultimately receive from these debt instruments is dependent upon the performance of the issuers of such obligations. In addition, the securities and cash in our investment portfolios are held with several custodians and prime brokers, subjecting us to the related credit risk from the possibility that one or more of them may default on their obligations to us. Our Investment Managers regularly monitor the concentration of credit risk with each broker and if necessary, transfer cash or securities among brokers to diversify and mitigate our credit risk. Liquidity risk Certain of our investments are, or may become, illiquid. Disruptions in the credit markets may materially affect the liquidity of certain investments including our Level 3 (non-quoted) assets, which as of December 31, 2018, 2017 and 2016, represented 6.0%, 5.6% and 5.0% of our total investments, respectively. If we require significant amounts of cash on short notice in excess of normal cash requirements, which could include the payment of claims expenses or to satisfy a requirement of rating agencies in a period of market illiquidity, certain of our investments may be difficult to sell in a timely manner and may have to be sold or otherwise liquidated for less than what may otherwise have been possible under normal market conditions. Political risk We are exposed to political risk to the extent that we underwrite business from entities located in foreign markets; we operate through subsidiaries located in Bermuda, the United States and Gibraltar, and to the extent that HPS or AIM trade securities or assets that are originated, listed, or traded in various U.S. and foreign markets. The governments in any of these jurisdictions could impose restrictions, regulations or other measures which may have a material impact on our investment strategy, the value of our investments and our underwriting operations. We do not currently write political risk coverage in our insurance or reinsurance contracts; however, changes in government law and regulation may impact our underwriting operations. 92 Item 5. Supplementary Financial Information The following table presents financial highlights: December 31, 2018 September 30, 2018 June 30, 2018 March 31, 2018 December 31, 2017 September 30, 2017 June 30, 2017 March 31, 2017 Three Months Ended Revenues Gross premiums written ...................................................................... $ Gross premiums ceded ......................................................................... Net premiums written ......................................................................... Change in unearned premiums........................................................... Net premiums earned .......................................................................... Other underwriting income (loss) ....................................................... Interest income .................................................................................... Investment management fees - related parties ................................. Borrowing and miscellaneous other investment expenses ............... Net interest income ............................................................................. Realized and unrealized gains (losses) on investments ..................... Investment performance fees - related parties .................................. Net investment income (loss) .............................................................. Total revenues ...................................................................................... Expenses Loss and loss adjustment expenses ..................................................... Acquisition expenses............................................................................ General and administrative expenses ................................................. Net foreign exchange gains (losses) ................................................... Non-recurring direct listing expenses ................................................. Total expenses ...................................................................................... Income (loss) before income taxes ...................................................... Income tax expense ............................................................................. Net income (loss) before preferred dividends.................................... Preferred dividends.............................................................................. Net income (loss) available to common shareholders ....................... $ 160,937 (28,577) 132,360 14,613 146,973 630 43,086 (4,390) (8,741) 29,955 (97,597) 6,558 (61,084) 86,519 (129,168) (34,428) (6,037) 1,764 (9,000) (176,869) (90,350) — (90,350) (4,909) (95,259) $ $ 185,033 (33,356) 151,677 (16,053) 135,624 703 38,704 (4,314) (6,993) 27,397 (3,617) (2,407) 21,373 157,700 (96,957) (33,778) (5,801) 2,582 — (133,954) 23,746 — 23,746 (4,909) 18,837 Earnings (loss) per share: Basic and diluted .................................................................................. $ (4.20) $ 0.83 Weighted average number of common shares used in the determination of earnings (loss) per share: $ $ $ 175,175 (34,589) 140,586 18,932 159,518 688 36,481 (4,156) (6,283) 26,042 (10,614) (1,602) 13,826 174,032 (117,141) (37,967) (5,416) 548 — (159,976) 14,056 (24) 14,032 (4,908) 9,124 0.41 $ $ $ 213,870 (34,318) 179,552 (42,805) 136,747 701 34,645 (4,146) (6,360) 24,139 (2,006) (2,597) 19,536 156,984 (97,989) (34,963) (5,057) (1,283) — (139,292) 17,692 (3) 17,689 (4,907) 12,782 0.56 $ $ $ 127,173 (11,872) 115,301 15,045 130,346 803 37,265 (6,455) (6,634) 24,176 (11,566) (3,853) 8,757 139,906 (116,790) (33,535) (4,727) 461 — (154,591) (14,685) — (14,685) (4,909) (19,594) $ $ 166,198 (12,471) 153,727 (25,098) 128,629 737 31,181 (5,316) (3,891) 21,974 2,510 (3,713) 20,771 150,137 (123,581) (34,835) (5,506) 567 — (163,355) (13,218) (21) (13,239) (4,909) (18,148) $ $ 152,813 (12,410) 140,403 10,351 150,754 824 26,746 (4,961) (3,449) 18,336 3,324 (3,271) 18,389 169,967 (110,621) (37,639) (5,960) (334) — (154,554) 15,413 — 15,413 (4,908) 10,505 (0.86) $ (0.80) $ 0.46 $ $ $ 154,120 (10,434) 143,686 (21,689) 121,997 816 30,271 (4,719) (3,515) 22,037 6,852 (4,068) 24,821 147,634 (85,410) (34,717) (4,981) 726 — (124,382) 23,252 — 23,252 (4,907) 18,345 0.81 Basic and diluted .................................................................................. 22,682,875 22,682,875 22,682,875 22,682,875 22,682,875 22,682,875 22,682,875 22,682,875 93 Item 6. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure Not applicable. 94 Item 7. Directors and Executive Officers The following table sets forth the names, ages as of December 31, 2018 and positions of the individuals who will serve as our directors and executive officers following the listing of our common shares on the Nasdaq Global Select Market. Name Executive Officers and Directors Age Title and Position John F. Rathgeber ................................................... Walter Harris ........................................................... Maamoun Rajeh ...................................................... Nicolas Papadopoulo .............................................. Garth Lorimer Turner .............................................. Deborah DeCotis ..................................................... Thomas Miller ......................................................... Elizabeth Gile .......................................................... Jonathan D. Levy ..................................................... Robert L. Hawley ..................................................... Laurence B. Richardson II ....................................... Alexandre J.M. Scherer ........................................... 64 67 48 56 52 66 62 63 43 49 60 51 Biographical information Chief Executive Officer and Director Chairman of the Board and Director Director Director Director Director Director Director President and Chief Risk Officer Chief Financial Officer Chief Operating Officer Chief Executive Officer, WSIC and WIC Biographical information on our directors and executive officers is set forth below. John Rathgeber, Chief Executive Officer and Director. Mr. Rathgeber has served as our Chief Executive Officer and as a director since January 2014. From October 2009 to January 2014, Mr. Rathgeber was Vice Chairman of the Arch Worldwide Reinsurance Group and Chairman of Arch Reinsurance Company. He served as President and Chief Executive Officer of Arch Reinsurance Company for eight years beginning with its formation in December 2001. Prior to joining Arch Reinsurance Company, Mr. Rathgeber was Executive Vice President of the Financial Solutions Business Unit of St. Paul Re, the reinsurance operation of the St. Paul Companies. From 1996 until 1998, he served as Senior Vice President in the Non-Traditional Underwriting Department of F&G Re Inc., the reinsurance operation of USF&G Corp., and from November 1992 until 1996, Mr. Rathgeber was Vice President of Non-Traditional reinsurance at F&G Re. Mr. Rathgeber started his career at Prudential Re, the reinsurance operation of The Prudential Insurance Company of America, in 1980 and worked there until 1992. During that time, he held various underwriting positions and was also a director in Prudential Re’s Actuarial Department. He is a former Chairman of the Reinsurance Association of America and currently serves on its board of directors. Mr. Rathgeber received a B.A. from Williams College. He is a Chartered Property and Casualty Underwriter, a Fellow of the Casualty Actuarial Society and a Member of the American Academy of Actuaries. We believe Mr. Rathgeber’s qualifications to serve on our board of directors include his many decades of insurance and reinsurance industry executive-level leadership and underwriting experience as well as his actuarial expertise. Walter Harris, Chairman of the Board and Director. Mr. Harris has served as our Chairman of the Board since March 2014. Since October 2014, Mr. Harris has been President and Chief Executive Officer of FOJP Service Corporation, a provider of insurance and risk management advisory services to major healthcare organizations, and President and Chief Executive Officer of Hospitals Insurance Company, Inc., a provider of medical professional liability insurance to physicians and hospitals. Before joining FOJP Service Corporation and Hospitals Insurance Company, Mr. Harris served as Senior Advisor and Vice Chairman Emeritus to Alliant Insurance Services, Inc., one of the largest insurance brokerage firms in the United States from December 2010 to May 2013. Prior to joining Alliant, he served as Chairman and Chief Executive Officer of T&H Group, one of the largest privately held insurance brokerage firms in the United States, from 1980 until its acquisition by Alliant in 2010. Mr. Harris has also served as an advisor to investors in insurance entities as well 95 as special counsel to several major insurance coverage litigations. He is currently a director of Loews Corp. and chairman of its audit committee. Mr. Harris received a B.A. from Stanford University, a J.D. from the University of California, Berkeley and an LLM in Taxation from the N.Y.U. School of Law. We believe Mr. Harris’s qualifications to serve on our board of directors include his extensive background in the insurance industry, substantial board experience and his broad strategic and operational leadership. Maamoun Rajeh, Director. Mr. Rajeh has served as our director since March 2018. Since October 2017, Mr. Rajeh has served as the Chairman and Executive Officer of Arch Worldwide Reinsurance Group. Prior to October 2017, Mr. Rajeh served as President and Chief Executive Officer of Arch Reinsurance Ltd since July 2014. Prior to July 2014, Mr. Rajeh served as President and Chief Executive Officer of Arch Reinsurance Europe Underwriting Limited since August 2012. Prior to August 2012, he served as Chief Underwriting Officer of Arch Reinsurance Ltd. since November 2005, which he had joined as an underwriter in 2001. Prior to joining Arch Reinsurance Ltd., Mr. Rajeh served as an Assistant Vice President at HartRe, a subsidiary of The Hartford Financial Services Group, Inc. Mr. Rajeh graduated from The Wharton School of Business of the University of Pennsylvania with a B.S. degree. He is also a Chartered Property Casualty Underwriter. We believe Mr. Rajeh’s qualifications to serve on our board of directors include his many years of executive- level reinsurance industry leadership and his deep reinsurance industry underwriting experience. Nicolas Papadopoulo, Director. Mr. Papadopoulo has served as our director since March 2014. Since October 2017, Mr. Papadopoulo has served as Chief Executive Officer of Arch Insurance Group, an officer position of Arch Capital Group Ltd. Prior to October 2017, Mr. Papadopoulo served as the Chief Executive Officer of Arch Reinsurance Group, also an officer position of Arch Capital Group Ltd. Prior to July 2014, Mr. Papadopoulo served as President and Chief Executive Officer of Arch Reinsurance Ltd. since November 2005. Prior to November 2005, Mr. Papadopoulo served as Chief Underwriting Officer of Arch Reinsurance Ltd. from October 2004. Mr. Papadopoulo joined Arch Reinsurance Ltd. in December 2001 as Senior Global Property Underwriter. Prior to joining Arch Reinsurance Ltd., he held various positions at Sorema N.A. Reinsurance Group, a U.S. subsidiary of Groupama S.A., a Paris-based global insurance group, from 1990, including Executive Vice President and Chief Underwriting Officer beginning in 1997. Prior to 1990, Mr. Papadopoulo was an insurance examiner with the Ministry of Finance, Insurance Department, in France. Mr. Papadopoulo graduated from École Polytechnique in France in 1986 and École Nationale de la Statistique et de l’Administration Économique in France with the French equivalent of a Ph.D. in 1989. He is also a member of the International Actuarial Association and a fellow at the French Actuarial Society. We believe Mr. Papadopoulo’s qualifications to serve on our board of directors include his many years of executive-level reinsurance industry leadership, his deep insurance and reinsurance industry underwriting experience as well as his actuarial expertise. Garth Lorimer Turner, Director. Mr. Lorimer Turner has served as our director since March 2014. Mr. Lorimer Turner currently serves as Co-Founder and Director of Cohort Limited, a Bermuda company founded in July 2012 which provides corporate management and consultancy services to offshore companies and funds and acts as a Trading Member of the Bermuda Stock Exchange. From August 2001 to July 2012, Mr. Lorimer Turner served as Managing Director of Jupiter Asset Management (Bermuda) Limited, a wholly-owned subsidiary of Jupiter Fund Management Plc, a leading U.K. fund management group listed on the London Stock Exchange with products that range from unit trusts to investment companies and offshore funds. Mr. Lorimer Turner received an LL.B. from the University of Southampton, England and Law Society Finals from the College of Law at Lancaster Gate in London. Mr. Lorimer Turner is a qualified lawyer in England & Wales and Hong Kong and a Bermuda qualified barrister and attorney. We believe Mr. Lorimer Turner’s qualifications to serve on our board of directors include his extensive experience in the investment and broader financial services industries and his general financial and business acumen, all of which have provided him with significant expertise relevant to our business model which combines insurance and reinsurance underwriting with an investment strategy designed to complement our target business mix. Deborah DeCotis, Director. Ms. DeCotis has served as our director since March 2017. Ms. DeCotis is a retired Morgan Stanley Managing Director. Currently she serves as director on both Allianz Global Investors Capital LLC - Multi-Fund Board and the PIMCO Closed-End Funds Board. Her prior professional experience also includes being a director and member of the Audit and Governance Committee for Armor Holdings, a manufacturer of military-grade safety equipment, and she served as Lead Director during the sale of Armor 96 to BAE. Prior to Armor she was an Executive Vice-President for Sotheby Holdings, Inc. Outside of the professional realm she is a member of Circle Financial Group and the Council of Foreign Relations. She also recently ended her term as a trustee on the board of Stanford University, where she previously served on the Advisory Council of Stanford Business School and was trustee and Chair of the Stanford Business School Trust where she was a recipient of the John W. Gardner Volunteer Leadership Award. In addition, Ms. DeCotis recently completed her ten year term as co-Chair of the Special Projects Committee at Memorial Sloane Kettering Hospital, having served on that Committee for 28 years. Ms. DeCotis holds a B.A. in Mathematics from Smith College and an M.B.A. from the Stanford Graduate School of Business, from which she graduated with distinction as a Miller Scholar. We believe Ms. DeCotis’ qualifications to serve on our board of directors includes her broad and deep senior- level experience in the financial services industry as well as her service on the boards of several well-known registered investment funds. Thomas Miller, Director. Mr. Miller has served as our director since May 2017. Mr. Miller retired from PricewaterhouseCoopers Bermuda in 2016, having been with the firm since 1984, where he served a wide variety of financial services and specifically insurance and reinsurance company clients. He became a partner of Coopers & Lybrand in 1991 and was managing partner of the firm at the time of the merger with Price Waterhouse in 1998 and was joint managing partner of the merged PwC firm until 2003. Mr. Miller lives in Bermuda and has served on the boards of a number of Bermuda organizations including the Bermuda Government’s Audit Committee and The Bermuda Institute of Chartered Accountants. Mr. Miller obtained his professional designation as a Chartered Accountant in 1981. He received his Bachelor of Commerce from Queen’s University, Kingston Ontario, and holds the professional designation of FCPA. We believe Mr. Miller’s qualifications to serve on our board of directors include his extensive experience and expertise in public accounting for public and private financial services companies as well as his general business acumen. Elizabeth Gile, Director. Ms. Gile has served as our director since September 2017. Ms. Gile retired from Deutsche Bank AG in 2005, where she served as Managing Director and Global Head of the Loan Exposure Management Group. She spent the first 24 years of her career at J.P. Morgan, where she was responsible for High Grade Credit Markets trading, Credit Portfolio Management, Corporate Lending and Credit Research in North America. She is currently a member of the Board of Directors of KeyCorp, a bank holding company, Deutsche Bank Trust Company of the Americas, a subsidiary of Deutsche Bank AG, and of various funds managed by BlueMountain Capital, a diversified alternative asset manager. She is the head of the Risk Committee at both KeyCorp and Deutsche Bank Trust Company of the Americas. Ms. Gile holds a Bachelor of Arts in Government and History from Dartmouth College, where she graduated Phi Beta Kappa, Summa Cum Laude. We believe Ms. Gile’s qualifications to serve on our board of directors include her broad and deep corporate credit lending, trading and research expertise gained through her many years of senior-level management experience in the financial services industry, as well as her service on the boards of several large banks for which she is also the head of the Risk Committee. Jonathan D. Levy, President and Chief Risk Officer. Mr. Levy has served as our President since February 2018 and our Chief Risk Officer since March 2014. Mr. Levy has over 20 years of insurance experience, most recently with Endurance Specialty Holdings Ltd., where he worked from July 2008 to March 2014, most recently serving as Senior Vice President and Chief Pricing Actuary of Global Insurance. His prior roles within Endurance include Chief Pricing Actuary of Bermuda Insurance, after joining Endurance in 2008 as its Corporate Actuary. Prior to Endurance, Mr. Levy was a Senior Consultant at Tillinghast (now Towers Watson) in Philadelphia where he provided consulting services for domestic and international insurers and reinsurers, as well as asbestos and pollution liability analyses for corporate and insurance clients. Prior to Tillinghast, Mr. Levy spent five years with ACE INA in Philadelphia, including three years in its run-off claims division, Brandywine Holdings. Mr. Levy holds an A.B. from Lafayette College. He is also a Fellow of the Casualty Actuarial Society and a member of the American Academy of Actuaries. Robert L. Hawley, Chief Financial Officer. Mr. Hawley has served as our Chief Financial Officer since July 2015. Mr. Hawley has over 20 years of professional experience in public accounting and reinsurance. Prior to joining our company, he held the position of Vice President, Corporate Treasury Manager at XL Group Ltd. from January 2010 to July 2014. At XL Group Ltd., he was responsible for capital and collateral management, including debt capital market and credit facility transactions. From 2006 to 2009, Mr. Hawley worked at 97 RenaissanceRe Holdings Ltd., Bermuda, as the Assistant Treasurer where his role included treasury, rating agency and investor relations management. From 2002 to 2006, he worked as Assistant Vice President, Account Executive at Marsh & McLennan Companies Inc., Bermuda and was responsible for management of several Fortune 500 captive insurance companies. Prior to that, Mr. Hawley was a Corporate Advisory Services Manager at KPMG LLP, London, Canada, from 1995 to 2002. Mr. Hawley is a Chartered Professional Accountant, Chartered Accountant and a member of the Chartered Professional Accountants of Ontario, Canada. Mr. Hawley received an Advanced Business Accounting Diploma from Fanshawe College, Ontario, Canada. Laurence B. Richardson, II, Chief Operating Officer. Mr. Richardson has served as our chief operating officer since January 2017. From March 2012 to January 2017, he held the position of Senior Vice President-Capital Markets at Arch Capital Group Ltd., where he primarily focused on convergence transactions through which reinsurance risk is transferred to capital markets investors. In such capacity, Mr. Richardson was involved in the formation and launch of our company. Mr. Richardson was seconded to our company by Arch Capital Group Ltd. from July 1, 2016 to January 3, 2017. Prior to joining Arch Capital Group Ltd., Mr. Richardson held the position of Senior Vice President in the Ventures Group at RenaissanceRe, which develops and structures non-traditional reinsurance products, makes strategic investments and creates and manages RenaissanceRe’s joint ventures and other managed vehicles, including Top Layer Re, DaVinci Re, Timicuan Re, Starbound Re-I, Starbound Re-II and Channel Re. Mr. Richardson had joined RenaissanceRe in mid-2001. Prior to joining RenaissanceRe, Mr. Richardson was an investment banker with over 15 years of experience in the structured products and securitization arena, having been employed at a number of nationally recognized Wall Street firms, including the investment banks of E. F. Hutton & Co., Donaldson, Lufkin & Jenrette Securities Corporation, and Alex Brown & Sons, Incorporated and prior thereto was an attorney with the law firm Thacher, Proffitt & Wood LLP. Mr. Richardson graduated from the University of Virginia with both a B.S. degree from the McIntire School of Commerce and a J.D. degree from the School of Law. Alexandre J.M. Scherer, Chief Executive Officer of WSIC and WIC. Alexandre Scherer is the head of our U.S. insurance operations and has served as the President and Chief Executive Officer of WSIC and WIC since September 2015 and August 2016, respectively. Mr. Scherer has over 26 years of experience in the insurance and reinsurance industry, including 11 years with AXA Insurance Company, a subsidiary of AXA S.A., of which he served eight years as President, Chief Executive Officer and director, as well as three years as Executive Vice President and Chief Operating Officer. Mr. Scherer also served as President and Chief Executive Officer, as well as Executive Vice President and Chief Operating Officer, of AXA Liabilities Managers, Inc., a subsidiary of AXA S.A. specializing in non-life insurance and reinsurance legacy business acquisition and management. Prior to that, he served as Vice President, Alternative Risk Transfer Underwriter, as well as Risk Manager, at AXA Reinsurance Company. Mr. Scherer also served as Second Vice President of Sorema North America and Underwriter and Head of Alternative Risk Transfer of Sorema SA. Mr. Scherer holds a degree of Diplome d’Ingenieur from École Centrale Paris in France. He is a Qualified Actuary from the French Actuaries Institute (France) and a Member of the American Academy of Actuaries. 98 Item 8. Consolidated Financial Statements Report of Independent Registered Public Accounting Firm ....................................................................... Consolidated Balance Sheets as of December 31, 2018, 2017 and 2016 .................................................... Consolidated Statements of Income (Loss) for the Years Ended December 31, 2018, 2017 and 2016 ...... Consolidated Statements of Comprehensive Income (Loss) for the Years Ended December 31, 2018, 2017 and 2016 .............................................................................................................................................. Consolidated Statements of Changes in Shareholders’ Equity for the Years Ended December 31, 2018, 2017 and 2016 .............................................................................................................................................. Consolidated Statements of Cash Flows for the Years Ended December 31, 2018, 2017 and 2016 .......... Notes to the Consolidated Financial Statements ........................................................................................ Page 100 101 102 103 104 105 106 99 Report of Independent Registered Public Accounting Firm To the Board of Directors and Shareholders of Watford Holdings Ltd. Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Watford Holdings Ltd. and its subsidiaries (“the Company”) as of December 31, 2018, 2017 and 2016, and the related consolidated statements of income (loss) and comprehensive income (loss), of changes in shareholders’ equity and of cash flows for each of the three years in the period ended December 31, 2018, including the related notes and financial statement schedules listed in the accompanying index (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2018, 2017 and 2016, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2018 in conformity with accounting principles generally accepted in the United States of America. Basis for Opinion These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits of these consolidated financial statements in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion. /s/ PricewaterhouseCoopers Ltd. Hamilton, Bermuda March 5, 2019 We have served as the Company’s auditor since 2014. 100 WATFORD HOLDINGS LTD. CONSOLIDATED BALANCE SHEETS (U.S. dollars in thousands, except share data) Assets Investments: Term loans, fair value option (Amortized cost: $1,055,664, $879,010 and $804,521) ................................................................ $ Fixed maturities, fair value option (Amortized cost: $972,653, $1,176,982 and $745,148) ............................................................. Short-term investments, fair value option (Cost: $281,959, $323,663 and $374,269) (1) ........................................................... Equity securities, fair value option ..................................................... Other investments, fair value option (1) ............................................ 2018 December 31, 2017 2016 1,000,652 $ 877,818 $ 813,621 922,819 1,177,033 282,132 56,638 49,762 323,883 67,868 49,613 733,133 374,480 2,315 — Investments, fair value option ......................................................... 2,312,003 2,496,215 1,923,549 Fixed maturities, available for sale (Amortized cost: $397,509, $Nil and $Nil) ........................................................................................ Equity securities, fair value through net income ............................... Total investments .............................................................................. Cash and cash equivalents .................................................................. Accrued investment income ............................................................... Premiums receivable (1) ...................................................................... Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses (1) ............................................................... Prepaid reinsurance premiums (1) ...................................................... Deferred acquisition costs, net (1) ...................................................... Receivable for securities sold .............................................................. Intangible assets .................................................................................. Funds held by reinsurers (1) ................................................................ Other assets ......................................................................................... 393,351 33,013 2,738,367 63,529 19,461 227,301 86,445 61,587 80,858 24,507 7,650 44,830 18,321 Total assets ........................................................................................ $ 3,372,856 Liabilities Reserve for losses and loss adjustment expenses (1) ......................... $ 1,032,760 $ $ Unearned premiums (1) ...................................................................... Losses payable (1) ................................................................................ Reinsurance balances payable (1) ....................................................... Payable for securities purchased ........................................................ Payable for securities sold short ......................................................... Revolving credit agreement borrowings ........................................... Amounts due to affiliates (1) .............................................................. Investment management and performance fees payable (1) ........... Other liabilities .................................................................................... 390,114 24,750 21,034 60,142 8,928 693,917 5,888 3,807 20,916 — — 2,496,215 54,503 18,261 177,492 42,777 24,762 85,961 36,374 7,650 45,196 25,392 3,014,583 798,262 330,644 35,805 18,424 42,501 34,375 549,165 4,484 21,036 11,383 $ $ — — 1,923,549 74,893 17,017 189,911 24,420 12,145 86,379 1,326 7,650 27,341 18,119 2,382,750 510,809 293,480 17,795 12,289 42,922 33,157 258,861 3,319 27,942 4,552 Total liabilities ................................................................................... $ 2,262,256 $ 1,846,079 $ 1,205,126 Commitments and contingencies Contingently redeemable preferred shares ....................................... Shareholders’ equity Common shares ($0.01 par; shares authorized: 120 million and 80 million; shares issued and outstanding: 22,682,875) ................... Additional paid-in capital ................................................................... Retained earnings (deficit) ................................................................. Accumulated other comprehensive income (loss) ............................. Total shareholders’ equity ................................................................ 220,992 220,622 220,253 227 895,386 (1,275) (4,730) 889,608 227 895,386 53,241 (972) 947,882 227 895,386 62,133 (375) 957,371 Total liabilities, contingently redeemable preferred shares and shareholders’ equity ................................................................... $ 3,372,856 $ 3,014,583 $ 2,382,750 (1) See Note 14 - “Transactions with related parties” for disclosure of related party amounts. 101 WATFORD HOLDINGS LTD. CONSOLIDATED STATEMENTS OF INCOME (LOSS) (U.S. dollars in thousands, except share and per share data) Year Ended December 31, 2018 2017 2016 Revenues Gross premiums written (1) .................................................... $ 735,015 $ 600,304 $ 535,094 Gross premiums ceded (1) ...................................................... (130,840) Net premiums written (1) ....................................................... 604,175 Change in unearned premiums (1) ........................................ (25,313) Net premiums earned (1)........................................................ 578,862 Other underwriting income (loss) .......................................... 2,722 Interest income ....................................................................... 152,916 Investment management fees - related parties (1)............... Borrowing and miscellaneous other investment expenses .. (17,006) (28,377) Net interest income ................................................................ 107,533 Realized and unrealized gains (losses) on investments ........ (113,834) Investment performance fees - related parties (1)................ Net investment income (loss) ................................................. (48) (6,349) Total revenues ......................................................................... 575,235 (47,187) 553,117 (21,391) 531,726 3,180 125,463 (21,451) (17,489) 86,523 1,120 (14,905) 72,738 607,644 (21,306) 513,788 (45,818) 467,970 3,746 122,378 (16,563) (15,997) 89,818 80,643 (24,065) 146,396 618,112 Expenses Loss and loss adjustment expenses (1) ................................... (441,255) Acquisition expenses (1) ......................................................... (141,136) General and administrative expenses (1) .............................. (22,311) Net foreign exchange gains (losses) ...................................... Non-recurring direct listing expenses ......................................... 3,611 (9,000) (436,402) (140,726) (21,174) 1,420 — (321,581) (136,733) (17,956) 4,893 — Total expenses ......................................................................... (610,091) (596,882) (471,377) Income (loss) before income taxes ......................................... (34,856) 10,762 146,735 Income tax expense ................................................................ Net income (loss) before preferred dividends....................... Preferred dividends................................................................. (27) (34,883) (19,633) (21) 10,741 (19,633) (1) 146,734 (19,634) Net income (loss) available to common shareholders .......... $ (54,516) $ (8,892) $ 127,100 Earnings (loss) per share: Basic and diluted ..................................................................... $ (2.40) $ (0.39) $ 5.60 Weighted average number of common shares used in the determination of earnings (loss) per share: Basic and diluted ..................................................................... 22,682,875 22,682,875 22,682,875 (1) See Note 14 - “Transactions with related parties” for disclosure of related party amounts. 102 WATFORD HOLDINGS LTD. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (U.S. dollars in thousands) Year Ended December 31, 2018 2017 2016 Net income (loss) available to common shareholders ................ $ (54,516) $ (8,892) $ 127,100 Other comprehensive income (loss) net of income tax: Available for sale investments: Unrealized holding gains (losses) arising during the year .... (5,204) Reclassification of net realized (gains) losses, net of income taxes, included in net income ................................... Foreign currency translation adjustments ............................... Other comprehensive income (loss) net of income tax .............. Comprehensive income (loss) ...................................................... 1,046 400 (3,758) (58,274) — — (597) (597) — — (77) (77) (9,489) 127,023 103 WATFORD HOLDINGS LTD. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (U.S. dollars in thousands) Year Ended December 31, 2018 2017 2016 Common shares Balance at beginning of year ............................................ $ Common shares issued ...................................................... Balance at end of year ....................................................... 227 $ 227 $ — 227 — 227 227 — 227 Additional paid-in capital Balance at beginning of year ............................................ Common shares issued, net ............................................... Balance at end of year ....................................................... 895,386 895,386 895,386 — — — 895,386 895,386 895,386 Accumulated other comprehensive income (loss) Balance at beginning of year ............................................ Unrealized holding gains (losses) of available for sale investments: Balance at beginning of year...................................... Unrealized holding gains (losses) of available for sale investments, net of reclassification adjustment . Balance at end of year ................................................ Currency translation adjustment: Balance at beginning of year...................................... Currency translation adjustment ................................ Balance at end of year ................................................ Balance at end of year ....................................................... (972) (375) (298) — (4,158) (4,158) (972) 400 (572) (4,730) — — — (375) (597) (972) (972) — — — (298) (77) (375) (375) Retained earnings (deficit) Balance at beginning of year ............................................ Net income (loss) before preferred dividends .................. Preferred share dividends paid and accrued .................... Balance at end of year ....................................................... Total shareholders’ equity ................................................. $ 53,241 (34,883) (19,633) (1,275) 62,133 10,741 (19,633) 53,241 (64,967) 146,734 (19,634) 62,133 889,608 $ 947,882 $ 957,371 104 WATFORD HOLDINGS LTD. CONSOLIDATED STATEMENTS OF CASH FLOWS (U.S. dollars in thousands) Operating Activities Net income (loss) before preferred dividends ......................................... $ (34,883) $ 10,741 $ 146,734 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Year Ended December 31, 2018 2017 2016 Net realized and unrealized (gains) losses on investments ................. Amortization of fixed assets .................................................................. Changes in: Accrued investment income ............................................................... Premiums receivable ........................................................................... Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses ..................................................................... Prepaid reinsurance premiums ........................................................... Deferred acquisition costs, net ........................................................... Reserve for losses and loss adjustment expenses ............................... Unearned premiums ........................................................................... Reinsurance balances payable ............................................................ Funds held with reinsurers .................................................................. Other liabilities .................................................................................... Other items .......................................................................................... Net Cash Provided By Operating Activities ........................................ Investing Activities Purchase of term loans ............................................................................. Purchase of fixed maturity investments .................................................. Purchase of other investments ................................................................. Purchase of short-term investments with maturities over three months ...................................................................................................... Proceeds from sale, redemptions and maturity of term loans ............... Proceeds from sales, redemptions and maturities of fixed maturity investments ......................................................................................... Purchases of equity securities .................................................................. Proceeds from sales of equity securities .................................................. Net (purchases) sales of short-term investments with maturities less than three months .................................................................................... Net settlements of derivative instruments .............................................. Purchase of business, net of cash acquired ............................................. Purchases of furniture, equipment and other assets .............................. Net Cash Used For Investing Activities ............................................... Financing Activities Dividends paid on redeemable preferred shares .................................... Repayments on borrowings ..................................................................... Proceeds from borrowings ....................................................................... Borrowings issuance costs ........................................................................ Net Cash Provided By (Used For) Financing Activities ....................... Effects of exchange rate changes on foreign currency cash .................. Increase (decrease) in cash ....................................................................... Cash and cash equivalents, beginning of year ........................................ Cash and cash equivalents, end of year ................................................... $ Supplementary information Income taxes paid ..................................................................................... $ Interest paid .............................................................................................. $ 105 120,915 157 (1,212) (58,700) (42,822) (36,825) 5,709 257,479 62,138 3,847 (5,219) (24,021) (17,249) 229,314 (4,977) 187 (1,237) 18,923 (18,023) (11,716) 950 272,295 33,106 5,367 (17,855) 18,051 (13,587) 292,225 (774,570) (1,286,151) — (25,876) 633,923 (827,757) (1,579,591) (50,000) — 731,679 1,062,966 1,162,210 (122,766) 95,371 70,165 1,642 — (11) (345,307) (19,264) (201,401) 348,433 — 127,768 (2,749) 9,026 54,503 63,529 27 26,717 $ $ $ (71,562) 8,486 50,829 (1,734) — (21) (577,461) (19,264) (72,000) 359,238 (5,667) 262,307 2,539 (20,390) 74,893 54,503 21 15,719 $ $ $ (80,295) 199 2,232 (29,409) (10,297) (1,534) (11,480) 232,174 47,352 (1,196) (27,208) 36,149 (28,333) 275,088 (619,611) (1,058,200) — — 667,914 945,578 (1,274) — (14,311) (6,633) (19,451) (9) (105,997) (19,263) (222,384) 46,000 — (195,647) (7,101) (33,657) 108,550 74,893 1 13,795 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (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 term “Company” or “Companies” collectively refers to the Parent and/or, as applicable, its subsidiaries. In the first quarter of 2014, the Company raised approximately $1.1 billion of capital consisting of $907.3 million in common equity ($895.6 million net of issuance costs) and $226.6 million in preference equity ($219.2 million net of issuance costs and discount). Through its wholly-owned subsidiary, Arch Reinsurance Ltd. (“ARL”), Arch Capital Group Ltd. (“ACGL”) invested $100.0 million and acquired approximately 11% of the Company’s common equity and a warrant to purchase up to 975,503 of common shares. See Note 17 - “Shareholders’ equity” for further details. 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. In August 2016, the Company acquired Watford Insurance Company (“WIC”), domiciled in New Jersey. WIC is a wholly-owned subsidiary of Watford Specialty Insurance Company (“WSIC”). See Note 2 - “Business acquired” for further details. In May 2018, Watford Insurance Company Europe (“WICE”) formed a branch in Romania and commenced underwriting operations in June 2018. WICE is a wholly-owned subsidiary of Watford Re. Watford Re and 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 14 - “Transactions with related parties” for further details. WSIC and WIC 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 14 - “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, subject to the terms of the applicable investment management agreements. See Note 14 - “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 the assets in its investment grade portfolio pursuant to various investment management agreements. AIM manages the Company’s investment grade assets pursuant to the terms of the investment management agreements with AIM. See Note 14 - “Transactions with related parties” for further details. 106 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) 2. Business acquired In August 2016, the Company’s U.S.-based subsidiary, WSIC, acquired a previously-dormant insurance company that held admitted insurance licenses in all 50 states and the District of Columbia. The carrier was renamed “WIC” and was re-domesticated to New Jersey. WIC’s liabilities relating to pre-acquisition business are fully reinsured pursuant to a 100% quota share agreement with The Hanover Insurance Company (“Hanover”), which carries financial strength ratings of A/A/ A3 from A.M. Best Company (“A.M. Best”), Standard & Poor’s Financial Services, LLC and Moody’s Investors Service, respectively. Hanover will not have any liability for, or interest in, business written by WIC. WIC was purchased for approximately $19.5 million in cash. As part of the transaction, total assets purchased included investments of $11.8 million, insurance licenses of $7.7 million and unpaid losses and loss adjustment expenses recoverable of $8.9 million. The assets were offset by reserve for losses and loss adjustment expenses of $8.9 million. The licenses are disclosed as intangible assets at fair market value in the consolidated financial statements and have an indefinite useful life. 3. Significant accounting policies (a) Basis of presentation The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”). All significant intercompany transactions and balances have been eliminated in consolidation. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and assumptions. (b) Premium revenues and related expenses Reinsurance premiums written are recorded based on the type of contracts the Company writes. Premiums on the Company’s excess of loss and pro rata reinsurance contracts are estimated when the business is underwritten. For excess of loss contracts, premiums are recorded as written, on the inception date, based on the terms of the contract. Estimates of premiums written under pro rata contracts are recorded in the period in which the underlying risks are expected to incept and are based on information provided by the brokers and the ceding companies. For multi-year reinsurance treaties which are payable in annual installments, premium recognition depends on whether the contract is non-cancellable. If either party retains the ability to cancel or commute coverage prior to expiration, only the initial annual installment is included as premiums written at policy inception. The remaining annual installments would then be included as premiums written at each successive anniversary date within the multi-year term. If, on the other hand, the contract is non-cancellable, the full multi-year premiums would be recognized as written at policy inception. Reinsurance premiums written and assumed include amounts reported by brokers and ceding companies, supplemented by the Company’s own estimates of premiums where reports have not been received. The determination of premium estimates requires a review of the ceding companies, familiarity with each market, the timing of the reported information, an analysis and understanding of the characteristics of each line of business, and management’s judgment of the impact of various factors, including premium or loss trends, on the volume of business written and ceded to the Company. On an ongoing basis, the Company reviews the amounts reported by these third parties for reasonableness based on their experience and knowledge of the subject class of business. In addition, reinsurance contracts under which the Company assumes business generally contain specific provisions which allow the Company to perform audits of the ceding company to ensure compliance with the terms and conditions of the contract, including accurate and timely reporting of information. Based on a review of all available information, management establishes premium estimates where reports have not been received. Premium estimates are updated when new 107 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) information is received and differences between such estimates and actual amounts are recorded in the period in which estimates are changed or the actual amounts are determined. Adjustments to premium estimates could be material and such adjustments could directly and significantly impact earnings favorably or unfavorably in the period they are determined because the estimated premium may be fully or substantially earned. Reinstatement premiums are recognized at the time a loss event occurs, where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms. Reinstatement premiums, if obligatory, are fully earned when recognized. The accrual of reinstatement premiums is based on an estimate of losses and loss adjustment expenses, which reflects management’s judgment. Reinsurance premiums written, irrespective of the class of business, are generally earned on a pro rata basis over the term of the underlying policies or reinsurance contracts. Contracts and policies written on a “losses occurring” basis cover claims that may occur during the term of the contract or policy, which is typically 12 months. Accordingly, the premium is earned evenly over the term. Contracts which are written on a “risks attaching” basis cover claims which attach to the underlying insurance policies written during the terms of such contracts. Premiums earned on such contracts usually extend beyond the original term of the reinsurance contract, typically resulting in recognition of premiums earned over a 24-month period. Certain of the Company’s reinsurance contracts include provisions that adjust premiums or acquisition expenses based upon the experience under the contracts. Premiums written and earned, as well as related acquisition expenses are recorded based upon the projected experience under such contracts. 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. Deferred acquisition costs, which are based on the related unearned premiums, are carried at their estimated realizable value and take into account anticipated losses and loss adjustment expenses, based on historical and current experience, and anticipated investment income. A premium deficiency occurs if the sum of anticipated losses and loss adjustment expenses, unamortized acquisition costs and anticipated investment income exceed unearned premiums. A premium deficiency is recorded by charging any unamortized acquisition costs to expense to the extent required in order to eliminate the deficiency. If the premium deficiency exceeds unamortized acquisition costs then a liability is accrued for the excess deficiency. No premium deficiency charges were recorded by the Company during 2018, 2017 or 2016. (c) Retroactive Reinsurance Accounting Retroactive reinsurance reimburses a ceding company for liabilities incurred as a result of past insurable events covered by the underlying policies reinsured. For retroactive contracts that meet the established criteria for reinsurance accounting, written premiums are fully earned and corresponding losses and loss expense are recognized at inception. The initial gain, if applicable, is deferred and amortized into income over an actuarially determined expected payout period. Any future loss is recognized immediately and charged against earnings. The contracts can cause significant variances in gross premiums written, net premiums written, net premiums earned, and net incurred losses in the years in which they are written. Reinsurance contracts sold not meeting the established criteria for reinsurance accounting are recorded using the deposit method. In certain instances, reinsurance contracts cover losses both on a prospective basis and on a retroactive basis and, accordingly, the Company bifurcates the prospective and retrospective elements of these reinsurance contracts and accounts for each element separately where practical. 108 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) Underwriting income generated in connection with retroactive reinsurance contracts is deferred and amortized into income over the settlement period while losses are charged to income immediately. Subsequent changes in estimated or actual cash flows under such retroactive reinsurance contracts are accounted for by adjusting the previously deferred amount to the balance that would have existed had the revised estimate been available at the inception of the reinsurance transaction, with a corresponding charge or credit to income. (d) Reinsurance ceded The accompanying consolidated statements of income (loss) reflect premiums and losses and loss adjustment expenses and acquisition expenses, net of reinsurance ceded (see Note 5, “Reinsurance”). Ceded unearned premiums are reported as prepaid reinsurance premiums and estimated amounts of reinsurance recoverable on unpaid losses are reported as unpaid losses and loss adjustment expenses recoverable. Reinsurance premiums ceded and unpaid losses and loss adjustment expenses recoverable are estimated in a manner consistent with that of the original policies issued and the terms of the reinsurance contracts. If the reinsurers are unable to satisfy their obligations under the agreements, the Company would be liable for such defaulted amounts. Reinsurance ceding commissions are recognized as income on a pro rata basis over the period of risk. Reinsurance ceding commissions that represent a recovery of acquisition costs are recognized as a reduction to acquisition expenses while the remaining portion is deferred. (e) Cash and cash equivalents Cash includes cash equivalents, which are investments with original maturities of three months or less that are not managed by the external investment managers. Cash managed by the external investment managers is included in short-term investments. (f) Investments The Company has elected the fair value option for the majority of its long and short-term investments in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standard Codification (“ASC”) 825, Financial Instruments. As a result, the Company’s investments are reported at fair value with changes in fair value included in “realized and unrealized gain (loss) on investments” in the consolidated statements of income (loss). See Note 8 - “Investment information” for further information about the investment portfolios. The fair values of investments are based on quotations received from nationally recognized pricing services, or when such prices are not available, by reference to broker or underwriter bid indications. Short-term investments are comprised of securities due to mature within one year of the date of issue. Investment transactions are recorded on a trade date basis with balances pending settlement recorded separately in the consolidated balance sheets as receivable for securities sold or payable for securities purchased. See Note 9 - “Fair value” for further details. Beginning January 1, 2018, the Company elected to classify newly acquired debt investments in its investment grade portfolio as “available for sale.” Accordingly, they are carried at estimated fair value (also known as fair value) with the changes in fair value recorded as an unrealized gain or loss component of accumulated other comprehensive income in shareholders’ equity. The Company performs quarterly reviews of its investments to determine whether declines in fair value below the cost basis are considered other-than-temporary in accordance with applicable accounting guidance regarding the recognition and presentation of other-than-temporary impairment (“OTTI”). The process of determining whether a security is other-than-temporarily impaired requires judgment and involves analyzing many factors. These factors include (i) an analysis of the liquidity, business prospects and overall financial condition of the issuer, (ii) the time period in which there was a significant decline in value, (iii) the significance of the decline and (iv) the analysis of specific credit events. 109 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) When there are credit-related losses associated with debt securities for which the Company does not have an intent to sell and it is more likely than not that it will not be required to sell the security before recovery of its cost basis, the amount of the OTTI related to a credit loss is recognized in earnings and the amount of the OTTI related to other factors (e.g., interest rates, market conditions, etc.) is recorded as a component of other comprehensive income (loss). The amount of the credit loss of an impaired debt security is the difference between the amortized cost and the greater of (i) the present value of expected future cash flows and (ii) the fair value of the security. In instances where no credit loss exists but it is more likely than not that the Company will have to sell the debt security prior to the anticipated recovery, the decline in fair value below amortized cost is recognized as an OTTI in earnings. In periods after the recognition of an OTTI on debt securities, the Company accounts for such securities as if they had been purchased on the measurement date of the OTTI at an amortized cost basis equal to the previous amortized cost basis less the OTTI recognized in earnings. For debt securities for which OTTI were recognized in earnings, the difference between the new amortized cost basis and the cash flows expected to be collected will be accreted or amortized into net investment income. As of December 31, 2018, the Company had no investment losses considered as other-than-temporary. Investment gains or losses realized on the sale of investments are determined on a first-in, first-out basis and are reflected in net income. Unrealized appreciation or decline in the value of available for sale securities, which are carried at fair value, is excluded from net income and recorded as a separate component of accumulated other comprehensive income, net of applicable deferred income tax. Net interest income includes interest income together with amortization of market premiums and discounts, net of investment management fees, interest expense and custody fees. Anticipated prepayments and expected maturities are used in applying the interest method for certain investments, such as asset-backed securities. When actual prepayments differ significantly from anticipated prepayments, the effective yield is recalculated to reflect actual payments to date and anticipated future payments. The investment in such securities is adjusted to the amount that would have existed had the new effective yield been applied since the acquisition of the security. Such adjustments, if any, are included in interest income when determined. Investment gains or losses realized on the sale of investments are determined on a first-in, first-out basis and are reflected in “realized and unrealized gain (loss) on investments” in the consolidated statements of income (loss). Performance fees related to the non-investment grade portfolio (i) equal to 15% of income for periods prior to January 1, 2018 and (ii) for periods beginning January 1, 2018 equal to 10% of income plus an additional performance fee equal to 25% of any Excess Income (as defined in such 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, are reflected in “investment performance fees - related parties” in the consolidated statements of income (loss). See Note 8 - “Investment information” for further details. (g) Derivative instruments The Company recognizes all derivative financial instruments, including embedded derivative instruments, at fair value in the consolidated balance sheets. The Company’s investment and underwriting strategy allows for the use of derivative instruments to enhance investment performance, replicate investment positions or manage market exposures and duration risk that would be allowed under the Company’s investment guidelines if implemented in other ways. For such investment derivative instruments, changes in assets and liabilities measured at fair value are recorded as a component of “realized and unrealized gain (loss) on investments.” In addition, the Company’s derivative instruments include amounts related to underwriting activities where an insurance or reinsurance contract meets the accounting definition of a derivative instrument. For 110 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) such contracts, changes in fair value are reflected in “other underwriting income” in the consolidated statements of income (loss), as the underlying contract originates from the Company’s underwriting operations. See Note 11 - “Derivative instruments” for further details. (h) Reserves for losses and loss adjustment expenses The reserve for losses and loss adjustment expenses consists of estimates of unpaid reported losses and loss adjustment expenses and estimates for losses incurred but not reported. The reserve for unpaid reported losses and loss adjustment expenses, established by management based on reports from ceding companies and claims from insureds, represents the estimated ultimate cost of events or conditions that have been reported to or specifically identified by the Company. Such reserves are supplemented by management’s estimates of reserves for losses incurred for which reports or claims have not been received. The Company’s reserves are based on a combination of reserving methods, incorporating ceding company and industry loss development patterns. The Company selects the initial expected loss and loss adjustment expense ratios based on information derived by AUL and AUI managers during the initial pricing of the business, supplemented by industry data where appropriate. Such ratios consider, among other things, rate changes and changes in terms and conditions that have been observed in the market. The Company, in conjunction with data and analysis supplied by AUL and AUI, reviews the reserves regularly and, as experience develops and new information becomes known, the reserves are adjusted as necessary. Such adjustments, if any, are reflected in income in the period in which they are determined. Inherent in the estimates of ultimate losses and loss adjustment expenses are expected trends in claims severity and frequency and other factors which may vary significantly as claims are settled. Accordingly, ultimate losses and loss adjustment expenses may differ materially from the amounts recorded in the accompanying consolidated financial statements. Losses and loss adjustment expenses are recorded on an un- discounted basis. See Note 6 - “Reserve for losses and loss adjustment expenses” for further details. (i) Foreign exchange Monetary assets and liabilities, such as premiums receivable and the reserve for losses and loss adjustment expenses, denominated in foreign currencies are revalued at the exchange rate in effect at the balance sheet date with the resulting foreign exchange gains and losses included in net income. Accounts that are classified as non-monetary, such as deferred acquisition costs and the unearned premium reserves, are not subsequently re-measured. In the case of foreign currency- denominated cash and investments, the change in exchange rates between the local currency and the Company’s functional currency at each balance sheet date is included as a component of net foreign exchange gains and losses included in the consolidated statements of income (loss). Assets and liabilities of foreign operations whose functional currency is not the U.S. dollar are translated at the prevailing exchange rates at each balance sheet date. Revenues and expenses of such foreign operations are translated at average exchange rates during the year. The net effect of the translation adjustments for foreign operations is included in accumulated other comprehensive income. (j) Intangible assets The Company’s intangible assets with indefinite lives include licenses held by its U.S. insurance subsidiary which allow such subsidiary to write insurance business in various jurisdictions. These indefinite-lived intangible assets are carried at or below fair value and are tested annually for impairment, either qualitatively or quantitatively, and between annual tests if events or change in circumstances indicate that it is more likely than not that the asset is impaired. If intangible assets are impaired, such assets are written down to their fair values with the related expense recorded in the Company’s results of operations. 111 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) (k) Income taxes Deferred income taxes reflect the expected future tax consequences of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. A valuation allowance is recorded if it is more likely than not that some or all of a deferred tax asset may not be realized. The Company considers future taxable income and feasible tax planning strategies in assessing the need for a valuation allowance. In the event the Company determines that it will not be able to realize all or part of its deferred income tax assets in the future, an adjustment to the deferred income tax assets would be charged to income in the period in which such determination is made. In addition, if the Company subsequently assesses that the valuation allowance is no longer needed, a benefit would be recorded to income in the period in which such determination is made. See Note 13 - “Income taxes” for more information. 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. If the recognition threshold is met, the Company recognizes a tax benefit measured at the largest amount of the tax benefit that, in the Company’s judgment, is greater than 50% likely to be realized. The Company records related interest and penalties in income tax expense. (l) Warrants The Company issued certain warrant contracts to Arch and HPS in conjunction with the initial capitalization of the Company which may be settled by the Company using either the physical settlement or net-share settlement methods. In the event these warrants are exercised and settled, the fair value of these warrants would be recorded in equity as additional paid-in capital based on an option-pricing model (Black-Scholes) used to calculate the fair value of the warrants issued. (m) Earnings per share Basic earnings per share is calculated by dividing net income (loss) available to common shareholders by the weighted average number of common shares and participating securities outstanding during the period. The weighted average number of common shares excludes any dilutive effect of outstanding warrants, options and convertible securities, such as nonparticipating unvested restricted shares, if applicable. Diluted earnings per share are based on the weighted average number of common shares and share equivalents including any dilutive effects of warrants, options and other awards under stock plans, if applicable. U.S. GAAP requires that unvested stock awards that contain non-forfeitable rights to dividends or dividend equivalents, whether paid or unpaid (referred to as “participating securities”), be included in the number of shares outstanding for both basic and diluted earnings per share calculations. In the event of a net loss, the participating securities are excluded from the calculation of both basic and diluted loss per share. See Note 12 - “Earnings per common share” for more information. (n) Recent accounting pronouncements Issued and effective as of December 31, 2018 The FASB issued Accounting Standard Update 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”) in May 2014, and has updated it through various Accounting Standard Updates in 2016. This ASU (and as updated in 2016) creates a new comprehensive revenue recognition standard that will serve as a single source of revenue guidance for all companies in all industries. The guidance applies to all companies that either enter into contracts with customers to transfer goods or services, or enter into contracts for the transfer of non-financial assets, unless such contracts are within the scope of other standards, such as insurance contracts or financial instruments. The ASU also requires enhanced disclosures about revenue. The ASU is effective for financial statements issued for fiscal years beginning after December 15, 2017, and the Company 112 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) has adopted the ASU using the modified retrospective method, whereby the cumulative effect of adoption is recognized as an adjustment to retained earnings at the date of initial application. This ASU does not apply to premium revenues or revenues from its investment portfolio, which represent substantially all of the Company’s consolidated revenues. This ASU was adopted on January 1, 2018, and did not have a material impact on the Company’s consolidated financial statements. In January 2016, the FASB issued Accounting Standards Update 2016-01, Financial Instruments- Overall (Subtopic 825-10)-Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”). The new accounting guidance was issued to enhance the reporting model for financial instruments and to provide improved financial information to readers of the financial statements. Among other provisions focused on improving the recognition and measurement of financial instruments, the ASU requires that equity investments be measured at fair value on the balance sheet with changes in fair value reported in the income statement and that an exit price notion be used when measuring the fair value of financial instruments for disclosure purposes. The ASU also requires that an entity evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the entity’s other deferred tax assets. This ASU was adopted on January 1, 2018 and did not have a material impact on the Company’s financial position, cash flows, or comprehensive income. In August 2016, the FASB issued Accounting Standards Update 2016-15, Statement of Cash Flows (Topic 230), a Consensus of the FASB’s Emerging Issues Task Force (“ASU 2016-15”). ASU 2016-15 intended to reduce diversity in practice in how certain transactions are classified in the statement of cash flows. ASU 2016-15 is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. This ASU was adopted on January 1, 2018, and did not have a material impact on the Company’s consolidated statement of cash flows. In February 2018, the FASB issued Accounting Standards Update 2018-03, Technical Corrections and Improvements to Financial Instruments - Overall (Subtopic 825-10), Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2018-03”). ASU 2018-03 was issued to provide technical corrections and improvements related to ASU 2016-01, and added Topic 321, Investments - Equity Securities. ASU 2018-03 is effective for fiscal years beginning after December 31, 2017, and interim periods within those fiscal years beginning after June 15, 2018. This ASU was adopted on July 1, 2018, and did not have a material impact on the Company’s consolidated financial statements. In March 2018, the FASB issued Accounting Standards Update 2018-05, Income Taxes (Topic 740), Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118 (“ASU 2018-05”). ASU 2018-05 was issued to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available to complete the accounting for certain income tax effects of the Tax Cuts and Jobs Act. ASU 2018-05 is effective in the first quarter of 2018. This ASU was adopted on January 1, 2018, and did not have a material impact on the Company’s consolidated financial statements. Issued but not yet effective as of December 31, 2018 - Leases In February 2016, the FASB issued Accounting Standards Update 2016-02, Leases (“ASU 2016-02”). The new accounting guidance requires that the lessee recognize an asset and a liability for leases with a lease term greater than 12 months regardless of whether the lease is classified as operating or financing. Under current accounting, operating leases are not reflected in the balance sheet. In July 2018, the FASB issued Accounting Standards Update 2018-10, Codification Improvements to Topic 842, Leases (“ASU 2018-10”). ASU 2018-10 intends to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing transactions. 113 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) In July 2018, the FASB issued Accounting Standards Update 2018-11, Leases (Topic 842), Targeted Improvements (“ASU 2018-11”), which will ease implementation of the lease standard ASU 2016-02. The guidance provides an alternative transition method by which leases are recognized at the date of adoption. Entities that elect this transition option will still be required to adopt the new leases standard using the modified retrospective transition method required by the standard, but they will recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption rather than in the earliest period presented. The Company will adopt this alternative transition method when adopting the new lease standard as of January 1, 2019. This accounting guidance for leases is effective for the 2019 first quarter, though early application is permitted, and should be applied on a modified retrospective basis. The Company has assessed the impact of the implementation of these standard updates will have on its consolidated financial statements and disclosures, and does not believe such impact will be material. Issued but not yet effective as of December 31, 2018 In June 2016, the FASB issued Accounting Standards Update 2016-13, Financial Instruments - Credit Losses (Topic 326) (“ASU 2016-13”). The new accounting guidance introduces a new model for recognizing credit losses on financial instruments based on an estimate of current expected credit losses. ASU 2016-13 will be effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The Company is assessing the impact the implementation will have on its consolidated financial statements and disclosures, but does not believe such impact will be material. In August 2017, the FASB issued Accounting Standards Update 2017-12, Derivatives and Hedging (Topic 815), Targeted Improvements to Accounting for Hedging Activities (“ASU 2017-12”). ASU 2017-12 intends to improve the financial reporting of hedging relationships to better portray the economic results of an entity’s risk management activities in its financial statements. ASU 2017-12 is effective January 1, 2019. The Company is assessing the impact the implementation will have on its consolidated financial statements and disclosures, but does not believe such impact will be material. In February 2018, the FASB issued Accounting Standards Update 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220), Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income (“ASU 2018-02”). ASU 2018-02 permits companies to reclassify disproportionate tax effects in accumulated other comprehensive income caused by the Tax Cuts and Jobs Act of 2017 to retained earnings. ASU 2018-02 is effective for fiscal years beginning after December 31, 2018 and interim periods within those fiscal years. The Company is assessing the impact the implementation will have on its consolidated financial statements and disclosures, but does not believe such impact will be material. In August 2018, the FASB issued Accounting Standards Update 2018-13, Fair Value Measurement (Topic 820), Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurements (“ASU 2018-13”). ASU 2018-13 intends to modify the disclosure requirements on fair value measurements. The accounting guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Early adoption is permitted; removal or modification disclosures can be early adopted upon issuance of ASU 2018-13, and a delay of the adoption of additional disclosures is permitted until the effective date noted above. The Company is assessing the impact the implementation of this standard will have on its consolidated financial statements and disclosures. In November 2018, the FASB issued Accounting Standards Update 2018-19, Codification Improvements to Topic 326, Financial Instruments - Credit Losses (“ASU 2018-19”) which will clarify the implementation of ASU 2016-13. The guidance aligns the implementation date for non-public entities’ interim and annual financial statements, and clarifies the scope of the guidance in ASU 2016-13. ASU 2018-19 will be effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The Company is assessing the impact the implementation 114 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) will have on its consolidated financial statements and disclosures, but does not believe such impact will be material. 4. Segment information The Company reports results under one segment, which we refer to as our “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, net foreign exchange gains (losses), income tax expense and items related to the Company’s contingently redeemable preferred shares. 115 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) The following tables provide summary information regarding premiums written and earned by line of business and net premiums written by client location and underwriting location: Year Ended December 31, 2018 2017 2016 ($ in thousands) Gross premiums written: Casualty reinsurance .......................................................... $ Other specialty reinsurance ............................................... Property catastrophe reinsurance ..................................... Insurance programs and coinsurance ............................... Total .................................................................................... $ 274,661 $ 284,481 $ 331,127 196,170 10,424 253,760 169,100 12,740 133,983 125,404 11,756 66,807 735,015 $ 600,304 $ 535,094 Net premiums written: Casualty reinsurance .......................................................... $ Other specialty reinsurance ............................................... Property catastrophe reinsurance ..................................... Insurance programs and coinsurance ............................... Total .................................................................................... $ 273,048 $ 281,783 $ 329,149 181,096 10,193 139,838 155,666 12,455 103,213 117,267 11,463 55,909 604,175 $ 553,117 $ 513,788 Net premiums earned: Casualty reinsurance .......................................................... $ Other specialty reinsurance ............................................... Property catastrophe reinsurance ..................................... Insurance programs and coinsurance ............................... Total .................................................................................... $ 278,656 $ 308,526 $ 320,769 162,691 10,998 126,517 134,855 12,690 75,655 101,435 11,421 34,345 578,862 $ 531,726 $ 467,970 Net premiums written by client location: United States ...................................................................... $ Bermuda ............................................................................. Europe ................................................................................ Asia and Pacific .................................................................. Total .................................................................................... $ 290,437 $ 290,222 $ 352,519 44,578 265,267 3,893 56,740 197,952 8,203 56,682 102,004 2,583 604,175 $ 553,117 $ 513,788 Net premiums written by underwriting location: United States ...................................................................... $ Europe ................................................................................ Bermuda ............................................................................. Total .................................................................................... $ 49,800 $ 11,750 $ 91,635 462,740 91,463 449,904 5,714 50,195 457,879 604,175 $ 553,117 $ 513,788 5. Reinsurance Through reinsurance agreements with ARL and Arch Reinsurance Company (“ARC”), subsidiaries of ACGL and as well as other third-party reinsurance agreements, the Company cedes a portion of its 116 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) premiums. The effects of reinsurance on the Company’s written and earned premiums, losses and loss adjustment expenses were as follows: Premiums written Direct .................................................................................. $ Assumed ............................................................................. Ceded ................................................................................. Net ...................................................................................... $ Premiums earned Direct .................................................................................. $ Assumed ............................................................................. Ceded ................................................................................. Net ...................................................................................... $ Losses and loss adjustment expenses Direct .................................................................................. $ Assumed ............................................................................. Ceded ................................................................................. Net ...................................................................................... $ Year Ended December 31, 2018 2017 2016 ($ in thousands) 253,760 $ 133,983 $ 66,807 481,255 (130,840) 466,321 (47,187) 468,287 (21,306) 604,175 $ 553,117 $ 513,788 201,868 $ 96,125 $ 39,561 468,156 (91,162) 471,073 (35,472) 448,181 (19,772) 578,862 $ 531,726 $ 467,970 157,991 $ 71,679 $ 26,230 348,332 (65,068) 393,565 (28,842) 306,721 (11,370) 441,255 $ 436,402 $ 321,581 The Company monitors the financial condition of its reinsurers and attempts to place coverages only with financially sound carriers. At December 31, 2018, 2017 and 2016, a majority 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. 117 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) 6. 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 years ended December 31, 2018, 2017 and 2016: Year Ended December 31, 2018 2017 2016 ($ in thousands) Gross reserve for losses and loss adjustment expenses at beginning of year ......................................................... $ Unpaid losses and loss adjustment expenses recoverable .................................................................... Net reserve for losses and loss adjustment expenses at beginning of year ......................................................... 798,262 $ 510,809 $ 290,997 39,856 21,518 11,571 758,406 489,291 279,426 Net incurred losses and loss adjustment expenses relating to losses occurring in: Current year ....................................................................... Prior years ........................................................................... Total net losses and loss adjustment expenses................. 443,482 (2,227) 441,255 399,530 36,872 436,402 318,523 3,058 321,581 Foreign exchange gains (losses) ........................................ (23,962) 14,832 (12,360) Net paid losses and loss adjustment expenses relating to losses occurring in: Current year ....................................................................... Prior years ........................................................................... Total paid losses and loss adjustment expenses ............... (64,026) (160,180) (224,206) (70,423) (111,696) (182,119) (46,198) (53,158) (99,356) Net reserve for losses and loss adjustment expenses at end of year .................................................................... 951,493 758,406 489,291 Unpaid losses and loss adjustment expenses recoverable .................................................................... Gross reserve for losses and loss adjustment expenses at 81,267 39,856 21,518 end of year .................................................................... $ 1,032,760 $ 798,262 $ 510,809 During 2018, the Company recorded net favorable development on prior year loss reserves of $2.2 million. Net favorable development was experienced on property catastrophe losses of $5.9 million and other specialty reinsurance of $3.6 million. This favorable development was offset by adverse development on casualty reinsurance losses of $6.3 million and insurance losses of $0.9 million. During 2017, the Company recorded net unfavorable development on prior year loss reserves of $36.9 million. The net unfavorable prior year development was driven by casualty reinsurance and other specialty reinsurance contracts. Casualty reinsurance experienced net unfavorable development of $33.8 million primarily due to the U.K. Ministry of Justice’s reduction of the discount rate known as the “Ogden” rate and adverse development on certain large multi-line and professional liability contracts. The Ogden rate was reduced from 2.5% to negative 0.75%; the resulting claims development in 2017 was higher than expected. Other specialty reinsurance experienced net unfavorable development of $5.2 million primarily due to worse than expected emergence on nonstandard and U.K. motor quota share contracts. The 118 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) remaining lines had net favorable prior year development of $2.2 million due to better than expected emergence of reported losses. During 2016, the Company recorded estimated net unfavorable development on prior year loss reserves of $3.1 million, due to an increase in estimates for medium and short-tail lines. 7. Short duration contracts The Company is required by applicable insurance laws and regulations and U.S. GAAP to establish reserves for losses and loss adjustment expenses (“loss reserves”) that arise from the business it underwrites. Loss reserves are balance sheet liabilities representing estimates of future amounts required to pay losses and loss adjustment expenses for insured or reinsured events which have occurred at or before the balance sheet date. Loss reserves do not reflect contingency reserve allowances to account for future loss occurrences. Losses arising from future events will be estimated and recognized at the time the losses are incurred and could be substantial. Loss reserves are comprised of (1) case reserves for claims reported, (2) additional case reserves, or ACRs, and (3) IBNR reserves. Loss reserves are established to provide for loss adjustment expenses and represent the estimated expense of settling claims, including legal and other fees and the general expenses of administering the claims adjustment process. Periodically, adjustments to the reported or case reserves may be made as additional information regarding the claims is reported or payments are made. IBNR reserves are established to provide for incurred claims which have not yet been reported at the balance sheet date as well as to adjust for any projected variance in case reserving. Actuaries estimate ultimate losses and loss adjustment expenses using various generally accepted actuarial methods applied to known losses and other relevant information. Like case reserves, IBNR reserves are adjusted as additional information becomes known or payments are made. The process of estimating reserves involves a considerable degree of judgment by management and, as of any given date, is inherently uncertain. Ultimate losses and loss adjustment expenses are generally determined by extrapolation of claim emergence and settlement patterns observed in the past that can reasonably be expected to persist into the future. In forecasting ultimate losses and loss adjustment expenses with respect to any line of business, past experience with respect to that line of business is the primary resource, developed through both industry and company experience, but cannot be relied upon in isolation. Uncertainties in estimating ultimate losses and loss adjustment expenses are magnified by the time lag between when a claim actually occurs and when it is reported and settled. This time lag is sometimes referred to as the “claim-tail.” The claim-tail for most property coverages is typically short (usually several months up to a few years). The claim-tail for certain professional liability, executive assurance and health care coverages, which are generally written on a claims-made basis, is typically longer than property coverages but shorter than casualty lines. The claim-tail for liability/ casualty coverages, such as general liability, products liability, multiple peril coverage and workers’ compensation, may be especially long as claims are often reported and ultimately paid or settled years, or even decades, after the related loss events occur. During the claims reporting and settlement period, additional facts regarding coverages written in prior accident years, as well as about actual claims and trends, may become known and, as a result, management may adjust its reserves. If management determines that an adjustment is appropriate, the adjustment is recorded in the accounting period in which such determination is made in accordance with U.S. GAAP. Accordingly, if loss reserves need to be increased or decreased in the future from amounts currently established, future results of operations would be negatively or positively impacted, respectively. In addition, the inherent uncertainties of estimating such reserves are even greater for our reinsurance lines of business, due primarily to the following factors: (1) the claim-tail for reinsurers is generally longer because claims are first reported to the ceding company and then to the reinsurer through one or more intermediaries, (2) the reliance on premium estimates, where reports 119 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) have not been received from the ceding company, in the reserving process, (3) the potential for writing a number of reinsurance contracts with different ceding companies with the same exposure to a single loss event, (4) the diversity of loss development patterns among different types of reinsurance contracts, (5) the necessary reliance on the ceding companies for information regarding reported claims and (6) the differing reserving practices among ceding companies. In determining ultimate losses and loss adjustment expenses, the cost to indemnify claimants, provide needed legal defense and other services for insureds and administer the investigation and adjustment of claims are considered. These claim costs are influenced by many factors that change over time, such as expanded coverage definitions as a result of new court decisions, inflation in costs to repair or replace damaged property, inflation in the cost of medical services and legislated changes in statutory benefits, as well as by the particular, unique facts that pertain to each claim. As a result, the rate at which claims arose in the past and the costs to settle them may not always be representative of what will occur in the future. The factors influencing changes in claim costs are often difficult to isolate or quantify and developments in paid and incurred losses are frequently subject to multiple and conflicting interpretations. Changes in coverage terms or claims handling practices may also cause future experience and/or development patterns to vary from the past. A key objective of actuaries in developing estimates of ultimate losses and loss adjustment expenses, and resulting IBNR reserves, is to identify aberrations and systemic changes occurring within historical experience and accurately adjust for them so that the future can be projected reliably. Pricing actuaries devote considerable effort to understanding and analyzing a ceding company and program administrator’s operations and loss history during the underwriting of the business, using a combination of ceding company, program administrator, and industry statistics. Such statistics normally include historical premium and loss data by class of business, individual claim information for larger claims, distributions of insurance limits provided, loss reporting and payment patterns, and rate change history. Because of the factors previously discussed, this process requires the substantial use of informed judgment and is inherently uncertain. As mentioned above, there can be a considerable time lag from the time a claim is reported to a ceding company to the time it is reported to the reinsurer. The lag can be several years in some cases and may be attributed to a number of reasons; including the time it takes to investigate a claim, delays associated with the litigation process, the deterioration in a claimant’s physical condition many years after an accident occurs, the case reserving approach of the ceding company, etc. In the reserving process, the Company assumes that such lags are predictable, on average, over time and therefore the lags are contemplated in the loss reporting patterns used in their actuarial methods. This means that reserves for our reinsurance lines of business must rely on estimates for a longer period of time than for our insurance lines of business. Backlogs in the recording of assumed reinsurance can also complicate the accuracy of loss reserve estimation. As of December 31, 2018 there were no significant backlogs related to the processing of assumed reinsurance information for our reinsurance lines of business. Although loss reserves are initially determined based on underwriting and pricing analysis, we apply several generally accepted actuarial methods, as discussed below, on a quarterly basis. Each quarter, as part of the reserving process, actuaries at our operations reaffirm that the assumptions used in the reserving process continue to form a sound basis for projection of liabilities. If actual loss activity differs substantially from expectations based on historical information, an adjustment to loss reserves may be supported. Estimated loss reserves for more mature underwriting years are based more on actual loss activity and historical patterns than on the initial assumptions based on pricing indications. More recent underwriting years rely more heavily on internal pricing assumptions. We place more or less reliance on a particular actuarial method based on the facts and circumstances at the time the estimates of loss reserves are made. 120 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) These methods generally fall into one of the following categories or are hybrids of one or more of the following categories: • Expected loss methods: these methods are based on the assumption that ultimate losses vary proportionately with premiums. Expected loss and loss adjustment expense ratios are typically developed based upon the information derived by underwriters and actuaries during the initial pricing of the business, supplemented by industry data available from organizations, such as statistical bureaus and consulting firms, where appropriate. These ratios consider, among other things, rate changes and changes in terms and conditions that have been observed in the market. Expected loss methods are useful for estimating ultimate losses and loss adjustment expenses in the early years of long-tailed lines of business, when little or no paid or incurred loss information is available, and is commonly applied when limited loss experience exists for a company. • Historical incurred loss development methods: these methods assume that the ratio of losses in one period to losses in an earlier period will remain constant in the future. These methods use incurred losses (i.e., the sum of cumulative historical loss payments plus outstanding case reserves) over discrete periods of time to estimate future losses. Historical incurred loss development methods may be preferable to historical paid loss development methods because they explicitly take into account open cases and the claims adjusters’ evaluations of the cost to settle all known claims. However, historical incurred loss development methods necessarily assume that case reserving practices are consistently applied over time. Therefore, when there have been significant changes in how case reserves are established, using incurred loss data to project ultimate losses may be less reliable than other methods. • Historical paid loss development methods: these methods, like historical incurred loss development methods, assume that the ratio of losses in one period to losses in an earlier period will remain constant. These methods use historical loss payments over discrete periods of time to estimate future losses and necessarily assume that factors that have affected paid losses in the past, such as inflation or the effects of litigation, will remain constant in the future. Because historical paid loss development methods do not use incurred losses to estimate ultimate losses, they may be more reliable than the other methods that use incurred losses in situations where there are significant changes in how incurred losses are established by a company’s claims adjusters. However, historical paid loss development methods are more leveraged (meaning that small changes in payments have a larger impact on estimates of ultimate losses) than actuarial methods that use incurred losses because cumulative loss payments take much longer to equal the expected ultimate losses than cumulative incurred amounts. In addition, and for similar reasons, historical paid loss development methods are often slow to react to situations when new or different factors arise than those that have affected paid losses in the past. • Adjusted historical paid and incurred loss development methods: these methods take traditional historical paid and incurred loss development methods and adjust them for the estimated impact of changes from the past in factors such as inflation, the speed of claim payments or the adequacy of case reserves. Adjusted historical paid and incurred loss development methods are often more reliable methods of predicting ultimate losses in periods of significant change, provided the actuaries can develop methods to reasonably quantify the impact of changes. As such, these methods utilize more judgment than historical paid and incurred loss development methods. • Bornhuetter-Ferguson, or B-F, paid and incurred loss methods: these methods utilize actual paid and incurred losses and expected patterns of paid and incurred losses, taking the initial expected ultimate losses into account to determine an estimate of expected ultimate losses. The B-F paid and incurred loss methods are useful when there are few reported claims and a relatively less stable pattern of reported losses. • Additional analysis: other methodologies are often used in the reserving process for specific types of claims or events, such as catastrophic or other specific major events. These include vendor catastrophe models, which are typically used in the estimation of loss reserves at the early stage of 121 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) known catastrophic events before information has been reported to an insurer or reinsurer, and analysis of specific industry events, such as large lawsuits or claims. In the initial reserving process for short-tail lines, consisting of property catastrophe and other exposures, we rely on a combination of the reserving methods discussed above. For known catastrophic events, our reserving process also includes the usage of catastrophe models and a heavy reliance on analysis which includes ceding company inquiries and management judgment. The development of property losses may be unstable, especially where there is high catastrophic exposure, may be characterized by high severity, low frequency losses for excess and catastrophe- exposed business and may be highly correlated across contracts. As time passes, for a given underwriting year, additional weight is given to the paid and incurred B-F loss development methods and historical paid and incurred loss development methods in the reserving process. We make a number of key assumptions in reserving for short-tail lines, including that historical paid and reported development patterns are stable, catastrophe models provide useful information about our exposure to catastrophic events that have occurred and our underwriters’ judgment and guidance received from ceding companies as to potential loss exposures may be relied on. The expected loss ratios used in the initial reserving process for our property exposures will vary over time due to changes in pricing, reinsurance structure, estimates of catastrophe losses, terms and conditions and geographical distribution. As losses in property lines are reported relatively quickly, expected loss ratios are selected for the current underwriting year incorporating the experience for earlier underwriting years, adjusted for rate changes, inflation, changes in reinsurance programs, expectations about present and future market conditions and expected attritional losses based on modeling. Due to the short-tail nature of property business, reported loss experience emerges quickly and ultimate losses are known in a comparatively short period of time. In the initial reserving process for medium-tail and long-tail lines, consisting of casualty, other specialty, and other exposures, we primarily rely on the expected loss method. The development of medium-tail and long-tail business may be unstable, especially if there are high severity major events, with business written on an excess of loss basis typically having a longer tail than business written on a pro rata basis. As time passes, for a given exposure, additional weight is given to the paid and incurred B-F loss development methods and historical paid and incurred loss development methods in the reserving process. We make a number of key assumptions in reserving for medium- tail and long-tail lines, including that the pricing loss ratio is the best estimate of the ultimate loss ratio at the time the contract is entered into, historical paid and reported development patterns are stable and our claims personnel and underwriters analysis of our exposure to major events are assumed to be our best estimate of our exposure to the known claims on those events. The expected loss ratios used in initial reserving process for medium-tail and long-tail contracts will vary over time due to changes in pricing, terms and conditions and reinsurance structure. As the credibility of historical experience for earlier underwriting year’s increases, the experience from these underwriting years will be used in the actuarial analysis to determine future underwriting year expected loss ratios, adjusted for changes in pricing, loss trends, terms and conditions and reinsurance structure. Our reinsurance business receives reports of claims notices from ceding companies and record case reserves based upon the amount of reserves recommended by the ceding company. Case reserves on known events may be supplemented by ACRs, which are often estimated by our reinsurance operations’ claims personnel ahead of official notification from the ceding company, or when our reinsurance operations’ judgment regarding the size or severity of the known event differs from the ceding company. In certain instances, our reinsurance operations establish ACRs even when the ceding company does not report any liability on a known event. In addition, specific claim information reported by ceding companies or obtained through claim audits can alert our reinsurance operations to emerging trends such as changing legal interpretations of coverage and liability, claims from unexpected sources or classes of business, and significant changes in the frequency or severity of individual claims. 122 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) Our reinsurance business relies heavily on information reported by ceding companies, as discussed above. In order to determine the accuracy and completeness of such information, underwriters, actuaries, and claims personnel at our reinsurance operations often perform audits of ceding companies and regularly review information received from ceding companies for unusual or unexpected results. Material findings are usually discussed with the ceding companies. Our reinsurance operations sometimes encounter situations where they determine that a claim presentation from a ceding company is not in accordance with contract terms. In these situations, our reinsurance operations attempt to resolve the dispute with the ceding company. Most situations are resolved amicably and without the need for litigation or arbitration. However, in the infrequent situations where a resolution is not possible, our reinsurance operations will vigorously defend their position in such disputes. For our insurance programs and coinsurance line of business, Arch’s claim personnel, under our service arrangements, determine whether to establish a case reserve for the estimated amount of the ultimate settlement of individual claims. The estimate reflects the judgment of claims personnel based on general corporate reserving practices, the experience and knowledge of such personnel regarding the nature and value of the specific type of claim and, where appropriate, advice of counsel. We contract with a number of outside third-party administrators in the claims process who, in certain cases, have limited authority to establish case reserves. The work of these administrators is reviewed and monitored by such claims personnel. Our reserves for loss and loss adjustment expenses primarily relate to short-duration contracts with various characteristics (e.g. type of coverage, geography, claims duration). We have considered such information in determining the level of disaggregation for disclosures related to our short-duration contracts, as detailed in the table below: Level of disaggregation Included product lines Casualty reinsurance - pro rata Casualty reinsurance - excess of loss Other specialty reinsurance Executive assurance, medical malpractice liability, other professional liability, workers’ compensation, excess and umbrella liability and excess auto liability all written primarily on a treaty pro rata basis Executive assurance, medical malpractice liability, other professional liability, workers’ compensation, excess and umbrella liability and excess auto liability all written primarily on a treaty excess of loss basis Personal and commercial auto (other than excess auto liability), surety, accident and health, and workers compensation catastrophe written primarily on a treaty basis Property catastrophe reinsurance Property catastrophe reinsurance Insurance programs and coinsurance Primary and excess general liability, umbrella liability, professional liability, workers’ compensation, personal and commercial automobile, inland marine and property business with minimal catastrophe exposure written on a direct basis We have determined the following product lines to be insignificant for disclosure purposes: (i) mortgage reinsurance, (ii) marine and aviation reinsurance; (iii) other property reinsurance; and (iv) agriculture reinsurance. Such amounts are included as reconciling items. We do not include claim count information in our short duration triangles for reinsurance. A significant percentage of our reinsurance business is written on a proportional basis, for which individual loss information is typically unavailable. 123 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) For our insurance programs and coinsurance line of business, we generally consider a reported claim to be per claimant, and we include claims with nil or nominal payments and/or case reserves. We write the majority of our reinsurance contracts on an underwriting year basis and therefore may involve multiple accident years. Pursuant to customary cedant/reinsurer reporting requirements, the cedant reports premium for a given contract to us in total for the contract period, not separated by accident year. Similarly, for certain contract structures, the paid and outstanding losses will also be reported in total for the contract period, not by accident year. The short duration disclosure requires us to separately disclose paid losses, case reserves and IBNR losses by accident year, which necessitates an allocation of the underwriting year data between each of the applicable accident years. To separate reported losses by accident year we employ certain assumptions, which can lead to anomalies in the presentation of individual accident year results. The following tables present information on the short-duration contracts by line of business: Casualty reinsurance - Pro Rata ($000’s) Incurred losses and allocated loss adjustment expenses, net of reinsurance Year ended December 31, 2014 unaudited 2015 unaudited 2016 unaudited 2017 unaudited Accident year 2014 .................. $ 43,678 $ 43,014 $ 44,238 $ 45,822 $ 2015 .................. 2016 .................. 2017 .................. 2018 .................. 173,952 186,908 159,992 167,785 178,458 159,479 Total $ December 31, 2018 Total of IBNR liabilities plus expected development on reported claims 2018 48,647 $ 177,706 188,002 179,934 147,884 742,173 9,674 48,189 73,660 95,885 114,377 Cumulative paid losses and allocated loss adjustment expenses, net of reinsurance 2014 .................. $ 2015 .................. 2016 .................. 2017 .................. 2018 .................. 882 $ 6,866 $ 13,970 $ 20,722 $ 12,980 37,365 11,402 70,037 45,323 15,343 Liabilities for losses and loss adjustment expenses, net of reinsurance ..... $ Total 25,607 86,826 68,839 40,581 11,126 232,979 509,194 124 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) Casualty reinsurance - Excess of Loss ($000’s) Incurred losses and allocated loss adjustment expenses, net of reinsurance Year ended December 31, December 31, 2018 Total of IBNR liabilities plus expected development on reported claims Accident year 2014 .................. $ 2015 .................. 2016 .................. 2017 .................. 2018 .................. 2014 unaudited 2015 unaudited 2016 unaudited 2017 unaudited 2018 4,583 $ 5,541 $ 5,114 $ 11,193 $ 10,249 $ 27,016 28,108 37,231 35,475 41,230 44,024 36,986 47,900 35,207 68,301 Total $ 198,643 603 3,775 7,472 15,147 44,242 Cumulative paid losses and allocated loss adjustment expenses, net of reinsurance 2014 .................. $ 2015 .................. 2016 .................. 2017 .................. 2018 .................. — $ 2 $ 69 $ 645 $ 96 1,978 790 107 616 217 Total 1,296 6,845 2,581 968 154 11,844 Liabilities for losses and loss adjustment expenses, net of reinsurance ........... $ 186,799 Other specialty reinsurance ($000’s) Incurred losses and allocated loss adjustment expenses, net of reinsurance Year ended December 31, Accident year 2014.................. $ 2015.................. 2016.................. 2017.................. 2018.................. 2014 unaudited 2015 unaudited 2016 unaudited 2017 unaudited 2018 16,752 $ 17,130 $ 71,755 17,026 $ 73,150 66,286 17,474 $ 71,448 57,104 78,076 Total $ 306,477 Cumulative paid losses and allocated loss adjustment expenses, net of reinsurance 4,834 $ 12,445 $ 30,061 2014.................. $ 2015.................. 2016.................. 2017.................. 2018.................. 14,303 $ 49,160 25,275 Total 15,414 $ 16,804 58,101 38,313 29,560 67,222 45,383 55,015 18,954 203,378 Liabilities for losses and loss adjustment expenses, net of reinsurance ........... $ 103,099 125 December 31, 2018 Total of IBNR liabilities plus expected development on reported claims 935 17,907 $ 74,089 58,142 73,628 82,711 1,817 7,737 7,381 32,516 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) Property catastrophe reinsurance ($000’s) Incurred losses and allocated loss adjustment expenses, net of reinsurance Year ended December 31, December 31, 2018 Total of IBNR liabilities plus expected development on reported claims Accident year 2014 .................. $ 2015 .................. 2016 .................. 2017 .................. 2018 .................. 2014 unaudited 2015 unaudited 2016 unaudited 2017 unaudited 2018 1,517 $ 1,128 $ 4,645 816 $ 783 $ 660 $ 3,545 5,071 2,751 4,075 22,519 2,051 3,388 18,182 16,720 Total $ 41,001 27 88 208 685 1,498 Cumulative paid losses and allocated loss adjustment expenses, net of reinsurance 2014 .................. $ 2015 .................. 2016 .................. 2017 .................. 2018 .................. — $ 222 $ 546 $ 576 $ 377 1,358 1,914 6,615 804 1,004 Total 599 1,438 2,283 12,091 2,764 19,175 Liabilities for losses and loss adjustment expenses, net of reinsurance ........... $ 21,826 Insurance programs and coinsurance ($000’s except claim amount) Incurred losses and allocated loss adjustment expenses, net of reinsurance December 31, 2018 2014 unaudited Accident year 2014....... $ 2015....... 2016....... 2017....... 2018....... Year ended December 31, 2015 unaudited 2016 unaudited 2017 unaudited 2018 Total of IBNR liabilities plus expected development on reported claims — $ — $ — $ — $ — $ 993 993 25,325 1,116 25,029 57,974 1,124 26,600 56,942 98,353 Total $ 183,019 — 84 2,566 7,951 40,840 Cumulative number of reported claims — 774 31,550 54,997 46,507 — $ Cumulative paid losses and allocated loss adjustment expenses, net of reinsurance 2014....... $ 2015....... 2016....... 2017....... 2018....... 707 15,126 — $ 8 388 5,804 20,311 17,834 30,564 36,486 — $ — $ 824 — Liabilities for losses and loss adjustment expenses, net of reinsurance ...................................................................................... $ Total 88,185 94,834 126 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) The following table presents the average annual percentage payout of incurred losses and allocated loss adjustment expenses by age, net of reinsurance, as of December 31, 2018: Casualty reinsurance - pro rata ...................... Casualty reinsurance - excess of loss .............. Other specialty reinsurance ........................... Property catastrophe reinsurance.................. Insurance programs and coinsurance ............ Average annual percentage payout of incurred losses and loss adjustment expenses by age, net of reinsurance Year 1 4.7% 0.2% 30.2% 20.2% 21.2% Year 2 14.5% 1.3% 41.4% 27.9% 33.9% Year 3 15.2% 2.7% 11.5% 29.0% 23.9% Year 4 11.7% 9.4% 9.3% 4.3% 10.4% Year 5 10.0% 6.3% 7.8% 3.4% N/A For the year ended December 31, 2018, the Company did not make any significant changes in its methodologies or assumptions. The following table represents a reconciliation of the disclosures of net incurred and paid loss development tables to the reserve for losses and loss adjustment expenses at December 31, 2018: December 31, 2018 Net outstanding liabilities: Casualty reinsurance - pro rata ......................................................................................... $ Casualty reinsurance - excess of loss ................................................................................. Other specialty reinsurance .............................................................................................. Insurance programs and coinsurance ............................................................................... Property catastrophe reinsurance .................................................................................... Other short duration lines not included in disclosures (1) .............................................. Total for short duration lines ............................................................................................ ($ in thousands) Unpaid losses and loss adjustment expenses recoverable: .............................................. Insurance programs and coinsurance ............................................................................... Other specialty reinsurance .............................................................................................. Casualty reinsurance - pro rata ......................................................................................... Casualty reinsurance - excess of loss ................................................................................. Property catastrophe reinsurance .................................................................................... Other short duration lines not included in disclosures (1) .............................................. Total for short duration lines ............................................................................................ Unallocated claims adjustment expenses ......................................................................... 509,194 186,799 103,099 94,834 21,826 31,108 946,860 55,682 15,309 5,357 1,109 9 3,802 81,268 4,632 4,632 Reserve for losses and loss adjustment expenses ............................................................. $ 1,032,760 (1) Other short duration lines includes liabilities acquired in the purchase of WIC of $3.7 million, which are 100% reinsured pursuant to a 100% quota share agreement, and other miscellaneous items. 127 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) 8. Investment information Available for Sale Investments The following table summarizes the fair value of the Company’s securities classified as available for sale as at December 31, 2018: December 31, 2018 Fixed maturities: Cost or Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value ($ in thousands) U.S. government and government agency bonds $ 156,884 $ 672 $ (127) $ 157,429 Non-U.S. government and government agency bonds ................................................................ Corporate bonds .................................................... Asset-backed securities .......................................... Mortgage-backed securities .................................. Municipal government and government agency bonds ...................................................................... Total investments, available for sale ....................... $ 89,661 77,178 58,369 14,344 1,073 670 19 72 17 14 (2,859) (1,204) (1,351) (81) 87,472 75,993 57,090 14,280 — 1,087 397,509 $ 1,464 $ (5,622) $ 393,351 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 December 31, 2018 Fixed maturities: U.S. government and government agency bonds .... $ ($ in thousands) 66,422 $ (127) $ — $ — $ 66,422 $ (127) Non-U.S. government and government agency bonds ................................. Corporate bonds .................... Asset-backed securities .......... Mortgage-backed securities... 8,478 Total .......................................... $ 272,827 78,084 70,443 49,400 (2,859) (1,204) (1,351) (81) — — — — — — 78,084 70,443 8,478 (2,859) (1,204) (1,351) (81) $ (5,622) $ — $ — $ 223,427 $ (5,622) At December 31, 2018, 60 positions out of a total of 73 positions were in an unrealized loss position, however the unrealized loss was less than 10% for all positions. The decrease in value can be attributed to an increase in interest rates and unfavorable foreign exchange rates for the non-U.S. government agency bonds during the year ended December 31, 2018. The Company believes that such securities were temporarily impaired at December 31, 2018. 128 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (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 December 31, 2018 were as follows: Due after one year through five years ............................. $ Due after five years through ten years ............................. Asset-backed securities ...................................................... Mortgage-backed securities .............................................. Total investments, available for sale ................................. $ Fair Value Option and Fair Value Through Net Income December 31, 2018 Amortized Cost Estimated Fair Value % of Fair Value ($ in thousands) 278,443 $ 276,706 46,353 58,369 14,344 45,275 57,090 14,280 70.4% 11.5% 14.5% 3.6% 397,509 $ 393,351 100.0% The following table summarizes the fair value of the Company’s securities held as at December 31, 2018, 2017 and 2016, classified as fair value through net income or for which the fair value option was elected: December 31, 2018 Term loan investments ..................................... $ Fixed maturities: Cost or Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value ($ in thousands) 1,055,664 $ 767 $ (55,779) $ 1,000,652 Corporate bonds ............................................ 617,013 6,468 (44,867) 578,614 U.S. government and government agency bonds .............................................................. Asset-backed securities .................................. Mortgage-backed securities .......................... Non-U.S. government and government agency bonds ................................................. Municipal government and government agency bonds ................................................. Short term investments .................................... Other investments ............................................ Equities ............................................................. Investments, fair value option ......................... $ Fair Value Through Net Income: Equities, fair value through net income (1) .... 113,452 174,846 9,122 50,914 7,306 281,959 50,000 56,609 — 673 — 1 — 570 — (2,206) (6,626) (1,241) 111,246 168,893 7,881 (1,874) 49,041 (162) (397) (238) 7,144 282,132 49,762 56,638 5,136 (5,107) 2,416,885 $ 13,615 $ (118,497) $ 2,312,003 41,358 2,030 (10,375) 33,013 (1) Effective January 1, 2018, the Company adopted new accounting guidance for financial instruments (refer to Note 3, “Significant accounting policies”). As a result, equity securities acquired after January 1, 2018 are classified as fair value through net income and are shown separately above. 129 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) December 31, 2017 Term loan investments ..................................... $ Fixed maturities: Cost or Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value ($ in thousands) 879,010 $ 14,525 $ (15,717) $ 877,818 Corporate bonds ............................................ 713,393 21,719 (19,221) 715,891 U.S. government and government agency bonds .............................................................. Asset-backed securities .................................. Mortgage-backed securities .......................... Non-U.S. government and government agency bonds ................................................. Municipal government and government agency bonds ................................................. Short term investments .................................... Other investments ............................................ Equities ............................................................. Total .................................................................. $ December 31, 2016 Term loan investments ..................................... $ Fixed maturities: 233,810 100,105 11,372 102,687 15,615 323,663 50,000 63,461 3 2,329 — 1,538 1 220 — 6,825 (2,794) (1,287) (2,082) 231,019 101,147 9,290 (20) 104,205 (135) — (387) (2,418) 15,481 323,883 49,613 67,868 2,493,116 $ 47,160 $ (44,061) $ 2,496,215 Cost or Amortized Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value ($ in thousands) 804,521 $ 21,895 $ (12,795) $ 813,621 Corporate bonds ............................................ 494,639 19,741 (28,278) 486,102 U.S. government and government agency bonds .............................................................. Asset-backed securities .................................. Non-U.S. government and government agency bonds ................................................. Municipal government and government agency bonds ................................................. Short term investments .................................... Equities ............................................................. Total .................................................................. $ 199,262 31,547 15,363 4,337 374,269 1,274 50 227 89 8 222 1,041 (2,370) (1,450) — (32) (11) — 196,942 30,324 15,452 4,313 374,480 2,315 1,925,212 $ 43,273 $ (44,936) $ 1,923,549 130 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (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 December 31, 2018, 2017 and 2016 were as follows: December 31, 2018 Amortized Cost Estimated Fair Value % of Fair Value ($ in thousands) Due in one year or less ...................................................... $ Due after one year through five years ............................. Due after five years through ten years ............................. Due after ten years ............................................................ Asset-backed securities ...................................................... Mortgage-backed securities .............................................. 7,881 Total .................................................................................... $ 2,310,276 $ 2,205,603 300,554 $ 1,044,539 174,846 777,290 992,834 300,519 731,662 168,893 9,122 3,814 3,925 13.6% 45.0% 33.2% 0.2% 7.6% 0.4% 100.0% December 31, 2017 Amortized Cost Estimated Fair Value % of Fair Value ($ in thousands) Due in one year or less ...................................................... $ Due after one year through five years ............................. Due after five years through ten years ............................. Due after ten years ............................................................ Asset-backed securities ...................................................... Mortgage-backed securities .............................................. 9,290 Total .................................................................................... $ 2,379,655 $ 2,378,734 339,205 $ 1,193,733 1,197,346 100,105 718,766 101,147 339,358 721,973 12,861 11,372 13,233 14.3% 50.2% 30.3% 0.6% 4.2% 0.4% 100.0% December 31, 2016 Amortized Cost Estimated Fair Value % of Fair Value ($ in thousands) Due in one year or less ...................................................... $ Due after one year through five years ............................. Due after five years through ten years ............................. Due after ten years ............................................................ Asset-backed securities ...................................................... 30,324 Total .................................................................................... $ 1,923,938 $ 1,921,234 447,137 $ 543,407 900,587 533,666 446,743 909,235 31,547 1,260 1,266 23.3% 47.3% 27.8% 0.1% 1.5% 100.0% 131 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) The table below summarizes the credit quality of our total investments as of December 31, 2018, 2017 and 2016, as rated by Standard & Poor’s, Moody’s, Fitch, or KBRA as applicable: Credit Rating (1) December 31, 2018 Fair Value AAA AA A BBB BB B CCC CC C D Not Rated ($ in thousands) Term loan investments ............... $1,000,652 $ — $ — $ — $ — $ 57,844 $677,211 $201,116 $ 2,438 $ — $ — $ 62,043 Fixed maturities: Corporate bonds ...................... 654,607 3,961 58,185 100,590 63,791 15,246 174,867 203,505 U.S. government and government agency bonds 268,675 — 268,675 — — — — Asset-backed securities ............ 225,983 4,532 4,973 10,278 113,075 36,643 20,818 Mortgage-backed securities .... 22,161 — — 944 13,336 742 Non-U.S. government and government agency bonds 136,513 5,173 122,715 8,625 Municipal government and government agency bonds 8,231 6,490 715 1,026 — — — — — — — — — — — — — — — — — — 2,200 — — — — — — — — 2,962 — — 32,262 — 35,664 4,177 — — Total fixed income instruments . 2,316,822 20,156 455,263 121,463 190,202 110,475 872,896 404,621 2,438 2,200 2,962 134,146 Short term investments .............. 282,132 4,450 128,015 54,970 68,853 — 25,844 — — — — — Total fixed income instruments and short term investments . Other Investments ...................... Equities ....................................... 2,598,954 24,606 583,278 176,433 259,055 110,475 898,740 404,621 2,438 2,200 2,962 134,146 49,762 89,651 Total ............................................ $2,738,367 $ 24,606 $583,278 $176,433 $259,055 $ 110,475 $898,740 $404,621 $ 2,438 $ 2,200 $ 2,962 $ 134,146 (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. 132 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) December 31, 2017 Fair Value AAA AA A BBB BB B CCC CC D Not Rated ($ in thousands) Term loan investments ................................... $ 877,818 $ — $ — $ — $ 42,673 $ 68,556 $ 526,183 $131,743 $ 4,485 $ 4,324 $ 99,854 Credit Rating (1) Fixed maturities: Corporate bonds .......................................... 715,891 9,263 63,651 131,605 43,657 57,037 157,702 194,409 U.S. government and government agency bonds ...................................................... Asset-backed securities ................................ Mortgage-backed securities ........................ Non-U.S. government and government agency bonds ......................................... 231,019 101,147 9,290 14,676 12,201 — 216,343 — 3,003 3,419 — — 104,205 2,785 95,514 5,906 Municipal government and government agency bonds ......................................... 15,481 Total fixed income instruments ..................... 2,054,851 13,721 52,646 1,265 495 — — — — — — 15,353 — — — — 34,155 1,027 — — — — — — — — — — — — — 5,584 52,983 — — 6,682 — — — 33,016 1,581 — — 379,776 141,425 86,330 140,946 719,067 326,152 4,485 16,590 187,434 Short-term investments .................................. 323,883 366 224,176 767 70,149 — 21,404 — — — 7,021 Total fixed income instruments and short- term investments ...................................... Other investments .......................................... Equities ........................................................... 2,378,734 53,012 603,952 142,192 156,479 140,946 740,471 326,152 4,485 16,590 194,455 49,613 67,868 Total ................................................................ $ 2,496,215 $ 53,012 $ 603,952 $142,192 $156,479 $140,946 $ 740,471 $326,152 $ 4,485 $ 16,590 $ 194,455 (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. 133 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) December 31, 2016 Fair Value AAA AA A Credit Rating (1) BBB BB ($ in thousands) B CCC D Not Rated Term loan investments ................................... $ 813,621 $ — $ — $ — $ 15,024 $ 112,298 $ 321,078 $ 222,490 $ — $ 142,731 Fixed maturities: Corporate bonds .......................................... 486,102 860 3,629 5,942 13,150 53,970 107,603 266,938 9,733 24,277 U.S. government and government agency bonds ...................................................... Asset-backed securities ................................ Non-U.S. government and government agency bonds ......................................... Municipal government and government agency bonds ......................................... 196,942 30,324 15,452 — — — 196,942 — 15,452 4,313 429 2,576 Total fixed income instruments ..................... 1,546,754 1,289 218,599 — — — 1,039 6,981 — — — — — 9,940 — 3,195 — — — — — — — — — — — — 28,174 176,208 431,876 489,428 9,733 Short-term investments .................................. 374,480 — — 108,662 262,291 — — — — — 17,189 — 269 184,466 3,527 Total fixed income instruments and short- term investments ...................................... 1,921,234 1,289 218,599 115,643 290,465 176,208 431,876 489,428 9,733 187,993 Equities ........................................................... 2,315 Total ................................................................ $ 1,923,549 $ 1,289 $ 218,599 $ 115,643 $ 290,465 $ 176,208 $ 431,876 $ 489,428 $ 9,733 $ 187,993 (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. 134 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) Fair value option The Company elected to carry the majority of fixed maturity securities and other investments at fair value under the fair value option afforded by accounting guidance regarding the fair value option for financial assets and liabilities. Changes in fair value of investments accounted for using the fair value option are included in “realized and unrealized gain (loss) on investments” in the consolidated statements of income (loss). The Company elected to use this option as investments are not necessarily held to maturity, and in order to address simplification and cost-benefit considerations. Net investment income (loss) The components of net investment income (loss) for the years ended December 31, 2018, 2017 and 2016 were derived from the following sources: Year Ended December 31, 2018 Net Interest Income Net Unrealized Gains (Losses) Net Realized Gains (Losses) Net Investment Income (Loss) Net investment income (loss) by asset class: Term loan investments ................................. $ Fixed maturities - Fair value option ............. Fixed maturities - Available for sale (1) ....... Short term investments ................................ Equities (2) .................................................... Equities, fair value through net income (2) Other investments ........................................ Other (3) ........................................................ Investment management fees - related parties ....................................................... Borrowing and miscellaneous other investment expenses ................................ Investment performance fees - related parties ....................................................... 79,971 $ 63,556 5,802 2,722 (425) 1,290 — — (17,006) (28,377) — ($ in thousands) (53,702) $ (3,988) $ 22,281 (42,601) (11,490) — 390 (3,266) (8,786) 149 (1,230) — — — (878) 35 8,223 3,310 — — — — — 9,465 4,924 3,147 4,532 (4,186) 149 (1,230) (17,006) (28,377) (48) $ 107,533 $ (109,046) $ (4,788) $ (6,349) (1) Net realized gains (losses) from the fixed maturities available for sale portfolio consists of realized gains and realized losses of $86.0 thousand and $964.0 thousand, respectively. (2) Net interest income consists of dividends for securities held in long and short positions. (3) Other includes unrealized gains and unrealized losses for total return swaps. Fixed maturities that have been non-income producing for the twelve months preceding December 31, 2018, 2017 and 2016 have a market value of $1.0 million, $Nil and $1.3 million, respectively. 135 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) Year Ended December 31, 2017 Net Interest Income Net Unrealized Gains (Losses) Net Realized Gains (Losses) Net Investment Income (Loss) Net investment income (loss) by asset class Term loan investments .............................. $ Fixed maturities ......................................... Short term investments............................. Equities ...................................................... Other investments ..................................... Investment management fees - related parties ................................................... Borrowing and miscellaneous other investment expenses ............................ Investment performance fees - related parties ................................................... 73,472 $ 49,179 2,473 339 — (21,451) (17,489) — 86,523 $ $ ($ in thousands) (10,354) $ 346 $ 8,017 220 2,902 (387) — — — (660) (1,745) 2,781 — — — — 63,464 56,536 948 6,022 (387) (21,451) (17,489) (14,905) 398 $ 722 $ 72,738 Year Ended December 31, 2016 Net Interest Income Net Unrealized Gains (Losses) Net Realized Gains (Losses) Net Investment Income (Loss) Net investment income (loss) by asset class Term loan investments .............................. $ Fixed maturities ......................................... Short term investments............................. Equities ...................................................... Investment management fees - related parties ................................................... Borrowing and miscellaneous other investment expenses ............................ Investment performance fees - related parties ........................................................ Other-than-temporary impairments 66,018 $ 53,192 3,168 — (16,563) (15,997) — 89,818 $ $ ($ in thousands) 60,825 $ (15,298) $ 111,545 41,982 1,278 1,041 — — — (1,422) (7,763) — — — 93,752 (3,317) 1,041 (16,563) (15,997) — $ (24,065) 105,126 $ (24,483) $ 146,396 The Company reviews its available for sale investments on a quarterly basis to determine whether declines in fair value below the amortized cost basis are considered other-than-temporary in accordance with applicable guidance. As of the year ended December 31, 2018, the Company did not identify any other-than-temporary impairments. 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 136 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) 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 December 31, 2018, 2017 and 2016, the Company held $2.4 billion, $2.0 billion and $1.6 billion respectively, in pledged assets in support of insurance and reinsurance liabilities as well as to collateralize our credit facilities and investment derivatives. Included within total pledged assets, the Company held $5.5 million, $6.0 million and $6.6 million, respectively, in deposits with U.S. regulatory authorities. 9. 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 U.S. GAAP and provides a common definition of fair value to be used throughout U.S. GAAP. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In addition, it establishes a three-level valuation hierarchy for the disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement (Level 1 being the highest priority and Level 3 being the lowest priority). The levels in the hierarchy are defined as follows: • Level 1: Inputs to the valuation methodology are observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets; • Level 2: Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument; and • Level 3: Inputs to the valuation methodology are unobservable and significant to the fair value measurement. The availability of observable inputs can vary by financial instrument and is affected by a wide variety of factors including, for example, the type of financial instrument, whether the financial instrument is new and not yet established in the marketplace, and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires significantly more judgment. The degree of judgment exercised by the Company in determining fair value is greatest for financial instruments categorized in Level 3. In periods of market dislocation, the observability of prices and inputs may be reduced for many financial instruments. This may lead to a change in the valuation techniques used to estimate the fair value measurement and cause an instrument to be reclassified between levels within the fair value hierarchy. Fair value measurements on a recurring basis The following is a description of the valuation methodologies used for securities measured at fair value, as well as the general classification of such securities pursuant to the valuation hierarchy. The Company determines the existence of an active market based on its judgment as to whether transactions for the financial instrument occur in such market with sufficient frequency and volume to provide reliable pricing information. The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. The Company 137 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) 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 $2.7 billion of financial assets and liabilities measured at fair value at December 31, 2018, approximately $178.3 million, or 6.5% were priced using non-binding broker-dealer quotes or modeled valuations. Of the $2.5 billion of financial assets and liabilities measured at fair value at December 31, 2017, approximately $198.5 million, or 8.1%, were priced using non-binding broker- dealer quotes or modeled valuations. Of the $1.8 billion of financial assets and liabilities measured at fair value at December 31, 2016, approximately $131.4 million, or 7.1% were priced using non- binding broker-dealer quotes or modeled valuations. The Company reviews its securities measured at fair value and discusses the proper classification of such investments with its investment managers and others. A discussion of the general classification of the Company’s financial instruments follows: Fixed Maturities. The Company uses the market approach valuation technique to estimate the fair value of its fixed maturity securities, when possible. The market approach includes obtaining prices from independent pricing services, such as index providers and pricing vendors, as well as to a lesser extent quotes from broker-dealers. The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. Each source has its own proprietary method for determining the fair value of securities that are not actively traded. In general, these methods involve the use of “matrix pricing” in which the independent pricing source uses observable market inputs including, but not limited to, investment yields, credit risks and spreads, benchmarking of like securities, broker-dealer quotes, reported trades and sector groupings to determine a reasonable fair value. The following describes the significant inputs generally used to determine the fair value of the Company’s investment securities by asset class: Term Loans. Fair values are estimated by using quoted prices obtained from independent pricing services for term loan investments with similar characteristics, pricing models or matrix pricing. Such investments are generally classified within Level 2. The fair values for certain of the Company’s term loans are determined by the investment manager using quantitative and qualitative assessments such as internally modeled values, which are reviewed by the Company’s management. The modeled values are based on peer loans and comparison to industry-specific market data. In addition, the investment manager assesses the fair value based on the valuation of the underlying holdings in accordance with the fund’s governing documents. Significant unobservable inputs used to price these securities may include changes in peer and/or comparable credit spreads, accretion of 138 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) 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 is generally determined through the use of pricing models (including option adjusted spread) which use spreads to determine the appropriate average life of the securities. These spreads are generally obtained from the new issue market, secondary trading and from broker-dealers who trade in the relevant security market. The pricing services also review prepayment speeds and other indicators, when applicable. As the significant inputs used in the pricing process for asset-backed securities are observable market inputs, the fair value of these securities are classified within Level 2. Mortgage-Backed Securities. Valuations are provided by independent pricing services, substantially all through pricing vendors and index providers with a small amount through broker-dealers. The fair values of these securities are generally determined through the use of pricing models (including option adjusted spread) which use spreads to determine the expected average life of the securities. These spreads are generally obtained from the new issue market, secondary trading and from broker-dealers who trade in the relevant security market. The pricing services also review prepayment speeds and other indicators, when applicable. As the significant inputs used in the pricing process for mortgage-backed securities are observable market inputs, the fair value of these securities are classified within Level 2. U.S. Government and Government Agencies. Valuations are provided by independent pricing services, with all prices provided through index providers and pricing vendors. The Company determined that all U.S. Treasuries would be classified as Level 1 securities due to observed levels of trading activity, the high number of strongly correlated pricing quotes received on U.S. Treasuries and other factors. 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 139 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) generally determined using spreads obtained from broker-dealers who trade in the relevant security market, trade prices and the new issue market. As the significant inputs used in the pricing process for municipal bonds are observable market inputs, the fair value of these securities are classified within Level 2. Short-Term Investments. The Company determined that certain of its short-term investments, held in highly liquid money market-type funds, and equities would be included in Level 1 as their fair values are based on quoted market prices in active markets. The fair values of other short-term investments are generally determined using the spread above the risk-free yield curve and are classified within Level 2. Certain of the Company’s term loans purchased before the year ended December 31, 2017 with maturity dates less than one year but greater than 30 days are included in short-term investments. The fair values of these 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. In addition, the investment manager assesses the fair value based on the valuation of the underlying holdings in accordance with 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. 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 11 - “Derivative instruments” for more information. Investment Derivative Instruments. The Company values the investment derivatives, including total return swaps and options, at fair value. As the underlying investments have observable inputs, the fair value of these securities are classified within Level 2. Refer to Note 11 - “Derivative instruments” for more information. Other Investments. The fair value of the Company’s investment in the hedge fund is measured using the most recently available NAV as advised by a third-party administrator. Measuring the Fair Value of Other Investments Using Net Asset Valuations The fair value of the Company’s investment in the hedge fund is measured using the most recently available NAVs as advised by the third party administrator. The fund NAVs are based on the administrator’s valuation of the underlying holdings in accordance with the fund’s governing documents and in accordance with U.S. GAAP. 140 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) 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 fund manager or fund administrator. In order to assess the reasonableness of the NAVs, we perform a number of monitoring procedures on a quarterly basis, to assess the quality of the information provided by fund manager and funds 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 hedge fund is measured using the NAV as a practical expedient, therefore the fair value of the fund has not been categorized within the fair value hierarchy. The following table presents the Company’s financial assets and liabilities measured at fair value by level as at December 31, 2018, 2017 and 2016: December 31, 2018 Estimated Fair Value Fair Value Measurement Using: Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Assets measured at fair value: Term loans ................................................. $ 1,000,652 $ Fixed maturities: Corporate bonds ..................................... U.S. government and government agency bonds...................................... Asset-backed securities ........................... Mortgage-backed securities ................... Non-U.S. government and government agencies .............................................. Municipal government and government agency bonds ................ Short-term investments ............................ Equities ...................................................... Other underwriting derivative assets....... Investment derivative assets (1)................ Other investments measured at net asset value (2) ....................................... 654,607 268,675 225,983 22,161 136,513 8,231 282,132 89,651 249 51 49,762 ($ in thousands) — $ 953,173 $ 47,479 — 630,330 24,277 268,567 — — — — 256,288 7,977 — — — 108 203,423 22,161 136,513 8,231 25,844 11,223 249 51 — — 22,560 — — — — 70,451 — — — Total assets measured at fair value .......... $ 2,738,667 $ 532,832 $ 1,991,306 $ 164,767 Investment derivative liabilities (1) .......... Payable for securities sold short: .............. Corporate bonds ..................................... Equities (1) ............................................... Total liabilities measured at fair value ..... $ 1,279 7,790 1,138 — — — 1,279 7,790 1,138 10,207 $ — $ 10,207 $ — — — — (1) Investment derivative assets and liabilities represent the fair value of total return swaps, which are recorded in other assets and other liabilities, respectively, in the consolidated balance sheets as of December 31, 2018. The Company’s call options are recorded as equities in payable for securities sold short in the consolidated balance sheets as of December 31, 2018. The Company’s put options are recorded as equities in the consolidated balance sheets as of December 31, 2018. 141 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) (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. Fair Value Measurement Using: Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) ($ in thousands) Estimated Fair Value 877,818 $ — $ 815,340 $ 62,478 December 31, 2017 Assets measured at fair value: Term loans ................................................. $ Fixed maturities: Corporate bonds ..................................... U.S. government and government agency bonds...................................... Asset-backed securities ........................... Mortgage-backed securities ................... Non-U.S. government and government agencies .............................................. 715,891 231,019 101,147 9,290 104,205 Municipal government and 15,481 government agency bonds ................ Short-term investments ............................ Equities ...................................................... Other underwriting derivative assets....... Other investments measured at net asset value (1) ............................................ Total assets measured at fair value .......... $ 2,496,551 $ 323,883 67,868 49,613 336 — 691,181 24,710 231,019 — — — — 295,458 1,995 — — — 101,147 9,290 104,205 15,481 28,425 12,952 336 — — — — — — 52,921 — — 528,472 $ 1,778,357 $ 140,109 Liabilities measured at fair value: Payable for securities sold short: Corporate bonds ..................................... Equities .................................................... Total liabilities at fair value ...................... $ 29,750 4,625 — 4,625 29,750 — 34,375 $ 4,625 $ 29,750 $ — — — (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. 142 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) Fair Value Measurement Using: Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) ($ in thousands) Estimated Fair Value 813,621 $ — $ 741,392 $ 72,229 December 31, 2016 Assets measured at fair value: Term loans ................................................. $ Fixed maturities: Corporate bonds ..................................... U.S. government and government agency bonds...................................... Asset-backed securities ........................... Non-U.S. government and government agencies .............................................. 486,102 196,942 30,324 15,452 Municipal government and government agency bonds ................ Short-term investments ............................ Equities ...................................................... Other underwriting derivative assets....... Total assets measured at fair value .......... $ 1,923,703 $ 374,480 4,313 2,315 154 — 464,338 21,764 196,942 — — — 372,355 — — — 30,324 15,452 4,313 — 2,315 154 — — — — 2,125 — — 569,297 $ 1,258,288 $ 96,118 Liabilities measured at fair value: Payable for securities sold short: Corporate bonds ..................................... Non-U.S. government and government agencies .............................................. Total liabilities measured at fair value ..... $ 26,551 6,606 — — 26,551 6,606 33,157 $ — $ 33,157 $ — — — 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. The transfers into and out of fair value hierarchy levels reflect the fair value of the securities at the end of the reporting period. During 2018, one equity security with a fair value of $7.3 million was transferred to Level 1 from Level 2. During 2017, one equity security with a fair value of $1.1 million was transferred to Level 1 from Level 2. The fair value of both equities were based on quoted market prices in active markets. There were no additional transfers between Level 1 and Level 2 in 2018, 2017 or 2016. 143 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (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 2018, 2017 and 2016: Year Ended December 31, 2018 Term loans ........................... $ Corporate bonds ................. Asset-backed securities ....... Equities ................................ Total ..................................... $ Beginning Balance Net Purchases (Sales)(1) Net Unrealized Gains (Losses)(2) Net Unrealized Foreign Exchange Gains (Losses) Ending Balance 62,478 $ (11,705) $ (3,294) $ — $ 24,710 — 52,921 985 22,560 21,932 (285) — (4,402) (1,133) — — 47,479 24,277 22,560 70,451 140,109 $ 33,772 $ (7,981) $ (1,133) $ 164,767 Year Ended December 31, 2017 Beginnin g Balance Transfers in (out) of Level 3(3) Reclass of Level 3 Security (4) Net Purchases (Sales)(1) Net Unrealized Gains (Losses)(2) Net Unrealized Foreign Exchange Gains (Losses) Ending Balance Term loans .............................. $ 72,229 Corporate bonds .................... Short-term investments ......... Equities ................................... — Total ........................................ $ 96,118 21,764 2,125 $ 39,501 $ 2,125 $ (51,422) $ 45 $ — $ 62,478 — — — — (2,125) — — — 52,261 $ 39,501 $ — $ 839 $ 103 — 660 808 2,843 24,710 — — — 52,921 $ 2,843 $ 140,109 Year Ended December 31, 2016 Beginning Balance Transfers in (out) of Level 3 Net Purchases (Sales)(1) Net Unrealized Gains (Losses) (2) Net Unrealized Foreign Exchange Gains (Losses) Ending Balance Term loans ......................................... $ 43,763 Corporate bonds ............................... Other underwriting derivatives (5) ... Short-term investments ..................... — Total ................................................... $ 65,693 22,168 (238) $ — $ 26,520 $ 1,946 $ — $ 72,229 — 238 — — 2,125 218 — — (622) 21,764 — — — 2,125 $ 238 $ 28,645 $ 2,164 $ (622) $ 96,118 (1) For the year ended December 31, 2018, the net purchases (sales) consisted of purchases of $57.1 million of equities, $22.6 million of asset-backed securities, $18.0 million of term loans, $4.4 million of short-term investments and $1.0 million of corporate bonds, partially offset by sales, calls and redemptions of $35.1 million of equities and $29.7 million of term loans and the sale of short-term investments of $4.4 million. For the year ended December 31, 2017, the net purchases (sales) consisted of $54.4 million of term loan calls and redemptions, $52.3 million of equity purchases and $3.0 million of term loan purchases. (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). (3) During the year ended December 31, 2017, the Company was unable to obtain recent independent pricing for a term loan which was purchased during 2015. As such, the security was transferred from Level 2 to Level 3 at its fair value as of December 31, 2016. (4) As of December 31, 2017, it was determined that a Level 3 security would be held for longer than 1 year, and as such was reclassified from short-term investments to term loans. The security was transferred into term loans at its fair value as of December 31, 2016. (5) Realized and unrealized gains or losses in other underwriting derivatives classified as Level 3 are included in “other underwriting income (loss)” in the Company’s consolidated statements of income (loss). The transfer to Level 2 from Level 3 made during 2016 was primarily due to a review of the inputs used on certain other derivatives and occurred at the end of the period prior to the valuation. The transfer was effective December 31, 2016. See Note 11 - “Derivative instruments” for further details. 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, 144 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) certain other assets, payable for securities purchased and certain other liabilities approximated their fair values at December 31, 2018, 2017 and 2016 due to their respective short maturities. As these financial instruments are not actively traded, their respective fair values 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 measure the fair value of these assets when appropriate, as described below. Intangible Assets The Company tests intangible assets for impairment whenever events or changes in circumstances indicate the carrying amount may not be recoverable. When the Company determines intangible assets may be impaired, the Company uses techniques including discounted expected future cash flows, to measure fair value. 10. Borrowings to purchase investments Secured credit facility On November 30, 2017, Watford Re amended and restated its $800.0 million secured credit facility with Bank of America, N.A. “Bank of America” through Watford Asset Trust I, “Watford Trust” which had originally been entered into in June 2015. Watford Re owns all of the beneficial interests of Watford Trust. The facility expires on November 30, 2021 and is backed by a portion of Watford Re’s non-investment grade portfolio which has been transferred to Watford Trust and which continues to be managed by HPS pursuant to an investment management agreement between HPS and Watford Trust. The purpose of the facility is to provide borrowing capacity, including for the purchase of loans, securities and other assets and distributing cash or any such loans, securities or other assets to Watford Re. Borrowings on the facility may be made at LIBOR or an alternative base rate at our option, in either case plus an applicable margin. The applicable margin varies based on the applicable base rate and, in the case of LIBOR rate borrowings, the currency in which the borrowing is denominated. In addition, the facility allows for us to issue up to $400.0 million in evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which we have entered into reinsurance arrangements. We pay a fee on each letter of credit equal to the amount available to be drawn under such letter of credit multiplied by an applicable percentage. The applicable percentage varies based on the currency in which the letter of credit is denominated. As at December 31, 2018, 2017 and 2016, Watford Re, through Watford Trust, had borrowed approximately $455.7 million, $441.1 million and $256.7 million, respectively. Bank of America requires the Company to hold cash and investments in deposit with, or in trust accounts with respect to the borrowed funds and outstanding letters of credit. As at December 31, 2018, 2017 and 2016, the Company was required to hold $764.0 million, $728.6 million and $773.9 million, respectively, in such deposits and trust accounts. Watford Re has deferred the issuance and extension costs relating to the borrowings of $14.5 million and is subsequently amortizing the deferred costs over the term of the borrowing arrangements. Custodian bank facility During the years ended December 31, 2018, 2017 and 2016, the Company borrowed $238.2 million, $108.0 million and $2.2 million from the Company’s custodian bank to purchase U.S.-denominated securities. As of December 31, 2018, the total borrowed amount of $238.2 million included 2.0 million Swiss Francs, or CHF, (USD equivalent of $2.0 million) to purchase CHF-denominated 145 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) securities. The Company pays interest based on 3-month LIBOR plus a margin and the borrowed amount is payable upon demand. The custodian bank requires the Company to hold cash and investments in deposit with, or in an investment account with respect to the borrowed funds. As at December 31, 2018, 2017 and 2016, the Company was required to hold $339.1 million, $150.5 million and $3.0 million, respectively, in such deposits and investment accounts. The foreign exchange gain or loss on revaluation on the borrowed CHF-denominated funds is included as a component of foreign exchange gains (losses) included in the consolidated statements of net income (loss). Revolving credit agreement borrowings As at December 31, 2018, 2017 and 2016, the Company had total revolving credit agreement borrowings of $693.9 million, $549.2 million and $258.9 million, respectively, which consist of the borrowings from the secured credit facility and the custodian bank facility as discussed above. During 2018, 2017 and 2016, interest expense incurred on the secured credit facility and the custodian bank facility was $26.5 million, $15.9 million and $14.0 million, respectively. The interest expense incurred is included as a component of borrowings and miscellaneous other investment expenses in the Company’s consolidated statements of income (loss). As of December 31, 2018, 2017 and 2016, the fair value of the Company’s outstanding borrowings approximated their carrying value. 11. 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. During 2015, these transactions were classified in Level 3 of the valuation hierarchy based on inputs to the valuation methodology which were considered unobservable and significant to the fair value measurement. During 2016, these transactions were transferred from Level 3 to Level 2 primarily due to inputs to the existing valuation methodology which were considered observable based on non-binding broker dealer quotes. The derivative assets and derivative liabilities relating to these transactions are included in other assets and other liabilities, respectively, in the Company’s consolidated balance sheets. Realized and unrealized gains and losses from other derivatives are included in other underwriting income (loss) in the Company’s consolidated statements of net income (loss). The risk in force of these transactions is considered the notional amount. As at December 31, 2018, 2017 and 2016, the Company held $15.5 million, $17.9 million and $20.6 million, respectively, in assets as collateral for these transactions. These assets are included in fixed maturities accounted for using the fair value option in the Company’s consolidated balance sheets. Investment Derivatives The Company’s investment strategy allows for the use of derivative securities. Beginning in the third quarter of 2018, the Company invested in call options to manage specific market risks; such derivative instruments are recorded at fair value, and shown as part of payable for securities sold short on its consolidated balance sheets. Additionally, beginning in the fourth quarter of 2018, the Company invested in put options to manage specific market risks; such derivative instruments are recorded at fair value, and shown as part of equity investments on its consolidated balance sheets. 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 146 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) 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. As at December 31, 2018, the Company had collateral funds held by the counterparty of $36.3 million included in short term investments in the Company’s consolidated balance sheets. The fair value of such options and swaps are based on observable inputs and classified in Level 2 of the valuation hierarchy. Realized and unrealized gains and losses from investment derivatives are included in realized and unrealized gains (losses) on investments in the Company’s consolidated statements of net income (loss). The Company did not hold any derivatives which were designated as hedging instruments at December 31, 2018, 2017 and 2016. The following table summarizes information on the fair values and notional amount of the Company’s derivative instruments at December 31, 2018, 2017 and 2016: Estimated Fair Value Asset Derivatives Liability Derivatives Net Derivatives Notional Amount (1) December 31, 2018 Other underwriting derivatives ................ $ Investment derivatives .............................. Total ........................................................... $ ($ in thousands) 249 $ 859 — $ 249 $ 72,148 2,417 (1,558) 116,214 1,108 $ 2,417 $ (1,309) $ 188,362 December 31, 2017 Other underwriting derivatives ................ $ Total ........................................................... $ December 31, 2016 Other underwriting derivatives ................ $ Total ........................................................... $ 336 $ 336 $ 154 $ 154 $ — $ — $ — $ — $ 336 $ 336 $ 84,855 84,855 154 $ 154 $ 102,258 102,258 (1) The notional amount represents the absolute value of all outstanding contracts. The realized and unrealized gains and losses on the Company’s derivative instruments are reflected in the consolidated statements of income, as summarized in the following table: Year Ended December 31, 2018 2017 2016 ($ in thousands) Underwriting derivatives: Other underwriting income (loss) ................................... $ Investment derivatives: Realized and unrealized gains (losses) on investments . 2,722 $ 3,180 $ 3,746 84 — — 12. Earnings per common share The calculation of basic earnings per common share is computed by dividing income available to the Parent’s common shareholders by the weighted average number of common shares outstanding for 147 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) the periods. The following table sets forth the computation of basic and diluted earnings per common share: Year Ended December 31, 2018 2017 2016 Numerator: Net income (loss) before preferred dividends ............ $ Preferred dividends ...................................................... Net income (loss) available to common shareholders $ ($ in thousands except share and per share data) (34,883) $ 10,741 $ 146,734 (19,633) (19,633) (19,634) (54,516) $ (8,892) $ 127,100 Denominator: Weighted average common shares outstanding - basic and diluted ..................................................... Earnings (loss) per common share: Basic and diluted .......................................................... $ 22,682,875 22,682,875 22,682,875 (2.40) $ (0.39) $ 5.60 13. 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 2015 through 2018 in Gibraltar and 2018 in Romania. Watford Holdings (UK) Limited is incorporated in the United Kingdom and is subject to UK corporate income tax. The UK corporate income tax rates were reduced from 20% to 19% on April 1, 2017 and will be further reduced to 17% from April 1, 2020. The open tax years that are potentially subject to examination by UK tax authorities are 2018 and 2017. Watford Holdings (U.S.) Inc. is incorporated in the U.S. and files a consolidated U.S. federal tax return with its subsidiaries Watford Specialty Insurance Company, Watford Insurance Company, and Watford Services Inc. The U.S. federal tax rate was 35% through December 31, 2017. On December 22, 2017, the U.S. government passed new legislation (The United States Tax Cuts and Jobs Acts, or “TCJA”) which reduced the corporate income tax rate to 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 2018 through 2015. On December 22, 2017, Staff Accounting Bulletin No. 118 (“SAB 118”) was issued to address the application of GAAP in situations when a registrant does not have the necessary information available, prepared or analyzed in reasonable detail to complete the accounting for certain income tax effects of the Tax Cuts and Jobs Act of 2017 (“Tax Cuts Act”). Pursuant to the guidance within SAB 118, the Company’s remeasurement of its deferred taxes at December 31, 2017 included certain provisional effects associated with enactment of the Tax Cuts Act for which measurement could be reasonably estimated. 148 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) Additional information that may affect the provisional amounts would include, completion of the Company’s U.S. subsidiaries’ 2017 tax return filings, and potential future guidance from the IRS with respect to the transitional adjustment pertaining to loss reserve discounting. The Company’s income tax provision for the year ended December 31, 2018 does not include any adjustments to the provisional effects recorded at December 31, 2017. The components of income taxes attributable to operations were as follows: Current income tax expense (benefit): United States ...................................................................... $ Gibraltar ............................................................................. United Kingdom ................................................................ Deferred income tax expense (benefit): United States ...................................................................... Gibraltar ............................................................................. United Kingdom ................................................................ Year Ended December 31, 2018 2017 2016 ($ in thousands) 27 $ — $ — — 27 — — — — 21 — 21 — — — — Total income tax expense (benefit)................................... $ 27 $ 21 $ 1 — — 1 — — — — 1 The Company’s income or loss after preferred dividends and before income taxes was earned in the following jurisdictions: Year Ended December 31, 2018 2017 2016 ($ in thousands) Income (loss) before income taxes: Bermuda ............................................................................. $ United States ...................................................................... Other .................................................................................. Total income (loss) before income taxes........................... $ (52,953) $ (6,041) $ 129,041 (2,146) 610 (1,485) (1,345) (2,257) 317 (54,489) $ (8,871) $ 127,101 149 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) The reconciliation between the Company’s effective tax rate and the expected tax rate at the Bermuda statutory tax rate is as follows: Year Ended December 31, 2018 2017 2016 ($ in thousands) Expected income tax expense (benefit) at Bermuda statutory rate ................................................................ $ Foreign taxes at local expected rates ............................... Change in tax rate related to U.S. tax reform .................. Change in valuation allowance ......................................... Other .................................................................................. Total income tax expense (benefit)................................... $ — $ — $ (395) — 400 22 (659) 664 17 (1) 27 $ 21 $ — (758) — (3) 762 1 Deferred income tax assets and liabilities reflect temporary differences based on enacted tax rates between the carrying amounts of assets and liabilities for financial reporting and income tax purposes. Significant components of the Company’s deferred income tax assets and liabilities were as follows: Deferred income tax assets: Net operating loss ........................................................... $ Unearned premium reserve ............................................ Loss reserves .................................................................... Ceding commissions ........................................................ Capitalized expenses ....................................................... Goodwill and intangible assets ...................................... Deferred tax assets before valuation allowance ........... Valuation allowance ....................................................... Deferred tax assets net of valuation allowance ............ Deferred income tax liabilities: Goodwill and intangible assets ...................................... Investment basis differences .......................................... Total deferred tax liabilities ........................................... Net deferred income tax assets (liabilities).................... $ Year Ended December 31, 2018 2017 2016 ($ in thousands) 858 $ 1,068 $ 1,449 142 59 339 133 101 1,632 (1,488) 144 (144) — (144) 49 10 170 109 — 1,406 (1,127) 279 (27) (252) (279) — $ — $ 43 4 — 210 148 1,854 (1,110) 744 — (479) (479) 265 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 December 31, 2018, 2017 and 2016, the Company’s valuation allowance was $1.5 million, $1.1 million and $1.1 million, respectively. The 2018 valuation allowance primarily related to U.S. and Gibraltar operating loss carry-forwards. The U.S. net operating loss carry-forwards begin to expire in 2035 and the Gibraltar and U.K. net operating loss carry-forwards do not expire. After taking into account the impact of the increase in the valuation allowance, the Company recognized income tax expense during the years ended December 31, 2018, 2017 and 2016 of $27.0 thousand, $21.0 thousand and $1.0 thousand, respectively. 150 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) 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 December 31, 2018, 2017 and 2016 the Company’s total unrecognized tax benefits, including interest and penalties, were nil. Federal excise taxes The United States also imposes an excise tax on insurance and reinsurance premiums paid to non- U.S. insurers or reinsurers with respect to risks located in the United States. The rate of tax, unless reduced by an applicable U.S. tax treaty, is 1% for all reinsurance premiums. The Company incurs federal excise taxes on certain of its reinsurance transactions. For the years ended December 31, 2018, 2017 and 2016, the Company incurred approximately $4.3 million, $3.6 million and $4.0 million, respectively, of federal excise taxes. Such amounts are reflected as acquisition expenses in the Company’s consolidated statements of income (loss). 14. Transactions with related parties In March 2014, ARL invested $100.0 million in the Parent and acquired approximately 11% of its common equity. AUL acts as the insurance and reinsurance manager for Watford Re and WICE while AUI acts as the insurance and reinsurance manager for WSIC and WIC, all under separate long-term services agreements. HPS manages the Company’s non-investment grade portfolio as investment manager and AIM manages 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 our board of directors. The services agreements with AUL and AUI and the investment management agreements with HPS and AIM provide for services for an extended period of time with limited termination rights by the Company. In addition, these agreements allow for AUL, AUI, HPS and AIM to participate in the favorable results of the Company in the form of performance fees. AUL and AUI Watford Re and WICE entered into services agreements with AUL. WSIC and WIC entered into services agreements with AUI. AUL and AUI provide services related to the management of the underwriting portfolio for a term ending on December 2025. The services agreements perpetually renew automatically in five-year increments unless either we 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. 151 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) The related AUL and AUI fees and reimbursements incurred in the consolidated statement of income (loss) for the years ended December 31, 2018, 2017 and 2016 were as follows: Consolidated statement of income (loss) items: Acquisition expenses ......................................................... $ General and administrative expenses ............................... Year Ended December 31, 2018 2017 2016 ($ in thousands) 15,578 $ 10,755 $ 6,796 6,599 7,207 5,433 $ 22,374 $ 17,354 $ 12,640 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. For periods prior to January 1, 2018, the management fee was calculated at an annual rate of 1.5% of the aggregate net asset value of the assets that are managed by HPS, payable quarterly in arrears. For periods beginning January 1, 2018, the management fee is calculated at an annual rate of 1.0% of the aggregate net asset value of the assets that are managed by HPS, payable quarterly in arrears. For purposes of calculating the management fees, net asset value is determined by HPS in accordance with the investment management agreements and is measured before reduction for any management fees, performance fees or any expense reimbursement and as adjusted for any non-routine intra-month withdrawals. We have also agreed to reimburse HPS for certain expenses related to the management of our non-investment grade portfolio as set forth in the investment management agreements. For periods prior to January 1, 2018, the performance fee was equal to 15% of Income (as defined in such investment management agreements relating to Watford Re, WICE and Watford Trust) or Aggregate Income (as defined in such 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. For periods beginning January 1, 2018, the base performance fee is equal to 10% of the Income (as defined in the investment management agreements relating to Watford Re, WICE and Watford Trust) or Aggregate Income (as defined in the investment management agreements relating to WSIC and WIC), as applicable, if any, on the assets managed by HPS, calculated and payable as of each fiscal year-end and the date on which the investment management agreements are terminated and not renewed, and HPS is eligible to earn an additional performance fee equal to 25% of any Excess Income (as defined in the investment management agreements) in excess of a net 10% return to Watford after deduction for paid and accrued management fees and base performance fees, with the total performance fees not to exceed 17.5% of the Income or Aggregate Income, as applicable. No performance fees will be paid to HPS if the high water mark (as described in the investment management agreements with HPS) is not met. During the year ended December 31, 2017, the Company invested $50.0 million in a private fund (“Master Fund”) as part of HPS’s investment strategy. HPS acts as the Trading Manager and provides certain administrative management services to the Master Fund. As at December 31, 2018, the Master Fund balance was $261.9 million, and the Company’s investment represents approximately 19.0% of the Fund. The management fees and performance fees on the Master Fund will be subject to the existing fee structure of the existing investment management agreement between the Company and HPS, as discussed above. 152 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) The related consolidated statement of income (loss) for the years ended December 31, 2018, 2017 and 2016, and consolidated balance sheet account balances for HPS management fees and performance fees as of December 31, 2018, 2017 and 2016 were as follows: Consolidated statement of income (loss) items: Investment management fees - related parties ............... $ Investment performance fees - related parties ................ ($ in thousands) 15,830 $ 20,827 $ 48 14,905 $ 15,878 $ 35,732 $ 16,327 24,065 40,392 Year Ended December 31, 2018 2017 2016 Consolidated balance sheet items: Other investments, at fair value ....................................... $ Investment management and performance fees payable .......................................................................... AIM December 31, 2018 2017 2016 ($ in thousands) 49,762 $ 49,613 $ — 3,807 21,107 27,942 Watford Re, WSIC, WICE, and WIC entered into investment management agreements with AIM pursuant to which AIM manages our investment grade portfolio. Each of the Watford Re, WICE, WSIC and WIC investment management agreements with AIM has a one-year term, which terms end 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 the Company or AIM 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 on 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. We have 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 our portfolio, as set forth in the investment management agreements. The related consolidated statement of income (loss) for the years ended December 31, 2018, 2017 and 2016 were as follows: Consolidated statement of income (loss) items: Investment management fees - related parties ............... $ ($ in thousands) 1,176 $ 624 $ 236 Year Ended December 31, 2018 2017 2016 153 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) Consolidated balance sheet items: December 31, 2018 2017 2016 ($ in thousands) Investment management and performance fees payable (1) ..................................................................... $ — $ (71) $ — (1) The negative balance in “investment management and performance fees payable” relates to an over-accrual of investment management fees. ACGL Certain directors, executive officers and management of ACGL own common and preference shares of the Company. The Company reinsures ARL and other ACGL subsidiaries and affiliates for property and casualty risks on a quota share basis. ACGL cedes business to us pursuant to inward retrocession agreements our operating subsidiaries have entered into with ACGL. Pursuant to these inward retrocession agreements, we pay a ceding fee based on the business ceded and the applicable retrocession agreement. For the years ended December 31, 2018, 2017 and 2016, we incurred ceding fees to Arch, in aggregate, of $17.6 million, $17.0 million and $16.2 million, respectively, under these inward retrocession agreements. Such fees, in addition to origination fees, are reflected in “acquisition expenses” on the consolidated statement of income (loss). The related consolidated statement of income (loss) and consolidated balance sheets account balances for these transactions (excluding AUL and AUI expenses described above) for the years ended December 31, 2018, 2017 and 2016 were as follows: Consolidated statement of income (loss) items: Gross premiums written .................................................... $ Gross premiums ceded ....................................................... Net premiums earned ........................................................ Losses and loss adjustment expenses ................................ Acquisition expenses ......................................................... Year Ended December 31, 2018 2017 2016 ($ in thousands) 252,841 $ 289,484 $ 338,937 (55,934) 232,846 (32,028) 278,423 (13,817) 290,994 (180,403) (223,954) (189,007) (95,211) (97,192) (93,803) 154 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) Consolidated balance sheet items: Total investments ............................................................... $ Premiums receivable .......................................................... Reinsurance recoverable on unpaid and paid losses and loss adjustment expenses.............................................. Prepaid reinsurance premiums .......................................... Deferred acquisition costs, net .......................................... Funds held by reinsurers .................................................... Contingent commissions (1) .............................................. Reserve for losses and loss adjustment expenses ............. Unearned premiums .......................................................... Reinsurance balances payable ........................................... Amounts due to affiliates .................................................. Losses payable .................................................................... December 31, 2018 2017 2016 ($ in thousands) 719,189 $ 590,157 $ 358,559 118,208 115,192 137,252 45,954 27,598 48,380 33,352 2,967 631,670 166,491 20,299 5,888 19,098 27,817 16,853 60,863 39,687 1,794 517,450 191,226 14,104 4,484 33,065 18,059 8,763 71,804 25,155 447 358,237 204,516 10,352 3,319 15,092 (1) Contingent commissions are recorded in other assets in the consolidated balance sheet. Artex In 2015, WICE and AUL entered into an insurance management services agreement with Artex Risk Solutions (Gibraltar) Limited, or Artex, pursuant to which Artex provides services to WICE relating to management, secretarial, governance, underwriting, claims, reinsurance, financial management, investment, regulatory, compliance, risk management and Solvency II. In addition, two principals of Artex have been appointed directors of WICE. In exchange for these services, we pay 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 we paid to Artex under the insurance management services agreement for the years ended December 31, 2018, 2017 and 2016. Year Ended December 31, 2018 2017 2016 ($ in thousands) Fees paid to Artex under insurance management services agreement ........................................................................... $ 534 $ 325 $ 217 For the years ended December 31, 2018, 2017 and 2016, we paid no fees to Arch under this insurance management services agreement. 15. 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 155 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) 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 at December 31, 2018, 2017 and 2016 amounted to $53.3 million, $30.6 million and $16.5 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 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 issue. There were no investments in any entity in excess of 10% of the Company’s shareholders’ equity at December 31, 2018, 2017 and 2016, other than cash and cash equivalents held in operating and investment accounts with financial institutions with credit ratings between “A” and “AA-.” Letter of credit facility On May 16, 2018, Watford Re renewed its letter of credit facility with Lloyds Bank Plc, New York Branch (the “Lloyds Facility”). The Lloyds Facility amount is $100.0 million and was renewed through to May 16, 2019, and is expected to be renewed. The principal purpose of the Lloyds Facility is to issue, as required, evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which the Company has entered into reinsurance arrangements to ensure that such counterparties are permitted to take credit for reinsurance obtained from the Company as required under insurance regulations in the United States. The amount of letters of credit issued is driven by, among other things, the timing and payment of catastrophe losses, loss development of existing reserves, the payment pattern of such reserves, the further expansion of the Company’s business and the loss experience of such business. When issued, the letters of credit are secured by certificates of deposit or cash. In addition, the Lloyds Facility also requires the maintenance of certain covenants, which the Company was in compliance with at December 31, 2018, 2017 and 2016. At such dates, the Company had $68.9 million, $70.1 million and $65.9 million, respectively, in restricted assets as collateral for outstanding letters of credit issued from the Lloyds Facility, which were secured by certificates of deposit. These amounts are reflected as short-term investments in the Company’s consolidated balance sheets. Secured credit facility On November 30, 2017, Watford Re amended and restated its $800 million secured credit facility (the “Secured Facility”) with Bank of America, N.A. which expires on November 30, 2021. The purpose of the Secured Facility is to provide borrowings, backed by Watford Re’s investment portfolios. In addition, the Secured Facility allows for Watford Re to issue up to $400.0 million in evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which the Company has entered into reinsurance arrangements. At December 31, 2018, Watford Re 156 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) had $455.7 million and $52.5 million in borrowings and outstanding letters of credit, respectively. At December 31, 2017, Watford Re had $441.1 million and $43.9 million in borrowings and outstanding letters of credit, respectively. At December 31, 2016, Watford Re had $256.7 million and $186.6 million in borrowings and outstanding letters of credit, respectively. At December 31, 2018, 2017 and 2016, Watford Re was in compliance with all covenants contained in the Secured Facility. Custodian bank facility As of December 31, 2018, 2017 and 2016, we borrowed $238.2 million, $108.0 million and $2.2 million, respectively, from our custodian bank to purchase U.S.-denominated securities. As of December 31, 2018, the total borrowed amount of $238.2 million included 2.0 million Swiss Francs, or CHF, (USD equivalent of $2.0 million) to purchase CHF-denominated securities. We pay interest based on 3-month LIBOR plus a margin and the borrowed amount is payable upon demand. The foreign exchange gain or loss on revaluation on the borrowed funds is included as a component of foreign exchange gains (losses) included in the consolidated statements of net income (loss). The custodian bank requires us to hold cash and investments on deposit with, or in an investment account, with respect to the borrowed funds. As at December 31, 2018, 2017 and 2016, we were required to hold $339.1 million, $150.5 million and $3.0 million, respectively, in such deposits and investment accounts. Leases and purchase obligations At December 31, 2018 the future minimum rental commitments for the Company’s operating lease are as follows: Future rental commitments 2019 ..................................................................................................................................... $ 2020 ..................................................................................................................................... 2021 ..................................................................................................................................... 2022 ..................................................................................................................................... 2023 ..................................................................................................................................... Total ..................................................................................................................................... $ December 31, 2018 283 283 283 283 189 1,321 The lease is for the rental of office space, with an expiration date of September 2, 2023. Rental expense for each of the years ended December 31, 2018, 2017 and 2016 was $0.3 million. Employment and other arrangements The Company has employment agreements with certain of its executive officers. Such employment arrangements provide for compensation in the form of base salary, annual bonus, participation in the Company’s employee benefit programs and the reimbursements of expenses. Investment commitments As at December 31, 2018, 2017 and 2016, the Company had unfunded commitments of $Nil, $1.0 million and $1.1 million, respectively, relating to term loans within its investment portfolios. As at December 31, 2018, 2017 and 2016 the Company had unfunded commitments of $2.9 million, $10.9 million and $Nil, respectively, relating to equities within its investment portfolios. 157 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) 16. Contingently redeemable preference shares In March 2014, the Company issued 9,065,200 8½% cumulative redeemable preference shares (the “Preference Shares”). The Company recorded the Preference Shares in the mezzanine section of its consolidated balance sheets in accordance with applicable accounting guidance. 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 amount 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. Dividends accrue (i) from (and including) June 30, 2014 to (but excluding) June 30, 2019 (the “Fixed Rate Period”) at 8½% of the $25 per share liquidation preference per annum (equivalent to $2.125 per share per annum) and (ii) 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; 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 preferred 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 are recorded in the mezzanine section of its consolidated balance sheets. 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 September 28, 2017, the Company’s shareholders increased the authorized preferred share capital to 20 million preference shares from 10 million preference shares at a par value of $0.01 per share. For the year ended December 31, 2018, no additional preference shares have been issued. During 2018, 2017 and 2016, preferred dividends paid on the Preference Shares totaled $19.3 million, $19.3 million and $19.3 million, respectively, and accretion of the discount and issuance costs was $0.4 million, $0.4 million and $0.4 million, respectively. 17. Shareholders’ equity Common shares On September 28, 2017, the Company’s shareholders increased the authorized share capital of the Company to 80 million common shares from 40 million common shares at a par value of $0.01 per share. For the year ended December 31, 2018, no additional common shares have been issued. The Company issued 22,682,875 common shares in March 2014. The issued and outstanding share capital of the Company consists of 22,682,875 common shares, par value of $0.01 per share at December 31, 2018, 2017 and 2016. Warrants In connection with our initial private placement, we issued to Arch warrants to purchase up to 975,503 of common shares and to HPS warrants to purchase up to 729,188 of common shares. The warrants expire on March 25, 2020, and are exercisable at any time following a listing or public share offering by the Company. The exercise price of the warrants is determined on the date of exercise so that, if all such warrants then outstanding were exercised in full on such exercise date in respect of the common shares then subject to such warrants, initial holders who purchased common shares in our initial private placement would achieve a 15% target return (including dilution from such warrants and excluding dilution from start-up expenses related to our formation and initial private placement or any warrants we may issue in the future) from March 25, 2014, the initial closing of our private placement, through the date of such exercise, based on the $40.00 initial purchase price per common share paid by such initial holders and the market value of the common 158 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) shares that would be necessary for the initial holders to achieve such target return if the initial holders disposed of their common shares on the date of such exercise. The warrants issued to Arch and HPS contain a provision where, at the holder’s request and at our option and in our sole discretion, the holder may, subject to certain conditions, receive cash in lieu of common shares upon exercise of the warrants. The amount of the cash payment is calculated by multiplying (i) the number of common shares for which the warrant is being exercised by (ii) the volume weighted average price per common share for the 20 trading days immediately prior to (but not including) the date of exercise less the strike price. We are not, however, required to net cash settle the warrants. 18. Retirement plans For purposes of providing employees with retirement benefits, the Company maintains defined contribution retirement plans. Contributions are based on the participants’ eligible compensation. For the years ended December 31, 2018, 2017 and 2016, the Company expensed approximately $0.2 million, $0.2 million and $0.2 million, respectively, related to these retirement plans. 19. 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 December 31, 2018, 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. 20. Statutory information Bermuda Under the Insurance Act, Watford Re, the Company’s reinsurance subsidiary, is registered as a Class 4 insurer and is required to annually prepare and file statutory financial statements and a statutory financial return with the Bermuda Monetary Authority (“BMA”). The Insurance Act also requires Watford Re to maintain minimum share capital and must ensure that the value of its general business assets exceeds the amount of its general business liabilities by an amount greater than the prescribed minimum solvency margins and enhanced capital requirement pertaining to its general business. At December 31, 2018, 2017 and 2016, all such requirements were met. Watford Re is also required under its Class 4 license 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. As of December 31, 2018, 2017 and 2016, Watford Re met the minimum liquidity ratio requirement. Under the Insurance Act, Watford Re is subject to capital requirements calculated using the Bermuda Solvency Capital Requirement model (“BSCR Model”), which is a standardized statutory risk-based capital model used to measure the risk associated with Watford Re’s assets, liabilities and premiums. The BSCR Model is based on an economic balance sheet (“EBS”) derived from the U.S. GAAP financial statements, with certain adjustments related to loss reserves, intangibles and contingencies, among others. Under the BSCR Model, Watford Re’s minimum required statutory capital and surplus is referred to as the enhanced capital requirement (“ECR”). The ECR is the greater of the calculated BSCR and the minimum solvency margin (“MSM”). Watford Re is required to calculate and submit the ECR to the BMA annually. 159 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) The BSCR for Watford Re for the year ended December 31, 2018 will not be filed with the BMA until April 2019. As such, the minimum required statutory capital and surplus, the ECR, disclosed as at December 31, 2018 was $770.0 million, being the higher of the then-current MSM and the estimated BSCR as of December 31, 2018. The minimum required statutory capital and surplus as at December 31, 2017 and 2016 was $677.7 million and $517.5 million, respectively, which in each case is the ECR, being the higher of the then-current MSM and BSCR on those dates. As of December 31, 2018, 2017 and 2016, Watford Re met its ECR. The Bermuda Companies Act 1981 limits Watford Re’s ability to pay dividends and distributions to its Parent if there are reasonable grounds for believing that: (a) Watford Re is, or would after the payment be, unable to pay its liabilities as they become due; or (b) the realizable value of Watford Re’s assets would thereby be less than the aggregate of its liabilities and its issued share capital and share premium accounts. Under the Insurance Act, Watford Re may declare dividends subject to it continuing to meet its minimum solvency and capital requirements, which includes continuing to hold statutory capital and surplus equal to or exceeding its ECR. Watford Re is prohibited from declaring or paying in any fiscal year dividends of more than 25% of its prior year’s statutory capital and surplus unless Watford Re files with the BMA a signed affidavit by at least two members of the board of directors attesting that a dividend would not cause the company to fail to meet its relevant margins. As of December 31, 2018, Watford Re could pay dividends or return capital in 2019 of approximately $278.7 million without providing an affidavit to the BMA. During 2018, 2017 and 2016, Watford Re paid $19.3 million, $19.3 million and $19.3 million, respectively, in dividends to the Parent based on solvency and capital requirements in those years. Watford Re is also prohibited, without prior approval of the BMA, from reducing by 15% or more its prior year statutory capital. Group supervision The BMA acts as a group supervisor of Watford Re and its operating subsidiaries (“Group”) and has designated Watford Re as the designated insurer (“Designated Insurer”). As our Group Supervisor, the BMA performs a number of functions including: (i) coordinating the gathering and dissemination of information for other regulatory authorities; (ii) carrying out supervisory reviews and assessments of our Group; (iii) carrying out assessments of our Group’s compliance with the rules on solvency, risk concentration, intra-group transactions and good governance procedures; (iv) planning and coordinating through regular meetings with other authorities, supervisory activities in respect of our Group; (v) coordinating any enforcement action that may need to be taken against our Group or any Group members; and (vi) coordinating meetings of colleges of supervisors in order to facilitate the carrying out of these functions. As Designated Insurer, Watford Re is required to facilitate compliance by our Group with the group insurance solvency and supervision rules. On an annual basis, the Group is required to file Group statutory financial statements, a Group statutory financial return, a Group capital and solvency return, audited financial statements, a Group Solvency Self-Assessment (“GSSA”), and a financial condition report with the BMA. The GSSA is designed to document our perspective on the capital resources necessary to achieve our business strategies and remain solvent, and to provide the BMA with insights on our risk management, governance procedures and documentation related to this process. In addition, the Designated Insurer is required to file quarterly group financial returns with the BMA. The Group is also required to maintain available Group statutory economic capital and surplus in an amount that is at least equal to the group enhanced capital requirement (“Group ECR”) and the BMA has established a group target capital level equal to 120% of the Group ECR. The BMA maintains supervision over the controllers of all Bermuda registered insurers, and accordingly, any person who, directly or indirectly, becomes a holder of at least 10%, 20%, 33% or 50% of our ordinary shares must notify the BMA in writing within 45 days of becoming such a 160 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) holder (or ceasing to be such a holder). The BMA may object to such a person and require the holder to reduce its holding of ordinary shares and direct, among other things, that voting rights attached to the ordinary shares shall not be exercisable. Gibraltar WICE is licensed by the Gibraltar Financial Services Commission (“GFSC”) under the Gibraltar Financial Services (Insurance Companies) Act (“the Gibraltar Act”) to underwrite various insurance businesses across Europe. Under the Gibraltar Act, WICE is subject to capital requirements and is required to prepare and submit annual financial statements to the GFSC as outlined in the Gibraltar Act and in accordance with Gibraltar Generally Accepted Accounting Practice. WICE shall notify the GFSC of any proposals to declare or pay a dividend on any of its share capital. WICE shall not declare or pay any dividend within 14 days of the date of notification. As of December 31, 2018, 2017 and 2016, WICE was in compliance with the GFSC dividend requirement. United States The Company’s U.S. subsidiaries file financial statements prepared in accordance with statutory accounting practices prescribed or permitted by insurance regulators. Statutory net income and statutory policyholders’ surplus, as reported to the insurance regulatory authorities, differ in certain respects from the amounts prepared in accordance with U.S. GAAP. The main differences between statutory net income and U.S. GAAP net income relate to unrealized gains (losses) on investments and deferred acquisition costs, among others. In addition, other differences between statutory policyholders’ surplus and U.S. GAAP shareholder’s equity are unrealized appreciation or decline in value of investments and non-admitted assets, among others. The Company’s U.S. subsidiaries are subject to insurance laws and regulations in the jurisdictions in which they operate. The ability of the Company’s regulated U.S. subsidiaries to pay dividends or make distributions is dependent on their ability to meet applicable regulatory standards. These regulations include restrictions that limit the amount of dividends or other distributions, such as loans or cash advances, available to common shareholders without prior approval of the insurance regulatory authorities. Any dividends or distributions made by WSIC or WIC would result in an increase in available capital at Holdings U.S. WSIC and WIC can declare a maximum of $6.1 million and $1.7 million, respectively, of dividends during 2019, without prior approval from the New Jersey Commissioner of Insurance. The statutory policyholders’ surplus for WSIC at December 31, 2018, 2017 and 2016 was $61.0 million, $64.5 million and $65.1 million, respectively. The minimum required statutory policyholders’ surplus, referred to as authorized control level risk-based capital, for WSIC at December 31, 2018, 2017 and 2016 was $3.5 million, $3.0 million and $3.1 million, respectively. The statutory policyholders’ surplus for WIC at December 31, 2018, 2017 and 2016 was $17.1 million, $20.1 million and $20.7 million, respectively. The minimum required statutory policyholders’ surplus, referred to as authorized control level risk-based capital, for WIC at December 31, 2018 and 2017 and 2016 was $1.8 million, $671.3 thousand and $716.0 thousand, respectively. 161 WATFORD HOLDINGS LTD. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (U.S. dollars in thousands, except share data) The statutory capital and surplus in our significant regulatory jurisdictions at December 31, 2018, 2017 and 2016 was as follows: 2018 December 31, 2017 2016 Actual Required Actual Required Actual Required ($ in thousands) Statutory capital and surplus: Bermuda (1)................. $1,114,933 $ 770,000 $1,161,004 $ 677,677 $1,164,589 $ 517,486 United States ............... 3,835 Gibraltar ...................... 78,052 22,927 12,281 23,372 85,771 84,668 13,136 15,256 3,707 5,253 5,363 (1) The BSCR for Watford Re for the year ended December 31, 2018 will not be filed with the BMA until April 2019. As such, the required statutory capital and surplus as at December 31, 2018 is an estimate of ECR. The statutory net income (loss) in our significant regulatory jurisdictions at December 31, 2018, 2017 and 2016 was as follows: Year Ended December 31, 2018 2017 2016 ($ in thousands) Statutory net income (loss): Bermuda ............................................................................. $ United States ...................................................................... Gibraltar ............................................................................. (25,110) $ 10,982 $ 146,801 (1,963) 653 111 1,320 218 290 21. Subsequent events The Company has completed its subsequent events evaluation for the period subsequent to the balance sheet date of December 31, 2018 through March 5, 2019, the date the consolidated financial statements were available to be issued, and concluded that there are no subsequent events requiring recognition or disclosure. 162 

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