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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

        OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2010

OR

¨        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)

        OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number 001-31721

AXIS CAPITAL HOLDINGS LIMITED

(Exact name of registrant as specified in its charter)

BERMUDA

(State or other jurisdiction of incorporation or organization)

98-0395986

(I.R.S. Employer Identification No.)

92 Pitts Bay Road, Pembroke, Bermuda HM 08

(Address of principal executive offices and zip code)

(441) 496-2600

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x  No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  x  No  ¨

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

Large accelerated filer  x  Accelerated filer  ¨   Non-accelerated filer  ¨  Smaller reporting company  ¨

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

As of October 25, 2010 there were 123,613,982 Common Shares, $0.0125 par value per share, of the registrant outstanding.

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AXIS CAPITAL HOLDINGS LIMITED

INDEX TO FORM 10-Q

 

				Page
		PART I
		Financial Information			3
Item 1.		Consolidated Financial Statements			4
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			35
Item 3.		Quantitative and Qualitative Disclosures About Market Risk			69
Item 4.		Controls and Procedures			69
		PART II
		Other Information			70
Item 1.		Legal Proceedings			70
Item 1A.		Risk Factors			70
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds			71
Item 6.		Exhibits			72
		Signatures			74

 

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PART  I

FINANCIAL INFORMATION

 

 

Cautionary Statement Regarding Forward-looking Statements

This quarterly report contains forward-looking statements within the meaning of the U.S. federal securities laws. We intend these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in the United States securities laws. In some cases, these statements can be identified by the use of forward-looking words such as “may”, “should”, “could”, “anticipate”, “estimate”, “expect”, “plan”, “believe”, “predict”, “potential” and “intend”. Forward-looking statements contained in this report may include information regarding our estimates of losses related to catastrophes and other large losses, measurements of potential losses in the fair value of our investment portfolio and derivative contracts, our expectations regarding pricing and other market conditions, our growth prospects, and valuations of the potential impact of movements in interest rates, equity prices, credit spreads and foreign currency rates. Forward-looking statements only reflect our expectations and are not guarantees of performance.

These statements involve risks, uncertainties and assumptions. Accordingly, there are or will be important factors that could cause actual results to differ materially from those indicated in such statements. We believe that these factors include, but are not limited to, the following:

 

•

the occurrence of natural and man-made disasters,

 

•

actual claims exceeding our loss reserves,

 

•

general economic, capital and credit market conditions and the persistence of the recent financial crisis,

 

•

the failure of any of the loss limitation methods we employ,

 

•

the effects of emerging claims and coverage issues,

 

•

the failure of our cedants to adequately evaluate risks,

 

•

inability to obtain additional capital on favorable terms, or at all,

 

•

the loss of one or more key executives,

 

•

a decline in our ratings with rating agencies,

 

•

loss of business provided to us by our major brokers,

 

•

changes in accounting policies or practices,

 

•

changes in governmental regulations,

 

•

increased competition,

 

•

changes in the political environment of certain countries in which we operate or underwrite business,

 

•

fluctuations in interest rates, credit spreads, equity prices and/or currency values, and

 

•

the other matters set forth under Item 1A, ‘Risk Factors’ and Item 7, ‘Management’s Discussion and Analysis of Financial Condition and Results of Operations’ included in our Annual Report on Form 10-K for the year ended December 31, 2009.

We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

 

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ITEM 1.

CONSOLIDATED FINANCIAL STATEMENTS

 

 

 

		Page
Consolidated Balance Sheets as at September 30, 2010 (Unaudited) and December 31, 2009		5
Consolidated Statements of Operations for the three and nine months ended September  30, 2010 and 2009 (Unaudited)		6
Consolidated Statements of Comprehensive Income for the three and nine months ended September  30, 2010 and 2009 (Unaudited)		7
Consolidated Statements of Changes in Shareholders’ Equity for the nine months ended September  30, 2010 and 2009 (Unaudited)		8
Consolidated Statements of Cash Flows for the nine months ended September  30, 2010 and 2009 (Unaudited)		9
Notes to the Consolidated Financial Statements (Unaudited)		10

 

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AXIS CAPITAL HOLDINGS LIMITED

CONSOLIDATED BALANCE SHEETS

SEPTEMBER 30, 2010 (UNAUDITED) AND DECEMBER 31, 2009

 

		2010				2009
		(in thousands)
Assets
Investments:
Fixed maturities, available for sale, at fair value (Amortized cost 2010: $10,285,643; 2009: $9,628,287)		$	10,664,824			$	9,718,355
Equity securities, available for sale, at fair value (Cost 2010: $237,656; 2009: $195,011)			251,005				204,375
Other investments, at fair value			533,072				570,276
Short-term investments, at amortized cost			129,042				129,098
Total investments			11,577,943				10,622,104
Cash and cash equivalents			1,057,864				788,614
Restricted cash and cash equivalents			147,529				75,440
Accrued interest receivable			92,758				89,559
Insurance and reinsurance premium balances receivable			1,536,944				1,292,877
Reinsurance recoverable on unpaid and paid losses			1,551,612				1,424,172
Deferred acquisition costs			402,887				302,320
Prepaid reinsurance premiums			234,850				301,885
Securities lending collateral			-				129,814
Net receivable for investments sold			-				12,740
Goodwill and intangible assets			89,744				91,505
Other assets			154,399				175,494
Total assets		$	16,846,530			$	15,306,524
Liabilities
Reserve for losses and loss expenses		$	6,934,528			$	6,564,133
Unearned premiums			2,614,239				2,209,397
Insurance and reinsurance balances payable			123,127				173,156
Securities lending payable			-				132,815
Senior notes			993,976				499,476
Other liabilities			240,338				227,303
Net payable for investments purchased			91,384				-
Total liabilities			10,997,592				9,806,280
Commitments and Contingencies
Shareholders’ equity
Preferred shares - Series A and B			500,000				500,000
Common shares (2010: 154,697; 2009: 152,465 shares issued and 2010: 119,958; 2009: 132,140 shares outstanding)			1,931				1,903
Additional paid-in capital			2,046,297				2,014,815
Accumulated other comprehensive income			371,625				85,633
Retained earnings			4,033,018				3,569,411
Treasury shares, at cost (2010: 34,739; 2009: 20,325 shares)			(1,103,933	)			(671,518	)
Total shareholders’ equity			5,848,938				5,500,244
Total liabilities and shareholders’ equity		$	16,846,530			$	15,306,524

See accompanying notes to Consolidated Financial Statements.

 

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AXIS CAPITAL HOLDINGS LIMITED

CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009

 

		Three months ended								Nine months ended
		2010				2009				2010				2009
		(in thousands, except for per share amounts)
Revenues
Net premiums earned		$	758,873			$	706,025			$	2,190,092			$	2,078,154
Net investment income			111,800				134,788				299,004				346,300
Other insurance related income (loss)			884				(135,738	)			1,727				(159,394	)
Net realized investment gains (losses):
Other-than-temporary impairment losses			(2,091	)			(283,418	)			(16,581	)			(336,214	)
Portion of impairment losses transferred to (from) other comprehensive income			(272	)			4,080				1,284				5,523
Other realized investment gains			78,894				25,973				132,622				13,051
Total net realized investment gains (losses)			76,531				(253,365	)			117,325				(317,640	)
Total revenues			948,088				451,710				2,608,148				1,947,420
Expenses
Net losses and loss expenses			422,154				311,109				1,293,787				1,077,360
Acquisition costs			123,788				113,423				364,614				318,708
General and administrative expenses			103,435				92,009				309,266				265,515
Foreign exchange losses (gains)			24,961				6,784				(10,415	)			30,579
Interest expense and financing costs			15,800				7,977				40,185				23,869
Total expenses			690,138				531,302				1,997,437				1,716,031
Income (loss) before income taxes			257,950				(79,592	)			610,711				231,389
Income tax expense			9,890				7,082				27,550				24,785
Net income (loss)			248,060				(86,674	)			583,161				206,604
Preferred share dividends			9,218				9,218				27,656				27,656
Net income (loss) available to common shareholders		$	238,842			$	(95,892	)		$	555,505			$	178,948
Weighted average common shares and common share equivalents:
Basic			120,091				137,904				123,320				137,693
Diluted			134,406				137,904				137,382				150,258
Earnings (loss) per common share
Basic		$	1.99			$	(0.70	)		$	4.50			$	1.30
Diluted		$	1.78			$	(0.70	)		$	4.04			$	1.19
Cash dividends declared per common share		$	0.21			$	0.20			$	0.63			$	0.60

See accompanying notes to Consolidated Financial Statements.

 

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AXIS CAPITAL HOLDINGS LIMITED

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009

 

		Three months ended								Nine months ended
		2010				2009				2010				2009
		(in thousands)
Net income (loss)		$	248,060			$	(86,674	)		$	583,161			$	206,604
Other comprehensive income, net of tax:
Available for sale investments:
Unrealized gains arising during the period			231,879				357,290				401,468				512,336
Portion of other-than-temporary impairment losses recognized in other comprehensive income			272				(3,393	)			(1,284	)			(4,836	)
Adjustment for re-classification of realized investment (gains) losses and net impairment losses recognized in net income			(84,255	)			247,428				(114,473	)			312,064
Foreign currency translation adjustment			1,873				1,910				281				243
Comprehensive income		$	397,829			$	516,561			$	869,153			$	1,026,411

See accompanying notes to Consolidated Financial Statements.

 

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AXIS CAPITAL HOLDINGS LIMITED

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (UNAUDITED)

NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009

 

		2010				2009
		(in thousands)
Preferred shares - Series A and B
Balance at beginning and end of period		$	500,000			$	500,000
Common shares (par value)
Balance at beginning of period			1,903				1,878
Shares issued			28				23
Balance at end of period			1,931				1,901
Additional paid-in capital
Balance at beginning of period			2,014,815				1,962,779
Shares issued			580				509
Stock options exercised			3,851				2,475
Share-based compensation expense			27,051				37,654
Balance at end of period			2,046,297				2,003,417
Accumulated other comprehensive income (loss)
Balance at beginning of period			85,633				(706,499	)
Unrealized appreciation (depreciation) on available for sale investments, net of tax:
Balance at beginning of period			87,438				(702,548	)
Cumulative effect of change in accounting principle (see Note 3(d))			-				(38,334	)
Unrealized gains arising during the period, net of reclassification adjustment			286,995				824,400
Portion of other-than-temporary impairment losses			(1,284	)			(4,836	)
Balance at end of period			373,149				78,682
Cumulative foreign currency translation adjustments, net of tax:
Balance at beginning of period			803				-
Foreign currency translation adjustment			281				243
Balance at end of period			1,084				243
Supplemental Executive Retirement Plans (SERPs):
Balance at beginning of period			(2,608	)			(3,951	)
Net actuarial gain (loss)			-				-
Balance at end of period			(2,608	)			(3,951	)
Balance at end of period			371,625				74,974
Retained earnings
Balance at beginning of period			3,569,411				3,198,492
Cumulative effect of change in accounting principle, net of tax (see Note 3(d))			-				38,334
Net income			583,161				206,604
Series A and B preferred share dividends			(27,656	)			(27,656	)
Common share dividends			(91,898	)			(96,307	)
Balance at end of period			4,033,018				3,319,467
Treasury shares, at cost
Balance at beginning of period			(671,518	)			(495,609	)
Shares repurchased for treasury			(432,415	)			(6,043	)
Balance at end of period			(1,103,933	)			(501,652	)
Total shareholders’ equity		$	5,848,938			$	5,398,107

See accompanying notes to Consolidated Financial Statements.

 

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AXIS CAPITAL HOLDINGS LIMITED

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009

 

		2010				2009
		(in thousands)
Cash flows from operating activities:
Net income		$	583,161			$	206,604
Adjustments to reconcile net income to net cash provided by operating activities:
Net realized investment (gains) losses			(117,325)				317,640
Loss on insurance derivative contract			-				161,000
Net realized and unrealized gains of other investments			(38,476)				(63,322)
Amortization of fixed maturities			40,004				11,018
Other amortization and depreciation			10,081				11,650
Share-based compensation expense			27,051				37,654
Changes in:
Accrued interest receivable			(3,199)				(2,937)
Reinsurance recoverable balances			(127,440)				(27,819)
Deferred acquisition costs			(100,567)				(90,643)
Prepaid reinsurance premiums			67,035				(5,369)
Reserve for loss and loss expenses			370,395				335,131
Unearned premiums			404,842				385,671
Insurance and reinsurance balances, net			(294,096)				(343,335)
Other items			45,454				(39,237)
Net cash provided by operating activities			866,920				893,706
Cash flows from investing activities:
Purchases of:
Fixed maturities			(9,297,089)				(8,260,119)
Equity securities			(96,209)				(33,995)
Other investments			(45,000)				(91,800)
Proceeds from the sale of:
Fixed maturities			7,975,262				6,174,388
Equity securities			48,970				55,703
Other investments			120,680				86,190
Proceeds from redemption of fixed maturities			829,109				726,060
Net sales (purchases) of short-term investments			2,766				(13,552)
Purchase of other assets			(11,977)				(43,398)
Change in restricted cash and cash equivalents			(72,089)				(7,425)
Net cash used in investing activities			(545,577)				(1,407,948)
Cash flows from financing activities:
Net proceeds from issuance of senior notes			494,870				-
Repurchase of shares			(432,415)				(6,043)
Dividends paid - common shares			(83,090)				(85,218)
Dividends paid - preferred shares			(27,656)				(27,656)
Proceeds from issuance of common shares			4,459				3,007
Net cash used in financing activities			(43,832)				(115,910)
Effect of exchange rate changes on foreign currency cash			(8,261)				41,525
Increase (decrease) in cash and cash equivalents			269,250				(588,627)
Cash and cash equivalents - beginning of period			788,614				1,697,581
Cash and cash equivalents - end of period		$	1,057,864			$	1,108,954

See accompanying notes to Consolidated Financial Statements.

 

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AXIS CAPITAL HOLDINGS LIMITED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

1.	BASIS OF PRESENTATION AND ACCOUNTING POLICIES

Basis of Presentation

The interim consolidated financial statements include the accounts of AXIS Capital Holdings Limited (“AXIS Capital”) and its subsidiaries (herein referred to as “we,” “us,” “our,” or the “Company”).

The consolidated balance sheet at September 30, 2010 and the consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for the periods ended September 30, 2010 and 2009 have not been audited. The balance sheet at December 31, 2009 is derived from our audited financial statements.

These statements have been prepared in accordance with U.S. Generally Accepted Accounting Principles (“U.S. GAAP”) for interim financial information and with the Securities and Exchange Commission’s (“SEC”) instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, these financial statements reflect all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of our financial position and results of operations for the periods presented. The results of operations for any interim period are not necessarily indicative of the results for a full year. All inter-company accounts and transactions have been eliminated.

The following information should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2009. Tabular dollars and share amounts are in thousands, except per share amounts.

Significant Accounting Policies

There have been no changes to our significant accounting policies as described in our Annual Report on Form 10-K for the year ended December 31, 2009.

Adoption of New Accounting Standards

Fair Value Measurement and Disclosures

Effective January 1, 2010, we adopted new guidance issued by the FASB requiring additional disclosures about transfers into and out of Levels 1 and 2 of the fair value hierarchy and separate disclosures about purchases, sales, issuance, and settlements relating to Level 3 measurements. As these new requirements related solely to disclosures, the adoption did not impact our results of operations, financial condition or liquidity. The additional disclosures have been provided in Note 4 – Fair Value Measurements.

Consolidations

Effective January 1, 2010, we adopted amended FASB guidance related to the consolidation of variable interest entities (“VIEs”). This new guidance modifies the approach for determining the primary beneficiary of a VIE by eliminating the initial quantitative assessment and requiring ongoing qualitative reassessments. The adoption of this guidance did not impact our results of operations or financial condition.

Embedded Credit Derivatives

Effective July 1, 2010, we adopted amended FASB guidance that clarified the bifurcation scope exemption for embedded credit-derivative features. Embedded credit-derivative features related only to the transfer of credit risk in the form of subordination of one financial instrument to another (e.g. a mortgage-backed or asset-backed security with multiple tranches) are not subject to bifurcation and separate accounting. The adoption of this guidance did not impact our results of operations, financial condition or liquidity.

 

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AXIS CAPITAL HOLDINGS LIMITED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

1.	BASIS OF PRESENTATION AND ACCOUNTING POLICIES (CONTINUED)

 

 

Recently Issued Accounting Standards Not Yet Adopted

Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses

In July 2010, the FASB issued new guidance requiring disclosures about the nature of credit risk in financing receivables and how that risk is analyzed in determining the related allowance for credit losses, as well as details on changes in the allowance for credit losses during the reporting period. Financing receivables are defined to include instruments such as certain trade receivables, notes receivable and lease receivables, in addition to instruments more traditionally associated with an allowance for credit losses, such as consumer and commercial lending agreements. The new disclosure requirements related to information at the end of a reporting period will be effective for our December 31, 2010, year end reporting; while requirements related to activity that occurred during a reporting period will become effective at January 1, 2011. We are presently evaluating the disclosure impact of the adoption of this guidance.

Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts

In October 2010, the FASB issued guidance modifying the definition of the types of costs that can be capitalized in relation to the acquisition of new and renewal insurance contracts. The amended guidance requires costs to be incremental or directly related to the successful acquisition of new or renewal contracts in order to be capitalized as a deferred acquisition cost. Capitalized costs would include incremental direct costs, such as commissions paid to brokers. Additionally, the portion of employee salaries and benefits directly related to time spent for acquired contracts would be capitalized. Costs that fall outside the revised definition must be expensed when incurred. This new guidance is effective for January 1, 2012 and may be adopted either prospectively or retrospectively. Earlier adoption is permitted, provided the guidance is applied at the beginning of the Company’s financial year. The transitional provisions of this guidance also indicate that if the application of this guidance would result in the capitalization of acquisition costs that had not previously been capitalized, the Company may elect not to capitalize those types of costs. We are presently evaluating the impact of the adoption of this guidance on our results of operation and financial position.

 

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AXIS CAPITAL HOLDINGS LIMITED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

 

2.	SEGMENT INFORMATION

Our underwriting operations are organized around our two global underwriting platforms, AXIS Insurance and AXIS Reinsurance and therefore we have determined that we have two reportable segments, insurance and reinsurance. Except for goodwill and intangible assets, we do not allocate our assets by segment as we evaluate the underwriting results of each segment separately from the results of our investment portfolio.

The following tables summarize the underwriting results of our operating segments for the periods indicated and the carrying values of goodwill and intangible assets at September 30, 2010 and 2009:

 

		2010												2009
Three months ended September 30,		Insurance				Reinsurance				Total				Insurance				Reinsurance				Total
Gross premiums written		$	433,550			$	317,137			$	750,687			$	413,922			$	361,392			$	775,314
Net premiums written			309,277				317,045				626,322				239,781				355,363				595,144
Net premiums earned			320,184				438,689				758,873				278,637				427,388				706,025
Other insurance related income (loss)			884				-				884				(135,898	)			160				(135,738	)
Net losses and loss expenses			(150,860	)			(271,294	)			(422,154	)			(111,228	)			(199,881	)			(311,109	)
Acquisition costs			(38,962	)			(84,826	)			(123,788	)			(29,613	)			(83,810	)			(113,423	)
General and administrative expenses			(64,147	)			(22,292	)			(86,439	)			(55,685	)			(18,719	)			(74,404	)
Underwriting income (loss)		$	67,099			$	60,277				127,376			$	(53,787	)		$	125,138				71,351
Corporate expenses											(16,996	)											(17,605	)
Net investment income											111,800												134,788
Net realized investment gains (losses)											76,531												(253,365	)
Foreign exchange losses											(24,961	)											(6,784	)
Interest expense and financing costs											(15,800	)											(7,977	)
Income (loss) before income taxes										$	257,950											$	(79,592	)
Net loss and loss expense ratio			47.1%				61.8%				55.6%				39.9%				46.8%				44.1%
Acquisition cost ratio			12.2%				19.4%				16.3%				10.6%				19.6%				16.1%
General and administrative expense ratio			20.0%				5.1%				13.7%				20.0%				4.4%				13.0%
Combined ratio			79.3%				86.3%				85.6%				70.5%				70.8%				73.2%
Goodwill and intangible assets		$	89,744			$	-			$	89,744			$	93,049			$	-			$	93,049

 

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AXIS CAPITAL HOLDINGS LIMITED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

2. SEGMENT INFORMATION (CONTINUED)

 

 

		2010												2009
Nine months ended September 30,		Insurance				Reinsurance				Total				Insurance				Reinsurance				Total
Gross premiums written		$	1,419,372			$	1,696,389			$	3,115,761			$	1,304,844			$	1,708,606			$	3,013,450
Net premiums written			982,969				1,675,927				2,658,896				764,932				1,693,526				2,458,458
Net premiums earned			878,117				1,311,975				2,190,092				853,235				1,224,919				2,078,154
Other insurance related income (loss)			1,727				-				1,727				(160,659	)			1,265				(159,394	)
Net losses and loss expenses			(437,057	)			(856,730	)			(1,293,787	)			(451,143	)			(626,217	)			(1,077,360	)
Acquisition costs			(110,670	)			(253,944	)			(364,614	)			(84,122	)			(234,586	)			(318,708	)
General and administrative expenses			(189,802	)			(66,960	)			(256,762	)			(159,059	)			(54,515	)			(213,574	)
Underwriting income (loss)		$	142,315			$	134,341				276,656			$	(1,748	)		$	310,866				309,118
Corporate expenses											(52,504	)											(51,941	)
Net investment income											299,004												346,300
Net realized investment gains (losses)											117,325												(317,640	)
Foreign exchange (losses) gains											10,415												(30,579	)
Interest expense and financing costs											(40,185	)											(23,869	)
Income before income taxes										$	610,711											$	231,389
Net loss and loss expense ratio			49.8%				65.3%				59.1%				52.9%				51.1%				51.8%
Acquisition cost ratio			12.6%				19.4%				16.6%				9.9%				19.2%				15.4%
General and administrative expense ratio			21.6%				5.1%				14.1%				18.6%				4.4%				12.8%
Combined ratio			84.0%				89.8%				89.8%				81.4%				74.7%				80.0%
Goodwill and intangible assets		$	89,744			$	-			$	89,744			$	93,049			$	-			$	93,049

 

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a)	Fixed Maturities and Equities

The amortized cost or cost and fair values of our fixed maturities and equities were as follows:

 

		Amortized Cost or Cost				Gross Unrealized Gains				Gross Unrealized Losses				Fair Value				Non-credit OTTI in  AOCI(3)
At September 30, 2010
Fixed maturities
U.S. government and agency		$	1,339,503			$	33,029			$	(17	)		$	1,372,515			$	-
Non-U.S. government			769,425				23,523				(4,836	)			788,112				-
Corporate debt			4,085,798				237,285				(14,277	)			4,308,806				(491	)
Agency MBS(1)			2,043,754				52,445				(1,997	)			2,094,202				-
Non-Agency CMBS			467,848				33,470				(107	)			501,211				(166	)
Non-Agency RMBS			228,505				3,782				(11,033	)			221,254				(10,885	)
ABS(2)			665,359				13,011				(15,054	)			663,316				(3,746	)
Municipals			685,451				32,040				(2,083	)			715,408				(389	)
Total fixed maturities		$	10,285,643			$	428,585			$	(49,404	)		$	10,664,824			$	(15,677	)
Equity securities		$	237,656			$	20,940			$	(7,591	)		$	251,005
At December 31, 2009
Fixed maturities
U.S. government and agency		$	1,859,874			$	8,511			$	(11,726	)		$	1,856,659			$	-
Non-U.S. government			687,843				11,937				(2,966	)			696,814				-
Corporate debt			3,482,450				126,093				(27,777	)			3,580,766				(6,071	)
Agency MBS(1)			1,529,208				41,425				(4,374	)			1,566,259				-
Non-Agency CMBS			670,949				10,545				(28,283	)			653,211				(505	)
Non-Agency RMBS			257,865				324				(35,207	)			222,982				(8,673	)
ABS(2)			455,831				6,926				(19,618	)			443,139				(10,798	)
Municipals			684,267				18,495				(4,237	)			698,525				(389	)
Total fixed maturities		$	9,628,287			$	224,256			$	(134,188	)		$	9,718,355			$	(26,436	)
Equity securities		$	195,011			$	17,834			$	(8,470	)		$	204,375

(1)	Agency mortgage-backed securities (MBS) include agency residential MBS (RMBS) and agency commercial MBS (CMBS).

(2)	Asset-backed securities (ABS) include debt tranched securities collateralized by sub-prime mortgages, auto loans, credit cards, and other asset types. This asset class also includes an insignificant position in collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs).

(3)	Represents the non-credit component of the other-than-temporary impairment (OTTI) losses, adjusted for subsequent sales of securities. It does not include the change in fair value subsequent to the impairment measurement date.

In the normal course of investing activities, we actively manage allocations to non-controlling tranches of structured securities (variable interests) issued by VIEs. These structured securities include RMBS, CMBS and ABS and are included in the above table. Additionally, within our other investments portfolio, we also invest in limited partnerships (hedge and credit funds) and CLO equity tranched securities, which are all variable interests issued by VIEs (see Note 3(b)). For these variable interests, we do not have the power to direct the activities that are most significant to the economic performance of the VIEs and accordingly we are not the primary beneficiary for any of these VIEs. Our maximum exposure to loss on these interests is limited to the amount of our investment. We have not provided financial or other support with respect to these structured securities other than our original investment.

 

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Gross Unrealized Loss

The following tables summarize fixed maturities and equities in an unrealized loss position and the aggregate fair value and gross unrealized loss by length of time the security has continuously been in an unrealized loss position:

 

		12 months or greater								Less than 12 months								Total
		Fair Value				Unrealized Losses				Fair Value				Unrealized Losses				Fair Value				Unrealized Losses
At September 30, 2010
Fixed maturities
U.S. government and agency		$	-			$	-			$	33,884			$	(17	)		$	33,884			$	(17	)
Non-U.S. government			-				-				182,167				(4,836	)			182,167				(4,836	)
Corporate debt			19,856				(2,588	)			335,700				(11,689	)			355,556				(14,277	)
Agency MBS			775				(24	)			738,434				(1,973	)			739,209				(1,997	)
Non-Agency CMBS			11,046				(79	)			6,136				(28	)			17,182				(107	)
Non-Agency RMBS			112,427				(10,913	)			8,330				(120	)			120,757				(11,033	)
ABS			44,528				(14,958	)			41,305				(96	)			85,833				(15,054	)
Municipals			25,964				(1,678	)			48,658				(405	)			74,622				(2,083	)
Total fixed maturities		$	214,596			$	(30,240	)		$	1,394,614			$	(19,164	)		$	1,609,210			$	(49,404	)
Equity securities		$	10,506			$	(2,551	)		$	40,681			$	(5,040	)		$	51,187			$	(7,591	)
At December 31, 2009
Fixed maturities
U.S. government and agency		$	22,902			$	(915	)		$	1,252,602			$	(10,811	)		$	1,275,504			$	(11,726	)
Non-U.S. government			-				-				352,313				(2,966	)			352,313				(2,966	)
Corporate debt			160,213				(19,245	)			630,678				(8,532	)			790,891				(27,777	)
Agency MBS			1,587				(80	)			427,025				(4,294	)			428,612				(4,374	)
Non-Agency CMBS			273,845				(27,180	)			79,561				(1,103	)			353,406				(28,283	)
Non-Agency RMBS			181,700				(32,787	)			13,042				(2,420	)			194,742				(35,207	)
ABS			51,626				(18,721	)			94,008				(897	)			145,634				(19,618	)
Municipals			13,432				(1,624	)			117,825				(2,613	)			131,257				(4,237	)
Total fixed maturities		$	705,305			$	(100,552	)		$	2,967,054			$	(33,636	)		$	3,672,359			$	(134,188	)
Equity securities		$	31,368			$	(6,025	)		$	86,947			$	(2,445	)		$	118,315			$	(8,470	)

Fixed Maturities

At September 30, 2010, 448 fixed maturities (2009: 832) were in an unrealized loss position of $49 million (2009: $134 million) of which $15 million (2009: $20 million) of this balance was related to securities below investment grade or not rated.

At September 30, 2010, 157 (2009: 312) securities have been in continuous unrealized loss position for 12 months or greater and have a fair value of $215 million (2009: $705 million). These securities were primarily ABS and non-agency RMBS with a weighted average S&P credit rating of BB- and BBB, respectively. We concluded that these securities as well as the remaining securities in an unrealized loss position are temporarily depressed and are expected to recover in value as the securities approach maturity or as market spreads return to more normalized levels. Further, at September 30, 2010, we did not intend to sell these securities in an unrealized loss position and it is more likely than not that we will not be required to sell these securities before the anticipated recovery of their amortized costs.

 

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Equity Securities

At September 30, 2010, 82 securities (2009: 95) were in an unrealized loss position and 40 of these securities (2009: 56) have been in a continuous unrealized loss position for 12 months or greater. Based on our OTTI quarterly review process and our ability and intent to hold these securities for a reasonable period of time sufficient for a full recovery, we concluded that the above equities in an unrealized loss position were temporarily impaired at September 30, 2010 and December 31, 2009.

 

b)	Other Investments

The table below shows our portfolio of other investments reported at fair value:

 

		September 30, 2010								December 31, 2009
Funds of hedge funds		$	231,453				43.4%			$	256,877				45.0%
Hedge funds			143,393				26.9%				94,630				16.6%
Total hedge funds			374,846				70.3%				351,507				61.6%
Long/short credit			78,491				14.7%				84,392				14.8%
Distressed securities			22,799				4.3%				22,957				4.0%
Total credit funds			101,290				19.0%				107,349				18.8%
CLO - equity tranched securities			56,936				10.7%				61,332				10.8%
Short duration high yield fund			-				-    %				50,088				8.8%
Total other investments		$	533,072				100.0%			$	570,276				100.0%

The major categories and related investment strategies for our investments in hedge and credit funds are as follows:

 

Hedge Fund Type		Investment Strategy
Funds of hedge funds		Seek to achieve attractive risk-adjusted returns by investing in a large pool of hedge funds across a diversified range of hedge fund strategies.
Hedge funds		Seek to achieve attractive risk-adjusted returns primarily through multi-strategy and long/short equity approaches. Multi-strategy funds invest in a variety of asset classes on a long and short basis and may employ leverage. Long/short equity funds invest primarily in equity securities (or derivatives) on a long and short basis and may employ leverage.

In aggregate, 94% of our hedge fund allocation is redeemable within one year and 100% is redeemable within two years, subject to prior written redemption notice varying from 45 to 95 days. This includes recognition of certain funds we hold which restrict new investor redemptions during a lock-up period. A lock-up period is the initial amount of time an investor is contractually required to hold the security before having the ability to redeem. Another common restriction is the suspension of redemptions (known as “gates”) which may be implemented by the general partner or investment manager of the fund in order to defer, in whole or in part, the redemption request in the event the aggregate amount of redemption requests exceeds a predetermined percentage of the fund’s net assets or to prevent certain adverse regulatory, or any other reasons that may render the manager unable to promptly and accurately calculate the fund’s net asset value. During the nine months ended September 30, 2010, no gates were imposed on our redemption requests. At September 30, 2010, the only redemptions receivable relate to a December 31, 2009 redemption whereby $2 million is being held back until the completion of the fund’s annual audit.

Additionally, certain hedge funds may be allowed to invest a portion of their assets in illiquid securities, such as private equity or convertible debt. In such cases, a common mechanism used is a side-pocket, whereby the illiquid security is assigned to a designated account. Generally, the investor loses its redemption rights in the designated account. Only when the illiquid security is sold, or

 

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otherwise deemed liquid by the fund, may investors redeem their interest. At September 30, 2010, the fair value of our hedge funds held in side-pockets was $4 million (2009: $4 million).

 

Credit Fund Type		Investment Strategy
Long/short credit		Seek to achieve attractive risk-adjusted returns by executing a credit trading strategy involving selective long and short positions in primarily below investment-grade credit.
Distressed securities		Seek to achieve attractive risk-adjusted returns by executing a strategy which assesses the issuer’s ability to improve its operations and often attempts to influence the process by which the issuer restructures its debt.

At September 30, 2010, we had $44 million of a long/short credit fund that we do not have the ability to liquidate at our own discretion as the fund is beyond its investment period and is currently distributing capital to its investors. Of the remaining credit fund holdings, 32% of the carrying value has annual or semi-annual liquidity and 68% has quarterly liquidity, subject to prior written redemption notice varying from 65 to 95 days. At September 30, 2010 and December 31, 2009, none of our credit funds had established side-pockets.

At September 30, 2010, we have no unfunded commitments relating to our investments in hedge and credit funds.

 

c)	Net Investment Income

Net investment income was derived from the following sources:

 

		Three months ended September 30,								Nine months ended September 30,
		2010				2009				2010				2009
Fixed maturities		$	89,580			$	98,337			$	267,471			$	290,935
Other investments			25,094				38,646				39,374				57,384
Cash and cash equivalents			1,517				1,052				4,241				5,940
Equities			917				689				2,837				2,452
Short-term investments			308				81				735				524
Gross investment income			117,416				138,805				314,658				357,235
Investment expenses			(5,616	)			(4,017	)			(15,654	)			(10,935	)
Net investment income		$	111,800			$	134,788			$	299,004			$	346,300

 

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d)	Net Realized Investment Gains (Losses)

The following table provides an analysis of net realized investment gains (losses):

 

		Three months ended September 30,								Nine months ended September 30,
		2010				2009				2010				2009
Gross realized gains		$	105,701			$	51,610			$	224,661			$	136,191
Gross realized losses			(17,559	)			(23,880	)			(93,138	)			(122,487	)
Net OTTI recognized in earnings			(2,363	)			(279,338	)			(15,297	)			(330,691	)
Net realized gains (losses) on fixed maturities and equities			85,779				(251,608	)			116,226				(316,987	)
Change in fair value of investment derivatives(1)			(6,333	)			(341	)			(3,503	)			668
Fair value hedges:(1)
Derivative instruments			(66,760	)			(21,154	)			25,463				(27,801	)
Hedged investments			63,845				19,738				(20,861	)			26,480
Net realized investment gains (losses)		$	76,531			$	(253,365	)		$	117,325			$	(317,640	)

(1) Refer to Note 6 – Derivative Instruments

The following table summarizes the OTTI recognized in earnings by asset class:

 

		Three months ended September 30,								Nine months ended September 30,
		2010				2009				2010				2009
Fixed maturities:
Corporate debt		$	-			$	263,496			$	1,650			$	276,522
Agency MBS			-				-				-				344
Non-Agency CMBS			88				-				413				10,843
Non-Agency RMBS			772				4,733				4,715				12,335
ABS			-				675				1,126				10,658
Municipals			-				-				19				-
			860				268,904				7,923				310,702
Equities			1,503				10,434				7,374				19,989
Total OTTI recognized in earnings		$	2,363			$	279,338			$	15,297			$	330,691

On April 1, 2009, we adopted a new accounting standard which amended the previous OTTI recognition model for fixed maturities. For securities in an unrealized loss position that we intend to sell at the end of the reporting period, we recognized the entire unrealized loss position as a credit loss in earnings. For the remaining impaired fixed maturities, we have recorded only the estimated credit losses in earnings rather than the entire unrealized loss position. Because the new accounting standard does not allow for retrospective application, the OTTI amounts reported in the above table for the nine months ended September 30, 2010, are not measured on the same basis as prior period amounts and accordingly these amounts are not comparable. The adoption of this new accounting standard on April 1, 2009, resulted in $38 million net after-tax increase to retained earnings with a corresponding decrease to accumulated other comprehensive income (loss), resulting in no change to our shareholders’ equity.

 

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The following table provides a roll forward of the credit losses, (“credit loss table”), before income taxes, for which a portion of the OTTI was recognized in AOCI:

 

		Three months ended September 30,								Nine months ended September 30,
		2010				2009				2010				2009
Balance at beginning of period		$	146,963			$	37,229			$	162,390			$	-
Credit losses remaining in retained earnings related to adoption of accounting standard			-				-				-				45,347
Credit impairments recognized on securities not previously impaired			167				265,257				1,355				267,770
Additional credit impairments recognized on securities previously impaired			1,396				677				2,173				864
Change in recoveries of future cash flows expected to be collected			(141	)			670				(116	)			670
Intent to sell of securities previously impaired			(764	)			-				(829	)			-
Securities sold/redeemed/matured			(44,682	)			(10,585	)			(62,034	)			(21,403	)
Balance at end of period		$	102,939			$	293,248			$	102,939			$	293,248

Credit losses are calculated based on the difference between the amortized cost of the security and the net present value of its projected future cash flows discounted at the effective interest rate implicit in the debt security prior to the impairment. The significant inputs and the methodology used to estimate the credit losses for which a portion of the OTTI was recognized in AOCI were as follows:

Corporate Debt:

Our projected cash flows for corporate debt securities, excluding medium-term notes (“MTNs”), are primarily driven by our assumptions regarding the probability of default and the severity associated with those defaults. Our default and loss severity rates are based on credit rating, credit analysis, industry analyst reports and forecasts, Moody’s historical default data and any other data relevant to the recoverability of the security. At December 31, 2009, the weighted average default rate and loss severity rate were 34% and 100%, respectively, for determining the credit losses on our impaired corporate debt securities. For the nine months ended September 30, 2010, we have impaired one corporate debt security.

During the three and nine months ended September 30, 2010, we have sold some previously impaired corporate debt securities, resulting in a decrease in credit loss impairments of $1 million (2009: $9 million) and $9 million (2009: $19 million), respectively, in the above credit loss table.

For MTNs, our projected cash flows also include significant inputs such as future credit spreads and the use of leverage over the expected duration of each of the medium-term notes. At September 30, 2010, we have not modified our significant inputs since December 31, 2009, which were as follows:

 

Default rates, per annum		3% - 5%
Loss severity rates, per annum		45% - 70%
Collateral spreads, per annum		5.2% - 6.7%
Leveraged duration		6.5 - 8.5 years

During the three and nine months ended September 30, 2010, certain MTNs matured with realized gains of $11 million and $12 million, respectively, resulting in no additional credit losses. The previously estimated credit loss impairments on these matured MTNs were $44 million and have been reported as a reduction of the remaining estimated credit loss impairments for 2010 in the above credit loss table.

During the three months ended September 30, 2009, we recognized $263 million of estimated credit losses on MTNs, which are included in the above credit loss table. In response to the credit crisis, the MTNs managers reduced their leverage levels which in turn lowered the credit duration of the MTNs. As credit markets recovered and credit spreads tightened in 2009, price appreciation was not as pronounced as the depreciation during 2008 due to the lower credit duration of the MTNs. The tightening of credit spreads was

 

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more significant and much quicker than anticipated which has hindered the ability of the MTN managers to reinvest the underlying cash flows at wider credit spreads. Consequently, we revised the significant inputs in our projected cash flows for the MTNs, resulting in a significant credit impairment charge in the third quarter of 2009.

Agency MBS:

For agency MBS in an unrealized loss position, we do not impair these securities as they represent AAA-rated holdings backed by either the explicit or implicit guarantee of the U.S. government. We believe the risk of loss in this asset class is remote and linked to the overall credit-worthiness of the U.S. government. At September 30, 2010, the fair value of our agency MBS was $2.1 billion (2009: $1.6 billion), which included $2 million (2009: $4 million) of gross unrealized losses.

Non-agency CMBS:

Our investment in CMBS are diversified and rated highly with approximately 76% (2009: 79%) rated AAA by S&P, with a weighted average estimated subordination percentage of 28% at September 30, 2010 (2009: 27%). Based on discounted cash flows, the current level of subordination is sufficient to cover the estimated loan losses on the underlying collateral of the CMBS.

Non-agency RMBS:

For non-agency RMBS, we project expected cash flows to be collected by incorporating underlying data from widely accepted third-party data sources along with certain internal assumptions and judgments regarding the future performance of the security. At September 30, 2010, the fair value of our non-agency RMBS was $221 million (2009: $223 million), consisting primarily of $151 million (2009: $136 million) of Prime and $55 million (2009: $70 million) of Alt-A MBS. At September 30, 2010, we had gross unrealized losses of $11 million on these securities.

At December 31, 2009, our non-agency RMBS had gross unrealized losses of $35 million, consisting of $13 million of Prime, $16 million of Alt-A and $6 million of Subprime MBS. We used the following weighted average significant inputs to estimate the credit loss for potentially impaired Prime and Alt-A MBS in an unrealized loss position at December 31, 2009:

 

Vintage		Fair Value				Default Rate				Delinquency Rate				Loss Severity Rate				Prepayment Rate
Prime:
Pre-2004		$	29,429				1.1% - 1.2	%			2.3% - 5.1	%			10.5% - 15.3	%			19.1% - 26.5	%
2004			10,515				2.4	%			5.4	%			26.5	%			16.7	%
2005			30,282				1.7	%			4.0	%			25.4	%			14.5	%
2006			16,892				13.6	%			30.6	%			44.9	%			8.1	%
2007			21,411				4.2	%			10.5	%			40.5	%			11.7	%
		$	108,529				4.0	%			9.4	%			28.6	%			14.7	%
Alt-A:
Pre-2004		$	5,386				1.4% - 2.4	%			2.8% - 8.4	%			38.9% - 40.5	%			11.3% - 12.1	%
2004			20,502				5.0	%			13.7	%			31.3	%			12.4	%
2005			36,954				4.6	%			13.5	%			33.3	%			5.8	%
2006			2,075				20.9	%			51.6	%			49.7	%			11.3	%
2007			3,458				23.3	%			55.7	%			54.9	%			10.7	%
		$	68,375				5.9	%			16.2	%			34.8	%			8.7	%

These inputs require significant management judgment and vary for each structured security based on the underlying property type, vintage, loan to collateral value ratio, geographic concentration, and current level of subordination. We also corroborate our credit loss estimate with the independent investment manager’s credit loss estimate for each structured debt security with a significant unrealized loss position.

For the three and nine months ended September 30, 2010, based on expected cash flows to be collected, we have recorded additional credit losses of $1 million and $2 million, respectively, on non-agency RMBS.

 

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3.	INVESTMENTS (CONTINUED)

 

 

ABS:

The majority of the unrealized losses on ABS at September 30, 2010 were related to CLO debt tranched securities. We used the following weighted average significant inputs to estimate the credit loss for these securities:

 

		September 30, 2010				December 31, 2009
Default rate, per annum			4.4	%			4.4	%
Loss severity rate, per annum			50.0	%			50.0	%
Collateral spreads, per annum			3.3	%			3.1	%

Our assumptions on default and loss severity rates are established based on an assessment of actual experience to date for each CLO debt tranche and review of recent credit rating agencies’ default and loss severity forecasts. Based on projected cash flows at September 30, 2010, we do not anticipate credit losses on the CLO debt tranched securities.

 

4.	FAIR VALUE MEASUREMENTS

Fair Value Hierarchy

Fair value is defined as the price to sell an asset or transfer a liability (i.e. the “exit price”) in an orderly transaction between market participants. We use a fair value hierarchy that gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. The hierarchy is broken down into three levels as follows:

 

•

Level 1—Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that we have the ability to access. Valuation adjustments and block discounts are not applied to Level 1 instruments.

 

•

Level 2—Valuations based on quoted prices in active markets for similar assets or liabilities, quoted prices for identical assets or liabilities in inactive markets, or for which significant inputs are observable (e.g. interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.) or can be corroborated by observable market data.

 

•

Level 3—Valuations based on inputs that are unobservable and significant to the overall fair value measurement. The unobservable inputs reflect our own assumptions about assumptions that market participants might use.

The availability of observable inputs can vary from financial instrument to 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.

Accordingly, the degree of judgment exercised by management in determining fair value is greatest for instruments categorized in Level 3. In periods of market dislocation, the observability of prices and inputs may be reduced for many instruments. This may lead us to change the selection of our valuation technique (from market to cash flow approach) or may cause us to use multiple valuation techniques to estimate the fair value of a financial instrument. This circumstance could cause an instrument to be reclassified between levels.

We used the following methods and assumptions in estimating the fair value of our financial instruments as well as the general classification of such financial instruments pursuant to the above fair value hierarchy.

Fixed Maturities

At each valuation date, we use various valuation techniques to estimate the fair value of our fixed maturities portfolio. These techniques include, but are not limited to, prices obtained from third party pricing services for identical or comparable securities and the use of “pricing matrix models” using observable market inputs such as yield curves, credit risks and spreads, measures of volatility, and prepayment speeds. Pricing from third party pricing services are sourced from multiple vendors, and we maintain a vendor hierarchy by asset type based on historical pricing experience and vendor expertise. The following describes the techniques generally used to determine the fair value of our fixed maturities by asset class.

 

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U.S. government and agency

U.S. government and agency securities consist primarily of bonds issued by the U.S. Treasury and mortgage pass-through agencies such as the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation and the Government National Mortgage Association. As the fair values of our U.S. Treasury securities are based on unadjusted market prices, they are classified within Level 1. The fair values of U.S. government agency securities are priced using the spread above the risk-free yield curve. As the yields for the risk-free yield curve and the spreads for these securities are observable market inputs, the fair values of U.S. government agency securities are classified within Level 2.

Non-U.S. government

Non-U.S. government securities comprise bonds issued by non-U.S. governments and their agencies along with supranational organizations (also known as sovereign debt securities). The fair value of these securities is based on prices obtained from international indices or a valuation model that includes the following inputs: interest rate yield curves, cross-currency basis index spreads, and country credit spreads for structures similar to the sovereign bond in terms of issuer, maturity and seniority. As the significant inputs are observable market inputs, the fair value of non-U.S. government securities are classified within Level 2.

Corporate debt

Corporate debt securities consist primarily of investment-grade debt of a wide variety of corporate issuers and industries. 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 broker-dealer quotes. As these spreads and the yields for the risk-free yield curve are observable market inputs, the fair values of our corporate debt securities are classified within Level 2. Where pricing is unavailable from pricing services, we obtain unbinding quotes from broker-dealers. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. In this event, securities are classified within Level 3 and consisted of private corporate debt securities at September 30, 2010.

MBS

Our portfolio of RMBS and CMBS are originated by both agencies and non-agencies. The fair values of these securities are determined through the use of a pricing model (including Option Adjusted Spread) which uses prepayment speeds and spreads to determine the appropriate average life of the MBS. These spreads are generally obtained from the new issue market, secondary trading and broker-dealer quotes. As the significant inputs used to price MBS are observable market inputs, the fair values of the MBS are classified within Level 2. Where pricing is unavailable from pricing services, we obtain unbinding quotes from broker-dealers to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. These securities are classified within Level 3.

ABS

ABS include mostly investment-grade bonds backed by pools of loans with a variety of underlying collateral, including automobile loan receivables, credit card receivables, and CLO debt tranched securities originated by a variety of financial institutions. Similarly to MBS, the fair values of ABS are priced through the use of a model which uses prepayment speeds and spreads sourced primarily from the new issue market. As the significant inputs used to price ABS are observable market inputs, the fair values of ABS are classified within Level 2. Where pricing is unavailable from pricing services, we obtain unbinding quotes from broker-dealers or use a discounted cash flow model to estimate fair value. This is generally the case when there is a low volume of trading activity and current transactions are not orderly. At September 30, 2010, the use of a discounted cash flow model was limited to our investment in CLO debt tranched securities and included the following significant inputs: default and loss severity rates, collateral spreads, and risk free yield curves (see Note 3(d) for quantitative inputs). As most of these inputs are unobservable, these securities are classified within Level 3.

Municipals

Our municipal portfolio comprises bonds issued by U.S. domiciled state and municipality entities. The fair value of these securities is determined using spreads obtained from broker-dealers, trade prices and the new issue market. As the significant inputs used to price the municipals are observable market inputs, municipals are classified within Level 2.

Equity Securities

Equity securities include U.S. and foreign common stocks as well as a foreign bond mutual fund. For common stocks we classified these within Level 1 as their fair values are based on quoted market prices in active markets. Our investment in the foreign bond

 

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mutual fund has daily liquidity, with redemption based on the net asset value of the fund. Accordingly, we have classified this investment as Level 2.

Other Investments

The short-duration high yield fund is classified within Level 2 as its fair value is estimated using the net asset value reported by Bloomberg and it has daily liquidity. We sold our investment in this fund during the current quarter.

The hedge and credit funds are classified within Level 3 as we estimate their respective fair values using net asset values as advised by external fund managers or third party administrators. Refer to Note 3 for further details on this asset class.

The CLO – equity tranched securities (“CLO – Equities”) are classified within Level 3 as we estimate the fair value for these securities based on an discounted cash flow model due to the lack of observable, relevant trade in the secondary markets. At September 30, 2010, our discounted cash flow model included the following significant unobservable inputs.

 

Default rates:
- for 2010			4.6%
- thereafter per annum			4.4%
Loss severity rate per annum			50.0%
Collateral spreads per annum			2.5% - 4.1%

Derivative Instruments

Our foreign currency forward contracts and options are customized to our hedging strategies and trade in the over-the-counter derivative market. We estimate the fair value for these derivatives using models based on significant observable market inputs from third party pricing vendors, non-binding broker-dealer quotes and/or recent trading activity. Accordingly, we classified these derivatives within Level 2.

 

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4.	FAIR VALUE MEASUREMENTS (CONTINUED)

 

 

The table below presents the financial instruments measured at fair value on a recurring basis.

 

		Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)				Total Fair Value
At September 30, 2010
Assets
Fixed maturities
U.S. government and agency		$	1,008,283			$	364,232			$	-			$	1,372,515
Non-U.S. government			-				788,112				-				788,112
Corporate debt			-				4,305,706				3,100				4,308,806
Agency MBS			-				2,094,202				-				2,094,202
Non-Agency CMBS			-				501,211				-				501,211
Non-Agency RMBS			-				221,254				-				221,254
ABS			-				621,093				42,223				663,316
Municipals			-				715,408				-				715,408
			1,008,283				9,611,218				45,323				10,664,824
Equity securities			171,454				79,551				-				251,005
Other investments			-				-				533,072				533,072
Other assets (see Note 6)			-				184				-				184
Other liabilities (see Note 6)			-				(9,968	)			-				(9,968	)
Total		$	1,179,737			$	9,680,985			$	578,395			$	11,439,117
At December 31, 2009
Assets
Fixed maturities
U.S. government and agency		$	1,207,033			$	649,626			$	-			$	1,856,659
Non-U.S. government			-				696,814				-				696,814
Corporate debt			-				3,562,636				18,130				3,580,766
Agency MBS			-				1,566,259				-				1,566,259
Non-Agency CMBS			-				650,802				2,409				653,211
Non-Agency RMBS							216,343				6,639				222,982
ABS			-				399,554				43,585				443,139
Municipals			-				698,525				-				698,525
			1,207,033				8,440,559				70,763				9,718,355
Equity securities			142,716				61,659				-				204,375
Other investments			-				50,088				520,188				570,276
Other assets (see Note 6)			-				9,968				-				9,968
Total		$	1,349,749			$	8,562,274			$	590,951			$	10,502,974

During 2010 and 2009, we had no transfers between Levels 1 and 2.

 

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Level 3 financial instruments

The following tables present changes in Level 3 for financial instruments measured at fair value on a recurring basis for the periods indicated:

 

		Fixed Maturities
		Corporate Debt				Non-Agency CMBS				Non-Agency RMBS				ABS				Total				Other Investments				Total Assets
Three months ended September 30, 2010
Balance at beginning of period		$	3,100			$	3,600			$	2,973			$	46,816			$	56,489			$	496,087			$	552,576
Total net realized and unrealized gains included in net income(1)			-				-				-				-				-				23,469				23,469
Total net realized and unrealized losses included in net income(1)			-				-				-				-				-				-				-
Change in net unrealized gains included in other comprehensive income			-				180				92				-				272				-				272
Change in net unrealized losses included in other comprehensive income			-				-				(7	)			(47	)			(54	)			-				(54	)
Purchases			-				-				-				-				-				25,000				25,000
Sales			-				-				-				-				-				(3,588	)			(3,588	)
Settlements / distributions			-				-				(207	)			(356	)			(563	)			(7,896	)			(8,459	)
Transfers into Level 3			-				-				-				-				-				-				-
Transfers out of Level 3			-				(3,780	)			(2,851	)			(4,190	)			(10,821	)			-				(10,821	)
Balance at end of period		$	3,100			$	-			$	-			$	42,223			$	45,323			$	533,072			$	578,395
Level 3 gains / losses included in earnings attributable to the change in unrealized gains /losses relating to those assets held at the reporting date		$	-			$	-			$	-			$	-			$	-			$	23,469			$	23,469
Nine months ended September 30, 2010
Balance at beginning of period		$	18,130			$	2,409			$	6,639			$	43,585			$	70,763			$	520,188			$	590,951
Total net realized and unrealized gains included in net income(1)			-				-				-				-				-				35,818				35,818
Total net realized and unrealized losses included in net income(1)			(1,550	)			(119	)			(581	)			(1,134	)			(3,384	)			-				(3,384	)
Change in net unrealized gains included in other comprehensive income			3,751				1,273				1,238				2,406				8,668				-				8,668
Change in net unrealized losses included in other comprehensive income			(34	)			(238	)			(27	)			(71	)			(370	)			-				(370	)
Purchases			-				3,474				-				4,000				7,474				45,000				52,474
Sales			(12	)			(206	)			(211	)			(2,004	)			(2,433	)			(47,992	)			(50,425	)
Settlements / distributions			-				(694	)			(692	)			(369	)			(1,755	)			(19,942	)			(21,697	)
Transfers into Level 3			-				-				780				-				780				-				780
Transfers out of Level 3			(17,185	)			(5,899	)			(7,146	)			(4,190	)			(34,420	)			-				(34,420	)
Balance at end of period		$	3,100			$	-			$	-			$	42,223			$	45,323			$	533,072			$	578,395
Level 3 gains / losses included in earnings attributable to the change in unrealized gains /losses relating to those assets held at the reporting date		$	(1,550	)		$	-			$	-			$	-			$	(1,550	)		$	35,818			$	34,268

(1)	Realized gains and losses on fixed maturities are included in net realized investment gains (losses). Realized gains and (losses) on other investments are included in net investment income.

 

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		Fixed Maturities
		Corporate Debt				Non-Agency CMBS				Non-Agency RMBS				ABS				Municipals				Total				Other Investments				Total Assets				Other Liabilities
Three months ended September 30, 2009
Balance at beginning of period		$	16,923			$	-			$	20,692			$	48,343			$	-			$	85,958			$	493,767			$	579,725			$	87,597
Total net realized and unrealized gains included in net income(1)			-				-				-				-				-				-				34,345				34,345				136,000
Total net realized and unrealized losses included in net income(1)			-				-				-				-				-				-				-				-				-
Change in net unrealized gains included in other comprehensive income			163				-				1,297				771				21				2,252				-				2,252				-
Change in net unrealized losses included in other comprehensive income			(1,149	)			(83	)			(795	)			(54	)			-				(2,081	)			-				(2,081	)			-
Purchases			-				-				1,760				5,899				-				7,659				-				7,659				4,808
Sales			-				-				-				-				-				-				(30,577	)			(30,577	)			-
Settlements / distributions			(111	)			-				(952	)			(886	)			-				(1,949	)			(4,733	)			(6,682	)			-
Transfers into Level 3			436				9,590				-				25,956				4,447				40,429				-				40,429				-
Transfers out of Level 3			-				-				(7,557	)			(1,334	)			-				(8,891	)			-				(8,891	)			-
Balance at end of period		$	16,262			$	9,507			$	14,445			$	78,695			$	4,468			$	123,377			$	492,802			$	616,179			$	228,405
Level 3 gains / losses included in earnings attributable to the change in unrealized gains / losses relating to those assets and liabilities held at the reporting date		$	-			$	-			$	-			$	-			$	-			$	-			$	34,345			$	34,345			$	136,000
Nine months ended September 30, 2009
Balance at beginning of period		$	-			$	-			$	-			$	-			$	-			$	-			$	450,542			$	450,542			$	62,597
Total net realized and unrealized gains included in net income(1)			-				-				-				-				-				-				73,114				73,114				161,000
Total net realized and unrealized losses included in net income(1)			-				-				-				(373	)			-				(373	)			(16,897	)			(17,270	)			-
Change in net unrealized gains included in other comprehensive income			313				107				7,924				8,905				21				17,270				-				17,270				-
Change in net unrealized losses included in other comprehensive income			(3,389	)			(114	)			(1,502	)			(3,949	)			-				(8,954	)			-				(8,954	)			-
Purchases			-				-				1,760				5,899				-				7,659				91,800				99,459				4,808
Sales			-				-				-				-				-				-				(91,947	)			(91,947	)			-
Settlements / distributions			(140	)			-				(9,678	)			(1,283	)			-				(11,101	)			(13,810	)			(24,911	)			-
Transfers into Level 3			19,478				10,069				65,380				96,356				4,447				195,730				-				195,730				-
Transfers out of Level 3			-				(555	)			(49,439	)			(26,860	)			-				(76,854	)			-				(76,854	)			-
Balance at end of period		$	16,262			$	9,507			$	14,445			$	78,695			$	4,468			$	123,377			$	492,802			$	616,179			$	228,405
Level 3 gains / losses included in earnings attributable to the change in unrealized gains / losses relating to those assets and liabilities held at the reporting date		$	-			$	-			$	-			$	(373	)		$	-			$	(373	)		$	56,217			$	55,844			$	161,000

(1)	Realized gains and losses on fixed maturities are included in net realized investment gains (losses). Realized gains and (losses) on other investments are included in net investment income. Losses on other liabilities are included in other insurance related income (loss).

 

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Following the adoption of the new Fair Value Measurements and Disclosures guidance on January 1, 2010, transfers into and out of Level 3 reflect the fair value of the securities at the end of the reporting period. This transition was applied prospectively and accordingly the transfers into and out of Level 3 from Level 2 for the three and nine months ended September 30, 2010, are not comparable with prior periods as transfers into Level 3 were previously recorded at the fair value of the security at the beginning of the reporting period.

Transfers into Level 3 from Level 2

The transfers to Level 3 from Level 2 made in 2009 and 2010 were due to a reduction in the volume of recently executed transactions or a lack of available quotes from pricing vendors and broker-dealers. None of the transfers were as a result of changes in valuation methodology that we made.

Transfers out of Level 3 into Level 2

During the nine months ended September 30, 2010, the transfer relating to corporate debt was in relation to one issuer a result of entering into an agreement to take delivery of a new corporate debt security, which its fair value measurement was based on observable market inputs at September 30, 2010. The remaining transfers out of Level 3 into Level 2 made in 2009 and 2010 were primarily due to the availability of observable market inputs and multiple quotes from pricing vendors and broker-dealers as a result of the return of liquidity in the credit markets.

Fair Values of Financial Instruments

The carrying amount of financial assets and liabilities presented on the Consolidated Balance Sheets as at September 30, 2010, and December 31, 2009 approximated their fair values with the exception of senior notes. At September 30, 2010, the senior notes are recorded at amortized cost with a carrying value of $994 million (2009: $499 million) and a fair value of $1,041 million (2009: $510 million).

 

5.	RESERVE FOR LOSSES AND LOSS EXPENSES

The following table shows a reconciliation of our beginning and ending gross unpaid losses and loss expenses for the periods indicated:

 

		Nine months ended September 30,
		2010				2009
Gross reserve for losses and loss expenses, beginning of period		$	6,564,133			$	6,244,783
Less reinsurance recoverable on unpaid losses, beginning of period			(1,381,058	)			(1,314,551	)
Net reserve for losses and loss expenses, beginning of period			5,183,075				4,930,232
Net incurred losses related to:
Current year			1,525,564				1,380,535
Prior years			(231,777	)			(303,175	)
			1,293,787				1,077,360
Net paid losses related to:
Current year			(207,922	)			(155,452	)
Prior years			(835,972	)			(736,702	)
			(1,043,894	)			(892,154	)
Foreign exchange and other			(23,208	)			89,659
Net reserve for losses and loss expenses, end of period			5,409,760				5,205,097
Reinsurance recoverable on unpaid losses, end of period			1,524,768				1,374,817
Gross reserve for losses and loss expenses, end of period		$	6,934,528			$	6,579,914

We write business with loss experience generally characterized as low frequency and high severity in nature, which results in volatility in our financial results. During the nine months ended September 30, 2010, we recognized net loss and loss expenses of $215 million in relation to the February 2010 Chilean and September 2010 New Zealand earthquakes. Our estimates for these events

 

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were derived from ground-up assessments of our individual contracts and treaties in the affected regions and are consistent with our market share in the regions. As part of our estimation process, we also considered current industry insured loss estimates, market share analyses, catastrophe modeling analyses and the information available to date from clients, brokers and loss adjusters. Industry-wide insured loss estimates and our own loss estimates for these events are subject to change, as additional actual loss data becomes available. Actual losses in relation to these events may ultimately differ materially from current loss estimates.

Net losses and loss expenses incurred include net favorable prior period reserve development of $232 million and $303 million for the nine months ended September 30, 2010 and 2009, respectively. Prior period reserve development arises from changes to loss estimates recognized in the current year that relate to losses incurred in previous calendar years.

The following table summarizes net favorable reserve development by segment:

 

		Three months ended September 30,								Nine months ended September 30,
		2010				2009				2010				2009
Insurance		$	27,823			$	55,401			$	83,732			$	138,167
Reinsurance			43,884				66,698				148,045				165,008
Total		$	71,707			$	122,099			$	231,777			$	303,175

Overall, a significant portion of the net favorable prior period reserve development in the third quarters of 2010 and 2009 was generated from the property, marine, and aviation lines of our insurance segment and the property and catastrophe lines of our reinsurance segment. These lines of business, the majority of which have short tail exposures, contributed $32 million and $59 million of the total net favorable reserve development in the third quarters of 2010 and 2009, respectively. The favorable development on these lines of business primarily reflects the recognition of better than expected loss emergence, rather than explicit changes in our actuarial assumptions.

Approximately $25 million and $69 million of the net favorable reserve development in the third quarter of 2010 and 2009, respectively, was generated from professional lines insurance and reinsurance business. This favorable development was driven by increased incorporation of our own historical claims experience into our ultimate expected loss ratios for accident years 2007 and prior, with less weighting being given to information derived from i