Income Taxes

12 Months Ended

Dec. 31, 2020

Arch Capital is incorporated under the laws of Bermuda and, under current Bermuda law, is not obligated to pay any taxes in Bermuda based upon income or capital gains. The Company has received a written undertaking from the Minister of Finance in Bermuda under the Exempted Undertakings Tax Protection Act 1966 that, in the event that any legislation is enacted in Bermuda imposing any tax computed on profits, income, gain or appreciation on any capital asset, or any tax in the nature of estate duty or inheritance tax, such tax will not be applicable to Arch Capital or any of its operations until March 31, 2035. This undertaking does not, however, prevent the imposition of taxes on any person ordinarily resident in Bermuda or any company in respect of its ownership of real property or leasehold interests in Bermuda.Arch Capital and its non-U.S. subsidiaries will be subject to U.S. federal income tax only to the extent that they derive U.S. source income that is subject to U.S. withholding tax or income that is effectively connected with the conduct of a trade or business within the U.S. and is not exempt from U.S. tax under an applicable income tax treaty with the U.S. Arch Capital and its non-U.S. subsidiaries will be subject to a withholding tax on dividends from U.S. investments and interest from certain U.S. payors (subject to reduction by any applicable income tax treaty). Arch Capital and its non-U.S. subsidiaries intend to conduct their operations in a manner that will not cause them to be treated as engaged in a trade or business in the United States and, therefore, will not be required to pay U.S. federal income taxes (other than U.S. excise taxes on insurance and reinsurance premium and withholding taxes on dividends and certain other U.S. source investment income). However, because there is uncertainty as to the activities which constitute being engaged in a trade or business within the United States, there can be no assurances that the U.S. Internal Revenue Service will not contend

successfully that Arch Capital or its non-U.S. subsidiaries are engaged in a trade or business in the United States. If Arch Capital or any of its non-U.S. subsidiaries were subject to U.S. income tax, Arch Capital’s shareholders’ equity and earnings could be materially adversely affected. Arch Capital has subsidiaries and branches that operate in various jurisdictions around the world that are subject to tax in the jurisdictions in which they operate. The significant jurisdictions in which Arch Capital’s subsidiaries and branches are subject to tax are the United States, United Kingdom, Ireland, Canada, Switzerland, Australia and Denmark.

The components of income taxes attributable to operations were as follows:


	Year Ended December 31,
	2020		2019		2018
Current expense (benefit):
United States	$	181,571	$	139,407	$	73,078
Non-U.S.	16,091		4,954		12,785
	197,662		144,361		85,863
Deferred expense (benefit):
United States	(89,170)		11,849		19,544
Non-U.S.	3,346		(400)		8,544
	(85,824)		11,449		28,088
Income tax expense	$	111,838	$	155,810	$	113,951

The Company’s income or loss before income taxes was earned in the following jurisdictions:


	Year Ended December 31,
	2020		2019		2018
Income (Loss) Before Income Taxes:
Bermuda	$	1,114,117	$	1,122,952	$	388,492
United States	409,893		701,480		440,823
Other	53,539		24,678		12,457
Total	$	1,577,549	$	1,849,110	$	841,772

The expected tax provision computed on pre-tax income or loss at the weighted average tax rate has been calculated as the sum of the pre-tax income in each jurisdiction multiplied by that jurisdiction’s applicable statutory tax rate. The 2020 applicable statutory tax rates by jurisdiction were as follows: Bermuda (0.0%), United States (21.0 %), United Kingdom (19.0 %), Ireland (12.5 %), Denmark (22.0 %), Canada (26.5 %), Gibraltar (10.0 %), Australia (30.0 %), Hong Kong (16.5 %) and the Netherlands (16.5 %).

A reconciliation of the difference between the provision for income taxes and the expected tax provision at the weighted average tax rate follows:


	Year Ended December 31,
	2020		2019		2018
Expected income tax expense (benefit) computed on pre-tax income at weighted average income tax rate	$	111,947	$	149,799	$	91,529
Addition (reduction) in income tax expense (benefit) resulting from:
Tax-exempt investment income	(1,824)		(3,091)		(4,790)
Meals and entertainment	547		1,134		1,060
State taxes, net of U.S. federal tax benefit	5,027		3,314		2,086
Foreign branch taxes	2,094		1,231		5,428
Prior year adjustment	3,983		632		(2,522)
Foreign exchange gains & losses	(1,736)		436		1,293
Changes in applicable tax rate	—		—		(128)
Dividend withholding taxes	7,105		6,510		6,594
Change in valuation allowance	13,190		1,628		18,396
Contingent consideration	9		190		740
Share based compensation	(2,533)		(6,592)		(5,356)

Intercompany loan write-off	(22,083)		—		—
Other	(3,888)		619		(379)
Income tax expense (benefit)	$	111,838	$	155,810	$	113,951

The effect of a change in tax laws or rates on deferred taxes assets and liabilities is recognized in income in the period in which such change is enacted.

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:


	December 31,
	2020		2019
Deferred income tax assets:
Net operating loss	$	67,142	$	30,836
Uncrystallized losses	2,926		1,565
AMT credit carryforward	—		1,323
Discounting of net loss reserves	74,247		52,582

Net unearned premium reserve	66,368		64,269
Compensation liabilities	27,351		21,693
Foreign tax credit carryforward	19,160		9,521
Interest expense	622		—
Goodwill and intangible assets	14,450		11,644

Bad debt reserves	1,864		5,983
Lease liability	23,604		26,438
Net unrealized foreign exchange gains	165		598

Other, net	1,725		206
Deferred tax assets before valuation allowance	299,624		226,658
Valuation allowance	(88,255)		(48,219)
Deferred tax assets net of valuation allowance	211,369		178,439
Deferred income tax liabilities:
Depreciation and amortization	(495)		(1,215)

Deposit accounting liability	(1,751)		(2,169)
Contingency reserve	(64,593)		(132,831)
Deferred policy acquisition costs	(42,045)		(29,847)

Net unrealized appreciation of investments	(66,681)		(38,764)
Right-of-use asset	(19,239)		(23,416)
Other, net	(843)		(3,680)
Total deferred tax liabilities	(195,647)		(231,922)
Net deferred income tax assets (liabilities)	$	15,722	$	(53,483)

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, 2020, the Company’s valuation allowance was $88.3 million, compared to $48.2 million at December 31, 2019. The valuation allowance in both periods was primarily attributable to valuation allowance on the Company’s U.K. Canadian and Australian operations and certain other deferred tax assets relating to loss carryforwards that have a limited use.

At December 31, 2020, the Company’s net operating loss carryforwards and tax credits were as follows:


	Year Ended December 31,
	2020		Expiration
Operating Loss Carryforwards
United Kingdom	$	237,277	No expiration
Ireland	11,336		No expiration
Australia	37,995		No expiration
Hong Kong	21,094		No expiration
Denmark	23		No expiration
United States (1)	27,425		2029 - 2038

Tax Credits
U.K. foreign tax credits	19,160		No expiration
U.S. refundable AMT credits	0		No expiration

(1) On January 30, 2014, the Company’s U.S. mortgage operations underwent an ownership change for U.S. federal income tax purposes as a result of the Company’s acquisition of the CMG Entities. As a result of this ownership change, a limitation has been imposed upon the utilization of approximately $8.3 million of the Company’s existing U.S. net operating loss carryforwards. Utilization is limited to approximately $0.6 million per year in accordance with Section 382 of the Internal Revenue Code of 1986 as amended (“the Code”).

The Company’s U.S. mortgage operations are eligible for a tax deduction, subject to certain limitations, under Section 832(e) of the Code for amounts required by state law or regulation to be set aside in statutory contingency reserves. The deduction is allowed only to the extent that the Company purchases non-interest bearing U.S. Mortgage Guaranty Tax and Loss Bonds (“T&L Bonds”) issued by the U.S. Treasury Department in an amount equal to the tax benefit derived from deducting any portion of the statutory contingency reserves. T&L Bonds are reflected in ‘other assets’ on the Company’s balance sheet and totaled approximately $88.1 million at December 31, 2020, compared to $207.0 million at December 31, 2019.

Deferred income tax liabilities have not been accrued with respect to the undistributed earnings of the Company's U.S., U.K. and Ireland subsidiaries as it is the Company’s intention that all such earnings will be indefinitely reinvested. If the earnings were to be distributed, as dividends or otherwise, such amounts may be subject to withholding tax in the jurisdiction of the paying entity. The Company no longer intends to indefinitely reinvest earnings from the Company's Canada subsidiary, however, no income or withholding taxes have been accrued as the Canada subsidiary does not have positive cumulative earnings and profits and therefore a distribution from this particular subsidiary would not be subject to income taxes or withholding taxes. Potential tax implications of repatriation from the Company’s unremitted earnings that are indefinitely reinvested are driven by facts at the time of distribution. Therefore it is not practicable to estimate the income tax liabilities that might be incurred if

such earnings were remitted. Distributions from the U.K. or Ireland would not be subject to withholding tax and no deferred income tax liability would need to be accrued.

The Company recognizes interest and penalties relating to unrecognized tax benefits in the provision for income taxes. As of December 31, 2020, the Company’s total unrecognized tax benefits, including interest and penalties, were $2.0 million. If recognized, the full amount of the unrecognized tax benefit would impact the consolidated effective tax rate. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:


	December 31,
	2020		2019
Balance at beginning of year	$	2,008	$	2,008
Additions based on tax positions related to the current year	—		—
Additions for tax positions of prior years	—		—
Reductions for tax positions of prior years	—		—
Settlements	—		—
Balance at end of year	$	2,008	$	2,008

The Company or its subsidiaries or branches files income tax returns in the U.S. federal jurisdiction and various state, local and foreign jurisdictions. The following table details open tax years that are potentially subject to examination by local tax authorities, in the following major jurisdictions:


Jurisdiction						Tax Years
United States						2015-2020
United Kingdom						2019-2020
Ireland						2016-2020
Canada						2016-2020
Switzerland						2017-2020
Denmark						2016-2020
Australia						2016-2020

As of December 31, 2020, the Company’s current income tax payable (included in “Other liabilities”) was $9.2 million.

- Definition

The entire disclosure for income taxes. Disclosures may include net deferred tax liability or asset recognized in an enterprise's statement of financial position, net change during the year in the total valuation allowance, approximate tax effect of each type of temporary difference and carryforward that gives rise to a significant portion of deferred tax liabilities and deferred tax assets, utilization of a tax carryback, and tax uncertainties information.

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