AWH-2014.9.30-10Q
Table of Contents

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 ____________________________________
Form 10-Q
(Mark One)
  þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: September 30, 2014
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to              
Commission file number: 001-32938
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
(Exact Name of Registrant as Specified in Its Charter)
Switzerland
98-0681223
(State or Other Jurisdiction of
(I.R.S. Employer
Incorporation or Organization)
Identification No.)
Lindenstrasse 8
6340 Baar
Zug, Switzerland
(Address of Principal Executive Offices and Zip Code)

41-41-768-1080
(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 for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ 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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ 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. (Check one):

Large accelerated filer þ
Accelerated filer ¨
Non-accelerated filer ¨
Smaller reporting company ¨
(Do not check if a 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 þ
As of October 13, 2014, 96,409,738 common shares were outstanding.


Table of Contents

TABLE OF CONTENTS
PART I
 
 
 
 
Item 1.
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
PART II
 
 
 
 
Item 1.        
 
 
 
Item 1A.
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
Item 5.
 
 
 
Item 6.
 
 
 
 
 
 
 

-i-

Table of Contents

PART I
FINANCIAL INFORMATION
Item 1.
Financial Statements.
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
as of September 30, 2014 and December 31, 2013
(Expressed in thousands, except share and per share amounts)
 
As of
 
As of
 
September 30,
2014
 
December 31,
2013
ASSETS:
 
 
 
Fixed maturity investments trading, at fair value (amortized cost: 2014: $6,074,752; 2013: $6,065,350)
$
6,128,237

 
$
6,100,798

Equity securities trading, at fair value (cost: 2014: $901,300; 2013: $647,301)
945,076

 
699,846

Other invested assets
929,201

 
911,392

Total investments
8,002,514

 
7,712,036

Cash and cash equivalents
831,270

 
531,936

Restricted cash
178,958

 
149,393

Insurance balances receivable
926,183

 
664,731

Funds held
405,703

 
632,430

Prepaid reinsurance
376,651

 
340,992

Reinsurance recoverable
1,349,009

 
1,234,504

Accrued investment income
30,554

 
32,236

Net deferred acquisition costs
171,827

 
126,661

Goodwill
278,085

 
268,376

Intangible assets
46,931

 
48,831

Balances receivable on sale of investments
60,122

 
76,544

Net deferred tax assets
41,312

 
37,469

Other assets
110,449

 
89,691

Total assets
$
12,809,568

 
$
11,945,830

LIABILITIES:
 
 
 
Reserve for losses and loss expenses
$
6,052,263

 
$
5,766,529

Unearned premiums
1,716,927

 
1,396,256

Reinsurance balances payable
203,428

 
173,023

Balances due on purchases of investments
166,026

 
104,740

Senior notes
798,725

 
798,499

Dividends payable
21,686

 
16,732

Accounts payable and accrued liabilities
176,914

 
170,225

Total liabilities
$
9,135,969

 
$
8,426,004

Commitments and contingencies

 

SHAREHOLDERS’ EQUITY:
 
 
 
Common shares: 2014: par value CHF 4.10 per share and 2013: par value CHF 4.10 per share (2014: 100,775,256; 2013: 103,477,452 shares issued and 2014: 96,382,238; 2013: 100,253,646 shares outstanding)
407,990

 
418,988

Treasury shares, at cost (2014: 4,393,018; 2013: 3,223,806)
(134,633
)
 
(79,992
)
Retained earnings
3,400,242

 
3,180,830

Total shareholders’ equity
3,673,599

 
3,519,826

Total liabilities and shareholders’ equity
$
12,809,568

 
$
11,945,830


See accompanying notes to the consolidated financial statements.

1

Table of Contents

ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME
for the three and nine months ended September 30, 2014 and 2013
(Expressed in thousands, except share and per share amounts)
 
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2014
 
2013
 
2014
 
2013
REVENUES:
 
 
 
 
 
 
 
Gross premiums written
$
707,884

 
$
580,893

 
$
2,369,682

 
$
2,183,174

Premiums ceded
(139,142
)
 
(127,816
)
 
(475,402
)
 
(453,823
)
Net premiums written
568,742

 
453,077

 
1,894,280

 
1,729,351

Change in unearned premiums
(27,005
)
 
57,696

 
(285,011
)
 
(248,079
)
Net premiums earned
541,737

 
510,773

 
1,609,269

 
1,481,272

Net investment income
43,412

 
39,271

 
127,824

 
110,294

Net realized investment (losses) gains
(35,136
)
 
27,487

 
104,286

 
(8,074
)
Other income
1,032

 

 
1,032

 

 
551,045

 
577,531

 
1,842,411

 
1,583,492

EXPENSES:
 
 
 
 
 
 
 
Net losses and loss expenses
336,090

 
276,970

 
926,231

 
807,276

Acquisition costs
72,403

 
65,114

 
214,404

 
186,416

General and administrative expenses
88,294

 
88,553

 
264,822

 
251,818

Other expense
6,575

 

 
6,575

 

Amortization of intangible assets
633

 
633

 
1,900

 
1,900

Interest expense
14,325

 
14,094

 
43,451

 
42,416

Foreign exchange loss
278

 
4,353

 
978

 
7,361

 
518,598

 
449,717

 
1,458,361

 
1,297,187

Income before income taxes
32,447

 
127,814

 
384,050

 
286,305

Income tax expense
1,532

 
4,971

 
24,300

 
6,332

NET INCOME
30,915

 
122,843

 
359,750

 
279,973

 
 
 
 
 
 
 
 
Other comprehensive income

 

 

 

COMPREHENSIVE INCOME
$
30,915

 
$
122,843

 
$
359,750

 
$
279,973

PER SHARE DATA
 
 
 
 
 
 
 
Basic earnings per share
$
0.32

 
$
1.20

 
$
3.67

 
$
2.72

Diluted earnings per share
$
0.31

 
$
1.18

 
$
3.60

 
$
2.66

Weighted average common shares outstanding
96,458,231

 
101,974,077

 
97,926,378

 
103,020,681

Weighted average common shares and common share equivalents outstanding
98,444,238

 
104,184,579

 
99,965,296

 
105,393,276

Dividends paid per share
$
0.225

 
$
0.167

 
$
0.559

 
$
0.292


See accompanying notes to the consolidated financial statements.

2

Table of Contents

ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
for the nine months ended September 30, 2014 and 2013
(Expressed in thousands)
 
 
Share
Capital
 
Treasury
Shares
 
Retained
Earnings
 
Total
December 31, 2013
$
418,988

 
$
(79,992
)
 
$
3,180,830

 
$
3,519,826

Net income

 

 
359,750

 
359,750

Dividends

 

 
(60,017
)
 
(60,017
)
Stock compensation

 
17,235

 
1,333

 
18,568

Share repurchases

 
(164,528
)
 

 
(164,528
)
Shares cancelled
(10,998
)
 
92,652

 
(81,654
)
 

September 30, 2014
$
407,990

 
$
(134,633
)
 
$
3,400,242

 
$
3,673,599

 
 
 
 
 
 
 
 
December 31, 2012
$
454,980

 
$
(113,818
)
 
$
2,985,173

 
$
3,326,335

Net income

 

 
279,973

 
279,973

Dividends — par value reduction
(12,981
)
 

 

 
(12,981
)
Dividends

 

 
(34,069
)
 
(34,069
)
Stock compensation

 
26,093

 
(18,278
)
 
7,815

Share repurchases

 
(123,145
)
 

 
(123,145
)
Shares cancelled
(17,162
)
 
125,025

 
(107,863
)
 

September 30, 2013
$
424,837

 
$
(85,845
)
 
$
3,104,936

 
$
3,443,928

 
See accompanying notes to the consolidated financial statements.

3

Table of Contents

ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
for the nine months ended September 30, 2014 and 2013
(Expressed in thousands)
 
Nine Months Ended 
 September 30,
 
2014
 
2013
CASH FLOWS PROVIDED BY OPERATING ACTIVITIES:
 
 
 
Net income
$
359,750

 
$
279,973

Adjustments to reconcile net income to cash provided by operating activities:
 
 
 
Net realized gains on sales of investments
(118,640
)
 
(76,104
)
Mark to market adjustments
(5,634
)
 
80,136

Stock compensation expense
10,822

 
9,282

Undistributed loss (income) of equity method investments
10,452

 
(4,313
)
Changes in:
 
 
 
Reserve for losses and loss expenses, net of reinsurance recoverables
171,229

 
50,308

Unearned premiums, net of prepaid reinsurance
285,012

 
248,079

Insurance balances receivable
(260,627
)
 
(229,580
)
Funds held
226,727

 
(38,763
)
Reinsurance balances payable
30,405

 
57,379

Net deferred acquisition costs
(45,166
)
 
(37,941
)
Net deferred tax assets
(3,511
)
 
(16,252
)
Accounts payable and accrued liabilities
4,473

 
(18,540
)
Other items, net
4,441

 
34,508

Net cash provided by operating activities
669,733

 
338,172

CASH FLOWS (USED IN) PROVIDED BY INVESTING ACTIVITIES:
 
 
 
Purchases of trading securities
(5,608,594
)
 
(4,955,817
)
Purchases of other invested assets
(242,227
)
 
(211,501
)
Sales of trading securities
5,500,176

 
5,137,280

Sales of other invested assets
243,123

 
189,155

Purchases of fixed assets
(14,490
)
 
(4,171
)
Change in restricted cash
(29,565
)
 
(74,032
)
Net cash paid for acquisitions
(2,565
)
 

Net cash (used in) provided by investing activities
(154,142
)
 
80,914

CASH FLOWS USED IN FINANCING ACTIVITIES:
 
 
 
Dividends paid - partial par value reduction

 
(12,981
)
Dividends paid
(55,064
)
 
(17,117
)
Proceeds from the exercise of stock options
7,640

 
8,465

Share repurchases
(166,207
)
 
(120,163
)
Net cash used in financing activities
(213,631
)
 
(141,796
)
Effect of exchange rate changes on foreign currency cash
(2,626
)
 
(6,122
)
NET INCREASE IN CASH AND CASH EQUIVALENTS
299,334

 
271,168

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
531,936

 
681,879

CASH AND CASH EQUIVALENTS, END OF PERIOD
$
831,270

 
$
953,047

Supplemental disclosure of cash flow information:
 
 
 
Cash paid for income taxes
$
18,052

 
$
17,249

Cash paid for interest expense
$
45,750

 
$
45,750

See accompanying notes to the consolidated financial statements.

4

Table of Contents

ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)
1. GENERAL

Allied World Assurance Company Holdings, AG, a Swiss holding company (“Allied World Switzerland”), through its wholly-owned subsidiaries (collectively, the “Company”), provides property and casualty insurance and reinsurance on a worldwide basis. References to $ are to the lawful currency of the United States and to CHF are to the lawful currency of Switzerland.

The Company has reached definitive agreements to acquire the Hong Kong and Singapore operations of Royal & Sun Alliance Insurance plc for approximately $211,000, at current exchange rates, subject to adjustments at closing. In addition to the purchase price, the Company expects to contribute an additional $90,000 to capitalize the business on an ongoing basis. Subject to regulatory approvals in both Hong Kong and Singapore, as well as court approval in Singapore, the acquisition is expected to be completed in the first half of 2015.

2. BASIS OF PREPARATION AND CONSOLIDATION

These unaudited condensed consolidated financial statements include the accounts of the Company and have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and with Article 10 of Regulation S-X as promulgated by the U.S. Securities and Exchange Commission (“SEC”). 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 unaudited condensed consolidated financial statements reflect all adjustments that are normal and recurring in nature and necessary for a fair presentation of financial position and results of operations as of the end of and for the periods presented. The results of operations for any interim period are not necessarily indicative of the results for a full year.

The preparation of financial statements in conformity with U.S. 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. The significant estimates reflected in the Company’s financial statements, include, but are not limited to:

The premium estimates for certain reinsurance agreements,
Recoverability of deferred acquisition costs,
The reserve for outstanding losses and loss expenses,
Valuation of ceded reinsurance recoverables,
Determination of impairment of goodwill and other intangible assets, and
Valuation of financial instruments.

Intercompany accounts and transactions have been eliminated on consolidation and all entities meeting consolidation requirements have been included in the unaudited condensed consolidated financial statements.

On May 1, 2014, the shareholders approved a 3-for-1 stock split of the Company's common shares. All historical share and per share amounts reflect the effect of the stock split.

These unaudited condensed consolidated financial statements, including these notes, should be read in conjunction with the Company’s audited consolidated financial statements, and related notes thereto, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.
3. NEW ACCOUNTING PRONOUNCEMENTS
In April 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update 2014-08, "Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity" ("ASU 2014-08"). ASU 2014-08 changes the requirements for reporting discontinued operations, such that a disposal of a component of the Company's operations is required to be reported as discontinued operations if the disposal represents a strategic shift that has, or will have, a major effect on the Company's operations and financial results. Examples of strategic shifts that could have a major effect on

5

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ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


the Company's operations could include a disposal of a major geographical area, a major line of business, a major equity method investment, or other major parts of the Company. ASU 2014-08 is effective for all disposals that occur after January 1, 2015. The Company does not believe the adoption of ASU 2014-08 will have a material impact on future financial statements and related disclosures.
In May 2014, the FASB issued Accounting Standards Update 2014-09, "Revenue from Contracts with Customers" ("ASU 2014-09"). ASU 2014-09 provides a framework, through a five-step process, for recognizing revenue from customers, improves comparability and consistency of recognizing revenue across entities, industries, jurisdictions and capital markets, and requires enhanced disclosures. Certain contracts with customers are specifically excluded from the scope of ASU 2014-09, including; amongst others, insurance contracts accounted for under Accounting Standard Codification 944, Financial Services - Insurance. ASU 2014-09 is effective on January 1, 2017 with retrospective adoption required for the comparative periods. The Company is currently assessing the impact the adoption of ASU 2014-09 will have on future financial statements and related disclosures.
In August 2014, the FASB issued Accounting Standards Update 2014-15, "Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern" ("ASU 2014-15"). Currently, there is no guidance under U.S. GAAP regarding management's responsibility to assess whether there is substantial doubt about an entity's ability to continue as a going concern. Under ASU 2014-15, the Company will be required to assess its ability to continue as a going concern each interim and annual reporting period and provide certain disclosures if there is substantial doubt about the entity's ability to continue as a going concern, including management's plan to alleviate the substantial doubt. ASU 2014-15 is effective on January 1, 2017 and early adoption is permitted. The Company is currently assessing the impact the adoption of ASU 2014-15 will have on future financial statements and related disclosures.

4. INVESTMENTS

a) Trading Securities

Securities accounted for at fair value with changes in fair value recognized in the unaudited condensed consolidated statements of operations and comprehensive income (“consolidated income statements”) by category are as follows:
 
September 30, 2014
 
December 31, 2013
 
Fair Value
 
Amortized Cost
 
Fair Value
 
Amortized Cost
U.S. Government and Government agencies
$
1,184,115

 
$
1,186,185

 
$
1,676,788

 
$
1,684,832

Non-U.S. Government and Government agencies
219,287

 
229,792

 
191,776

 
197,082

States, municipalities and political subdivisions
260,690

 
251,628

 
231,555

 
234,406

Corporate debt:
 
 
 
 
 
 
 
Financial institutions
1,194,949

 
1,185,637

 
958,794

 
943,518

Industrials
1,202,906

 
1,201,341

 
1,174,047

 
1,165,448

Utilities
125,513

 
125,202

 
69,426

 
69,658

Mortgage-backed
1,240,362

 
1,196,683

 
1,292,502

 
1,267,863

Asset-backed
700,415

 
698,284

 
505,910

 
502,543

Total fixed maturity investments
$
6,128,237

 
$
6,074,752

 
$
6,100,798

 
$
6,065,350

 
September 30, 2014
 
December 31, 2013
 
Fair Value
 
Original Cost
 
Fair Value
 
Original Cost
Equity securities
$
945,076

 
$
901,300

 
$
699,846

 
$
647,301

Other invested assets
806,124

 
701,794

 
764,081

 
658,683

 
$
1,751,200

 
$
1,603,094

 
$
1,463,927

 
$
1,305,984


Other invested assets, included in the table above, include investments in private equity funds, hedge funds and a high yield loan fund that are accounted for at fair value, but excludes other private securities described below in Note 4(b) that are accounted for using the equity method of accounting.


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ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


b) Other Invested Assets

Details regarding the carrying value, redemption characteristics and unfunded investment commitments of the other invested assets portfolio as of September 30, 2014 and December 31, 2013 were as follows:

Investment Type
Carrying Value as of September 30, 2014
 
Investments
with
Redemption
Restrictions
 
Estimated
Remaining
Restriction
Period
 
Investments
without
Redemption
Restrictions
 
Redemption
Frequency(1)
 
Redemption
Notice
Period(1)
 
Unfunded
Commitments
Private equity
$
179,196

 
$
179,196

 
2 - 9 Years
 
$

 
 
 
 
 
$
223,030

Mezzanine debt
114,399

 
114,399

 
5 - 9 Years
 

 
 
 
 
 
251,486

Distressed
9,516

 
9,516

 
4 Years
 

 
 
 
 
 
5,119

Total private equity
303,111

 
303,111

 
 
 

 
 
 
 
 
479,635

Distressed
173,111

 
173,111

 
1 Year
 

 
 
 
 
 

Equity long/short
111,627

 
86,721

 
1 Year
 
24,906

 
Quarterly
 
30 -60 Days
 

Multi-strategy
81,576

 

 
 
 
81,576

 
Quarterly
 
45 -90 Days
 

Relative value credit
105,155

 

 
 
 
105,155

 
Quarterly
 
60 Days
 

Total hedge funds
471,469

 
259,832

 
 
 
211,637

 
 
 
 
 

High yield loan fund
31,544

 

 
 
 
31,544

 
Monthly
 
30 days
 

Total other invested assets at fair value
806,124

 
562,943

 
 
 
243,181

 
 
 
 
 
479,635

Other private securities
123,077

 

 
 
 
123,077

 
 
 
 
 

Total other invested assets
$
929,201

 
$
562,943

 
 
 
$
366,258

 
 
 
 
 
$
479,635


Investment Type
Carrying Value as of December 31, 2013
 
Investments
with
Redemption
Restrictions
 
Estimated
Remaining
Restriction
Period
 
Investments
without
Redemption
Restrictions
 
Redemption
Frequency(1)
 
Redemption
Notice
Period(1)
 
Unfunded
Commitments
Private equity
$
144,422

 
$
144,422

 
2 - 9 Years
 
$

 
 
 
 
 
$
263,519

Mezzanine debt
64,627

 
64,627

 
8 - 9 Years
 

 
 
 
 
 
198,756

Distressed
7,776

 
7,776

 
4 Years
 

 
 
 
 
 
5,249

Total private equity
216,825

 
216,825

 
 
 

 
 
 
 
 
467,524

Distressed
151,227

 
151,227

 
1 - 2 Years
 

 
 
 
 
 

Equity long/short
99,365

 

 
 
 
99,365

 
Quarterly
 
30 -60 Days
 

Multi-strategy
136,958

 

 
 
 
136,958

 
Quarterly
 
45 -90 Days
 

Event driven
14,018

 

 
 
 
14,018

 
Annual
 
60 Days
 

Relative value credit
113,730

 

 
 
 
113,730

 
Quarterly
 
60 Days
 

Total hedge funds
515,298

 
151,227

 
 
 
364,071

 
 
 
 
 

High yield loan fund
31,958

 

 
 
 
31,958

 
Monthly
 
30 days
 

Total other invested assets at fair value
764,081

 
368,052

 
 
 
396,029

 
 
 
 
 
467,524

Other private securities
147,311

 

 
 
 
147,311

 
 
 
 
 

Total other invested assets
$
911,392

 
$
368,052

 
 
 
$
543,340

 
 
 
 
 
$
467,524

_______________________
(1)
The redemption frequency and notice periods only apply to the investments without redemption restrictions. Some or all of these investments may be subject to a gate as described below.

In general, the Company has invested in hedge funds that require at least 30 days’ notice of redemption and may be redeemed on a monthly, quarterly, semi-annual, annual or longer basis, depending on the fund. Certain hedge funds have lock-

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ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


up periods ranging from one to three years from initial investment. A lock-up period refers to the initial amount of time an investor is contractually required to invest before having the ability to redeem. Funds that provide for periodic redemptions may, depending on the funds’ governing documents, have the ability to deny or delay a redemption request, called a “gate.” The fund may implement this restriction because the aggregate amount of redemption requests as of a particular date exceeds a specified level, generally ranging from 15% to 25% of the fund’s net assets. The gate is a method for executing an orderly redemption process to reduce the possibility of adversely affecting investors in the fund. Typically, the imposition of a gate delays a portion of the requested redemption, with the remaining portion settled in cash sometime after the redemption date. Certain funds may impose a redemption fee on early redemptions. Interests in private equity funds cannot be redeemed because the investments include restrictions that do not allow for redemption until termination of the fund.

The following describes each investment type:

Private equity funds: Primary funds may invest in companies and general partnership interests. Secondary funds buy limited partnership interests from existing limited partners of primary private equity funds. As owners of private equity funds seek liquidity, they can sell their existing investments, plus any remaining commitment, to secondary market participants. These funds cannot be redeemed because the investments include restrictions that do not allow for redemption until termination of the fund.
Mezzanine debt funds: Mezzanine debt funds primarily focus on providing capital to upper middle market and middle market companies and private equity sponsors, in connection with leveraged buyouts, mergers and acquisitions, recapitalizations, growth financings and other corporate transactions. The most common position in the capital structure will be between the senior secured debt holder and the equity; however, the funds will utilize a flexible approach when structuring investments, which may include secured debt, subordinated debt, preferred stock and/or private equity. These funds cannot be redeemed because the investments include restrictions that do not allow for redemption until termination of the fund.
Distressed funds: In distressed debt investing, managers take positions in the debt of companies experiencing significant financial difficulties, including bankruptcy, or in certain positions of the capital structure of structured securities. The manager relies on the fundamental analysis of these securities, including the claims on the assets and the likely return to bondholders. Certain funds cannot be redeemed because the investments include restrictions that do not allow for redemption until termination of the fund.
Equity long/short funds: In equity long/short funds, managers take long positions in companies they deem to be undervalued and short positions in companies they deem to be overvalued. Long/short managers may invest in countries, regions or sectors and vary by their use of leverage and by their targeted net long position.
Multi-strategy funds: These funds may utilize many strategies employed by specialized funds including distressed investing, equity long/short, merger arbitrage, convertible arbitrage, fixed income arbitrage and macro trading.
Event driven funds: Event driven strategies seek to deploy capital into specific securities whose returns are affected by a specific event that affects the value of one or more securities of a company. Returns for such securities are linked primarily to the specific outcome of the events and not by the overall direction of the bond or stock markets. Examples could include mergers and acquisitions (arbitrage), corporate restructurings and spin-offs, and capital structure arbitrage.
Relative value credit funds: These funds seek to take exposure to credit-sensitive securities, long and/or short, based upon credit analysis of issuers and securities and credit market views.
High yield loan fund: A long-only private mutual fund that invests in high yield fixed income securities.
Other private securities: These securities include strategic non-controlling minority investments in private asset management companies and other insurance related investments that are accounted for using the equity method of accounting.


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ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)



c) Net Investment Income
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2014
 
2013
 
2014
 
2013
Fixed maturity investments
$
38,762

 
$
31,179

 
$
110,998

 
$
96,366

Equity securities
3,711

 
6,110

 
12,876

 
13,718

Other invested assets: hedge funds and private equity
2,249

 
3,812

 
8,767

 
6,001

Other invested assets: other private securities
3,292

 
1,997

 
7,291

 
5,115

Cash and cash equivalents
552

 
302

 
1,562

 
1,319

Expenses
(5,154
)
 
(4,129
)
 
(13,670
)
 
(12,225
)
Net investment income
$
43,412

 
$
39,271

 
$
127,824

 
$
110,294


Net investment income from other invested assets: other private securities included the distributed and undistributed net income from investments accounted for using the equity method of accounting. The income reported for other invested assets: other private securities for the nine months ended September 30, 2014 included a loss of $9,348 recorded for an equity method investment due to impairment charges that it recorded.

d) Components of Realized Gains and Losses

 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2014
 
2013
 
2014
 
2013
Gross realized gains on sale of invested assets
$
28,773

 
$
51,915

 
$
146,780

 
$
154,387

Gross realized losses on sale of invested assets
(9,955
)
 
(40,770
)
 
(26,228
)
 
(82,812
)
Net realized and unrealized gains (losses) on derivatives
2,171

 
(4,169
)
 
(24,469
)
 
3,392

Mark-to-market (losses) gains:
 
 
 
 
 
 
 
Fixed maturity investments, trading
(40,843
)
 
30,383

 
18,039

 
(101,205
)
Equity securities, trading
(8,479
)
 
(17,198
)
 
(8,768
)
 
(18,555
)
Other invested assets, trading
(6,803
)
 
7,326

 
(1,068
)
 
36,719

Net realized investment (losses) gains
$
(35,136
)
 
$
27,487

 
$
104,286

 
$
(8,074
)

e) Pledged Assets

As of September 30, 2014 and December 31, 2013, $3,082,601 and $2,894,401, respectively, of cash and cash equivalents and investments were deposited, pledged or held in trust accounts in favor of ceding companies and other counterparties or government authorities to comply with reinsurance contract provisions, insurance laws and other contract provisions.

In addition, as of September 30, 2014 and December 31, 2013, a further $543,828 and $1,053,632, respectively, of cash and cash equivalents and investments were pledged as collateral for the Company’s letter of credit facilities. See Note 10(d) to the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013 for details on the Company’s credit facilities.

5. DERIVATIVE INSTRUMENTS

As of September 30, 2014 and December 31, 2013, none of the Company’s derivatives were designated as hedges for accounting purposes. The following table summarizes information on the location and amounts of derivative fair values on the unaudited condensed consolidated balance sheets (“consolidated balance sheets”):
 

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ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


 
September 30, 2014
 
December 31, 2013
 
Asset
Derivative 
Notional
Amount
 
Asset
Derivative 
Fair Value 
 
Liability
Derivative 
Notional
Amount
 
Liability
Derivative 
Fair Value
 
Asset
Derivative 
Notional
Amount
 
Asset
Derivative 
Fair Value
 
Liability
Derivative 
Notional
Amount
 
Liability
Derivative
Fair Value 
Foreign exchange contracts
$
38,940

 
$
814

 
$
2,355

 
$
22

 
$
294,788

 
$
6,254

 
$
122,439

 
$
1,176

Interest rate swaps
565,600

 
414

 

 

 
491,400

 
6,829

 
40,000

 
4,214

Total derivatives
$
604,540

 
$
1,228

 
$
2,355

 
$
22

 
$
786,188

 
$
13,083

 
$
162,439

 
$
5,390


Derivative assets and derivative liabilities are classified within “other assets” or “accounts payable and accrued liabilities” on the consolidated balance sheets.

The following table provides the net realized and unrealized gains (losses) on derivatives not designated as hedges recorded on the consolidated income statements:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2014
 
2013
 
2014
 
2013
Foreign exchange contracts
$
1,886

 
$
(2,336
)
 
$
(580
)
 
$
(1,091
)
Total included in foreign exchange loss
1,886

 
(2,336
)
 
(580
)
 
(1,091
)
Put options

 

 

 
(3,822
)
Foreign exchange contracts
1,701

 
(4,164
)
 
857

 
1,925

Interest rate futures and swaps
470

 
(5
)
 
(25,325
)
 
5,289

Total included in net realized investment gains (losses)
2,171

 
(4,169
)
 
(24,468
)
 
3,392

Total realized and unrealized gains (losses) on derivatives
$
4,057

 
$
(6,505
)
 
$
(25,048
)
 
$
2,301


The loss related to interest rate future and swap contracts for the nine months ended September 30, 2014 was the result of selling interest rate future and swap contracts to reduce the duration of the investment portfolio. Given the decrease in interest rates during the year, the Company recorded a loss related to these interest rate future and swap contracts.

Derivative Instruments Not Designated as Hedging Instruments

The Company is exposed to foreign currency risk in its investment portfolio. Accordingly, the fair values of the Company’s investment portfolio are partially influenced by the change in foreign exchange rates. These foreign currency hedging activities have not been designated as specific hedges for financial reporting purposes.

The Company’s insurance and reinsurance subsidiaries and branches operate in various foreign countries and consequently the Company’s underwriting portfolio is exposed to foreign currency risk. The Company manages foreign currency risk by seeking to match liabilities under the insurance policies and reinsurance contracts that it writes and that are payable in foreign currencies with cash and investments that are denominated in such currencies. When necessary, the Company may also use derivatives to economically hedge un-matched foreign currency exposures, specifically forward contracts and currency options.

The Company also purchases and sells interest rate future and interest rate swap contracts to actively manage the duration and yield curve positioning of its fixed income portfolio. Interest rate futures and interest rate swaps can efficiently increase or decrease the overall duration of the portfolio. Additionally, interest rate future and interest rate swap contracts can be utilized to obtain the desired position along the yield curve in order to protect against certain future yield curve shapes.

The Company also purchases options to actively manage its equity portfolio.

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ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


6. FAIR VALUE OF FINANCIAL INSTRUMENTS

In accordance with U.S. GAAP, fair value is defined 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. There is a three-level valuation hierarchy for disclosure of fair value measurements. The valuation hierarchy is based upon whether the inputs to the valuation of an asset or liability are observable or unobservable in the market at the measurement date, with quoted market prices being the highest level (Level 1) and unobservable inputs being the lowest level (Level 3). A fair value measurement will fall within the level of the hierarchy based on the input that is significant to determining such measurement. The three levels are defined as follows:
 
Level 1: Observable inputs to the valuation methodology that are quoted prices (unadjusted) for identical assets or liabilities in active markets.
Level 2: Observable inputs to the valuation methodology other than quoted market prices (unadjusted) for identical assets or liabilities in active markets. Level 2 inputs include quoted prices for similar assets and liabilities in active markets, quoted prices for identical assets in markets that are not active and inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the asset or liability.
Level 3: Inputs to the valuation methodology that are unobservable for the asset or liability.

The following table shows the fair value of the Company’s financial instruments and where in the fair value hierarchy the fair value measurements are included as of the dates indicated below:
September 30, 2014
 
Carrying
Amount
 
Total
Fair Value
 
Level 1
 
Level 2
 
Level 3
Fixed maturity investments:
 
 
 
 
 
 
 
 
 
 
U.S. Government and Government agencies
 
$
1,184,115

 
$
1,184,115

 
$
998,487

 
$
185,628

 
$

Non-U.S. Government and Government agencies
 
219,287

 
219,287

 

 
219,287

 

States, municipalities and political subdivisions
 
260,690

 
260,690

 

 
260,690

 

Corporate debt
 
2,523,368

 
2,523,368

 

 
2,523,368

 

Mortgage-backed
 
1,240,362

 
1,240,362

 

 
1,120,454

 
119,908

Asset-backed
 
700,415

 
700,415

 

 
609,045

 
91,370

Total fixed maturity investments
 
6,128,237

 
6,128,237

 
998,487

 
4,918,472

 
211,278

Equity securities
 
945,076

 
945,076

 
907,041

 

 
38,035

Other invested assets
 
806,124

 
806,124

 

 

 
806,124

Total investments
 
$
7,879,437

 
$
7,879,437

 
$
1,905,528

 
$
4,918,472

 
$
1,055,437

Derivative assets:
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
 
$
814

 
$
814

 
$

 
$
814

 
$

Interest rate swaps
 
414

 
414

 

 
414

 

Derivative liabilities:
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
 
$
22

 
$
22

 
$

 
$
22

 
$

Interest rate swaps
 

 

 

 

 

Senior notes
 
$
798,725

 
$
888,370

 
$

 
$
888,370

 
$


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ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


December 31, 2013
 
Carrying
Amount
 
Total
Fair Value
 
Level 1
 
Level 2
 
Level 3
Fixed maturity investments:
 
 
 
 
 
 
 
 
 
 
U.S. Government and Government agencies
 
$
1,676,788

 
$
1,676,788

 
$
1,370,088

 
$
306,700

 
$

Non-U.S. Government and Government agencies
 
191,776

 
191,776

 

 
191,776

 

States, municipalities and political subdivisions
 
231,555

 
231,555

 

 
231,555

 

Corporate debt
 
2,202,267

 
2,202,267

 

 
2,202,267

 

Mortgage-backed
 
1,292,502

 
1,292,502

 

 
1,145,164

 
147,338

Asset-backed
 
505,910

 
505,910

 

 
412,497

 
93,413

Total fixed maturity investments
 
6,100,798

 
6,100,798

 
1,370,088

 
4,489,959

 
240,751

Equity securities
 
699,846

 
699,846

 
625,942

 

 
73,904

Other invested assets
 
764,081

 
764,081

 

 

 
764,081

Total investments
 
$
7,564,725

 
$
7,564,725

 
$
1,996,030

 
$
4,489,959

 
$
1,078,736

Derivative assets:
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
 
$
6,254

 
$
6,254

 
$

 
$
6,254

 
$

Interest rate swaps
 
6,829

 
6,829

 

 
6,829

 

Derivative liabilities:
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
 
$
1,176

 
$
1,176

 
$

 
$
1,176

 
$

Interest rate swaps
 
$
4,214

 
$
4,214

 
$

 
$
4,214

 
$

Senior notes
 
$
798,499

 
$
897,601

 
$

 
$
897,601

 
$


“Other invested assets” excluded other private securities that the Company did not measure at fair value, but are accounted for using the equity method of accounting. Derivative assets and derivative liabilities relating to foreign exchange contracts and interest rate swaps are classified within “other assets” or “accounts payable and accrued liabilities” on the consolidated balance sheets.

The following describes the valuation techniques used by the Company to determine the fair value of financial instruments held as of the balance sheet date.

Recurring Fair Value of Financial Instruments

U.S. Government and Government agencies: Comprised primarily of bonds issued by the U.S. Treasury, the Federal Home Loan Bank, the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association. The fair values of the Company’s U.S. government securities are based on quoted market prices in active markets and are included in the Level 1 fair value hierarchy. The Company believes the market for U.S. Treasury securities is an actively traded market given the high level of daily trading volume. 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 included in the Level 2 fair value hierarchy.

Non-U.S. Government and Government agencies: Comprised of fixed income obligations of non-U.S. governmental entities. The fair values of these securities are based on prices obtained from international indices and are included in the Level 2 fair value hierarchy.

States, municipalities and political subdivisions: Comprised of fixed income obligations of U.S.-domiciled state and municipality entities. The fair values of these securities are based on prices obtained from the new issue market, and are included in the Level 2 fair value hierarchy.

Corporate debt: Comprised of bonds issued by or loan obligations of corporations that are diversified across a wide range of issuers and industries. The fair values of corporate debt that are short-term are priced using spread above the LIBOR yield curve, and the fair values of corporate debt that are long-term are priced using the spread above the risk-free yield curve. The

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ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


spreads are sourced from broker-dealers, trade prices and the new issue market. As the significant inputs used to price corporate bonds are observable market inputs, the fair values of corporate debt are included in the Level 2 fair value hierarchy.

Mortgage-backed: Primarily comprised of residential and commercial mortgages originated by both U.S. government agencies (such as the Federal National Mortgage Association) and non-U.S. government agencies. The fair values of mortgage-backed securities originated by U.S. government agencies and non-U.S. government agencies are based on a pricing model that incorporates prepayment speeds and spreads to determine the appropriate average life of mortgage-backed securities. The spreads are sourced from broker-dealers, trade prices and the new issue market. As the significant inputs used to price the mortgage-backed securities are observable market inputs, the fair values of these securities are included in the Level 2 fair value hierarchy, unless the significant inputs used to price the mortgage-backed securities are broker-dealer quotes and the Company is not able to determine if those quotes are based on observable market inputs, in which case the fair value is included in the Level 3 hierarchy.

Asset-backed: Principally comprised of bonds backed by pools of automobile loan receivables, home equity loans, credit card receivables and collateralized loan obligations originated by a variety of financial institutions. The fair values of asset-backed securities are priced using prepayment speed and spread inputs that are sourced from the new issue market or broker-dealer quotes. As the significant inputs used to price the asset-backed securities are observable market inputs, the fair values of these securities are included in the Level 2 fair value hierarchy, unless the significant inputs used to price the asset-backed securities are broker-dealer quotes and the Company is not able to determine if those quotes are based on observable market inputs, in which case the fair value is included in the Level 3 hierarchy.

Equity securities: Comprised of common and preferred stocks and mutual funds. Equities are generally included in the Level 1 fair value hierarchy as prices are obtained from market exchanges in active markets. Non-U.S. mutual funds where the net asset value is not provided on a daily basis are included in the Level 3 fair value hierarchy.

Other invested assets: Comprised of funds invested in a range of diversified strategies. In accordance with U.S. GAAP, the fair values of the funds are based on the net asset value ("NAV") of the funds as reported by the fund manager. The fair value of these investments are included in the Level 3 fair value hierarchy as the Company believes NAV is an unobservable input and these securities are not redeemable in the near term.

Derivative instruments: The fair value of foreign exchange contracts, interest rate futures and interest rate swaps are priced from quoted market prices for similar exchange-traded derivatives and pricing valuation models that utilize independent market data inputs. The fair value of derivatives are included in the Level 2 fair value hierarchy.

Senior notes: The fair value of the senior notes is based on reported trades. The fair value of the senior notes is included in the Level 2 fair value hierarchy.

Non-recurring Fair Value of Financial Instruments

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. These assets include investments accounted for using the equity method, goodwill and intangible assets. The Company uses a variety of techniques to measure the fair value of these assets when appropriate, as described below:

Investments accounted for using the equity method: When the Company determines that the carrying value of these assets may not be recoverable, the Company records the assets at fair value with the loss recognized in income. In such cases, the Company measures the fair value of these assets using discounted cash flow models and market multiple models.

Goodwill and intangible assets: The Company tests goodwill and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable, but at least annually for goodwill and indefinite-lived intangibles. If the Company determines that goodwill and intangible assets may be impaired, the Company uses techniques, including discounted expected future cash flows and market multiple models, to measure fair value.

 

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ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


Rollforward of Level 3 Financial Instruments

The following is a reconciliation of the beginning and ending balance of financial instruments using significant unobservable inputs (Level 3):
Three Months Ended September 30, 2014
Other invested
assets
 
Mortgage-backed
 
Asset-backed
 
Equities
Opening balance
$
804,505

 
$
146,801

 
$
71,232

 
$
34,863

Realized and unrealized gains (losses) included in net income
6,797

 
(882
)
 
(253
)
 
3,172

Purchases
78,629

 
16,311

 
18,021

 

Sales
(83,807
)
 
(28,761
)
 
(9,970
)
 

Transfers into Level 3 from Level 2

 
1,628

 
17,863

 

Transfers out of Level 3 into Level 2 (1)

 
(15,189
)
 
(5,523
)
 

Ending balance
$
806,124

 
$
119,908

 
$
91,370

 
$
38,035

Three Months Ended September 30, 2013
 
 
 
 
 
 
 
Opening balance
$
714,391

 
$
198,003

 
$
61,285

 
$
53,499

Realized and unrealized gains (losses) included in net income
9,403

 
464

 
(313
)
 
3,972

Purchases
67,554

 
69,775

 
16,969

 
10,000

Sales
(24,277
)
 
(79,001
)
 
(1,302
)
 

Transfers into Level 3 from Level 2

 
13

 
3,394

 

Transfers out of Level 3 into Level 2 (1)

 

 

 

Ending balance
$
767,071

 
$
189,254

 
$
80,033

 
$
67,471

Nine Months Ended September 30, 2014
Other invested
assets
 
Mortgage-backed
 
Asset-backed
 
Equities
Opening balance
$
764,081

 
$
147,338

 
$
93,413

 
$
73,904

Realized and unrealized gains (losses) included in net income
51,921

 
3,654

 
(659
)
 
(6,572
)
Purchases
267,549

 
34,187

 
35,526

 

Sales
(277,427
)
 
(65,038
)
 
(19,871
)
 
(29,297
)
Transfers into Level 3 from Level 2

 
1,253

 
13,923

 

Transfers out of Level 3 into Level 2 (1)

 
(1,486
)
 
(30,962
)
 

Ending balance
$
806,124

 
$
119,908

 
$
91,370

 
$
38,035

Nine Months Ended September 30, 2013
 
 
 
 
 
 
 
Opening balance
$
655,888

 
$
167,825

 
$
62,246

 
$
54,680

Realized and unrealized gains (losses) included in net income
53,365

 
(5,910
)
 
(791
)
 
2,791

Purchases
237,506

 
102,369

 
42,956

 
10,000

Sales
(179,688
)
 
(69,968
)
 
(26,728
)
 

Transfers into Level 3 from Level 2

 
5,073

 
2,350

 

Transfers out of Level 3 into Level 2 (1)

 
(10,135
)
 

 

Ending balance
$
767,071

 
$
189,254

 
$
80,033

 
$
67,471

_______________________ 
(1)
Transfers out of Level 3 are primarily attributable to the availability of market observable information.

The Company attempts to verify the significant inputs used by broker-dealers in determining the fair value of the securities priced by them. If the Company could not obtain sufficient information to determine if the broker-dealers were using significant observable inputs, then such securities have been transferred to the Level 3 fair value hierarchy. The Company believes the prices obtained from the broker-dealers are the best estimate of fair value of the securities being priced as the broker-dealers are typically involved in the initial pricing of the security, and the Company has compared the price per the broker-dealer to other pricing sources and noted no material differences. The Company recognizes transfers between levels at the end of the reporting period. There were no transfers between Level 1 and Level 2 during the period.

14

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ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


The Company’s external investment accounting service provider receives prices from internationally recognized independent pricing services to measure the fair values of its fixed maturity investments. Pricing sources are evaluated and selected in a manner to ensure that the most reliable sources are used. The Company uses a pricing service ranking to consistently select the most appropriate pricing service in instances where it receives multiple quotes on the same security. The Company obtains multiple quotes for the majority of its securities. The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. Each pricing service 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 service uses observable market inputs, including, but not limited to, reported trades, benchmark yields, broker-dealer quotes, interest rates, prepayment speeds, default rates and such other inputs as are available from market sources to determine a reasonable fair value.

All of the Company’s securities classified as Level 3, other than investments in other invested assets, are valued based on unadjusted broker-dealer quotes. This includes less liquid securities such as lower quality asset-backed securities, commercial mortgage-backed securities and residential mortgage-backed securities. The primary valuation inputs include monthly payment information, the probability of default, loss severity rates and estimated prepayment rates. Significant changes in these inputs in isolation would result in a significantly lower or higher fair value measurement. In general, a change in the assumption of the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity in an event of default and prepayment rates.

The Company records the unadjusted price provided and validates this price through a process that includes, but is not limited to, monthly and/or quarterly: (i) comparison of prices between two independent sources, with significant differences requiring additional price sources; (ii) quantitative analysis (e.g., comparing the quarterly return for each managed portfolio to their target benchmark, with significant differences identified and investigated); (iii) evaluation of methodologies used by external parties to calculate fair value, including a review of the inputs used for pricing; (iv) comparing the price to the Company’s knowledge of the current investment market; and (v) back-testing, which includes randomly selecting purchased or sold securities and comparing the executed prices to the fair value estimates from the pricing service. In addition to internal controls, management relies on the effectiveness of the valuation controls in place at the Company’s external investment accounting service provider (supported by a Statement on Standards for Attestation Engagements No. 16 report) in conjunction with regular discussion and analysis of the investment portfolio’s structure and performance.

7. RESERVE FOR LOSSES AND LOSS EXPENSES

The reserve for losses and loss expenses consists of the following:
 
September 30,
2014
 
December 31,
2013
Outstanding loss reserves
$
1,585,900

 
$
1,520,867

Reserves for losses incurred but not reported
4,466,363

 
4,245,662

Reserve for losses and loss expenses
$
6,052,263

 
$
5,766,529


















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ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


The table below is a reconciliation of the beginning and ending liability for unpaid losses and loss expenses. Losses incurred and paid are reflected net of reinsurance recoverables.
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2014
 
2013
 
2014
 
2013
Gross liability at beginning of period
$
5,935,678

 
$
5,696,865

 
$
5,766,529

 
$
5,645,549

Reinsurance recoverable at beginning of period
(1,301,742
)
 
(1,179,525
)
 
(1,234,504
)
 
(1,141,110
)
Net liability at beginning of period
4,633,936

 
4,517,340

 
4,532,025

 
4,504,439

Net losses incurred related to:
 
 
 
 
 
 
 
Current year
382,970

 
338,420

 
1,067,111

 
961,224

Prior years
(46,880
)
 
(61,450
)
 
(140,880
)
 
(153,948
)
Total incurred
336,090

 
276,970

 
926,231

 
807,276

Net paid losses related to:
 
 
 
 
 
 
 
Current year
53,596

 
30,399

 
80,401

 
54,983

Prior years
202,626

 
213,252

 
666,555

 
696,137

Total paid
256,222

 
243,651

 
746,956

 
751,120

Foreign exchange revaluation
(10,550
)
 
4,088

 
(8,046
)
 
(5,848
)
Net liability at end of period
4,703,254

 
4,554,747

 
4,703,254

 
4,554,747

Reinsurance recoverable at end of period
1,349,009

 
1,226,034

 
1,349,009

 
1,226,034

Gross liability at end of period
$
6,052,263

 
$
5,780,781

 
$
6,052,263

 
$
5,780,781


For the three months ended September 30, 2014, the Company recognized unfavorable prior year reserve development in its U.S. insurance segment and net favorable reserve development in its international insurance and reinsurance segments. The net unfavorable prior year reserve development for the U.S. insurance segment primarily related to the 2011 through 2013 loss years was due to a higher level of reported claims in the healthcare line of business and net unfavorable prior year reserve development for the 2005 loss year primarily related to the professional liability line of business. The net favorable reserve development in the international insurance segment was primarily due to lower than expected loss emergence across most lines of business and loss years partially offset by unfavorable prior reserve development for the 2012 loss year related to adverse development on two reported claims in our professional liability line of business. The net favorable reserve development in the reinsurance segment was primarily due to lower than expected loss activity in the property reinsurance line of business for the 2013 loss year.

For the nine months ended September 30, 2014, the Company recognized unfavorable prior year reserve development in its U.S. insurance segment and net favorable reserve development in its international insurance and reinsurance segments. The net unfavorable prior year reserve development in the U.S. insurance segment primarily related to the 2011 through 2013 loss years in our healthcare lines of business and was due to higher than expected loss frequency and severity. The net favorable prior year reserve development in the international insurance segment was primarily due to favorable reserve development for the 2007 loss year in the professional liability line of business, net favorable development for the 2009 and 2010 loss years due to actual loss emergence being lower than anticipated across several lines of business, net unfavorable development for the 2012 loss year in the professional liability line of business and the unfavorable reserve development for the 2013 loss year in the healthcare line of business. The net favorable reserve development in the reinsurance segment was primarily due to lower than expected loss activity in the property reinsurance line of business for the 2013 loss year.

For the three months ended September 30, 2013, the Company had net favorable reserve development in its international insurance and reinsurance segments due to actual loss emergence being lower than initially expected. The majority of the net favorable reserve development was recognized in the 2007 through 2011 loss years across most lines of business. In addition, the reinsurance segment recognized net favorable reserve development for the 2012 loss year due to the low level of reported property losses. This was partially offset by unfavorable development in the U.S. insurance segment in the 2011 and 2012 loss years primarily due to a higher level of reported claims for certain healthcare, errors and omissions and private/not for profit directors’ and officers’ lines of business.


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ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


For the nine months ended September 30, 2013, the Company had net favorable reserve development in its international insurance and reinsurance segments due to actual loss emergence being lower than initially expected for most loss years. The reinsurance segment recognized net favorable reserve development for the 2012 loss year due to the low level of reported property losses. This was partially offset by adverse development in the U.S. insurance segment in the 2011 and 2012 loss years for certain healthcare, errors and omissions and not-for-profit directors’ and officers’ classes of business.

While the Company at times has experienced favorable reserve development in its insurance and reinsurance lines, there is no assurance that conditions and trends that have affected the development of liabilities in the past will continue. It is not appropriate to extrapolate future redundancies based on prior years’ development. The methodology of estimating loss reserves is periodically reviewed to ensure that the key assumptions used in the actuarial models continue to be appropriate.

8. INCOME TAXES

Under Swiss law, a resident company is subject to income tax at the federal, cantonal and communal levels that is levied on net income. Income attributable to permanent establishments or real estate located abroad is excluded from the Swiss tax base. Allied World Switzerland is a holding company and, therefore, is exempt from cantonal and communal income tax. As a result, Allied World Switzerland is subject to Swiss income tax only at the federal level. Allied World Switzerland is a resident of the Canton of Zug and, as such, is subject to an annual cantonal and communal capital tax on its taxable equity. One of Allied World Switzerland's subsidiaries is a Swiss operating company, which is a resident in the Canton of Zug. The operating company is subject to federal, cantonal and communal income tax and to annual cantonal and communal capital tax.

Under current Bermuda law, Allied World Assurance Company Holdings, Ltd (“Allied World Bermuda”) and its Bermuda subsidiaries are not required to pay taxes in Bermuda on either income or capital gains. Allied World Bermuda and Allied World Assurance Company, Ltd have received an assurance from the Bermuda Minister of Finance under the Exempted Undertakings Tax Protection Act 1966 of Bermuda, that in the event of any such taxes being imposed, Allied World Bermuda and Allied World Assurance Company, Ltd will be exempted until March 2035.

Certain subsidiaries of Allied World Switzerland file U.S. federal income tax returns and various U.S. state income tax returns, as well as income tax returns in Canada, Hong Kong, Ireland, Labuan, the United Kingdom, Singapore and Switzerland. To the best of the Company’s knowledge, there are no income tax examinations pending by any tax authority.

Management has deemed all material tax positions to have a greater than 50% likelihood of being sustained based on technical merits if challenged. The Company does not expect any material unrecognized tax benefits within 12 months of September 30, 2014.
9. SHAREHOLDERS’ EQUITY

a) Authorized shares

The issued share capital consists of the following:
 
September 30,
2014
 
December 31,
2013
Common shares issued and fully paid, 2014: CHF 4.10 per share; 2013: CHF 4.10 per share
100,775,256

 
103,477,452

Share capital at end of period
$
407,990

 
$
418,988


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ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


 
Nine Months Ended September 30, 2014
Shares issued at beginning of period
103,477,452

Shares cancelled
(2,702,196
)
Total shares issued at end of period
100,775,256

Treasury shares issued at beginning of period
3,223,806

Shares repurchased
4,616,543

Shares issued out of treasury
(745,135
)
Shares cancelled
(2,702,196
)
Total treasury shares at end of period
4,393,018

Total shares outstanding at end of period
96,382,238


During the nine months ended September 30, 2014, 2,702,196 shares repurchased and designated for cancellation were constructively retired and cancelled.

b) Dividends

The Company paid the following dividends during the nine months ended September 30, 2014:
Dividend Paid
 
Dividend
Per
Share
 
Total
Amount
Paid
January 2, 2014
 
$
0.167

 
$
16,732

April 3, 2014
 
$
0.167

 
$
16,495

July 2, 2014
 
$
0.225

 
$
21,870


On May 2, 2013, the shareholders approved the Company’s proposal to pay cash dividends in the form of a distribution out of general legal reserve from capital contributions. The distribution amounts were paid to shareholders in quarterly dividends of $0.167 per share in July 2013, October 2013, January 2014 and April 2014.

On May 1, 2014, the shareholders approved the Company’s proposal to pay cash dividends in the form of a distribution out of general legal reserve from capital contributions. The distribution amount will be paid to shareholders in quarterly dividends of $0.225 per share. The first dividend was on July 2, 2014 and the second dividend was on October 2, 2014. The Company expects to distribute the remaining dividends in January 2015 and April 2015.

c) Share Repurchases

On May 1, 2014, the shareholders approved a new share repurchase program in order for the Company to repurchase up to $500,000 of its common shares. This new share repurchase program supersedes the 2012 share repurchase program and no further repurchases will be made under the 2012 share repurchase program. Repurchases may be effected from time to time through open market purchases, privately negotiated transactions, tender offers or otherwise. The timing, form and amount of the share repurchases under the program will depend on a variety of factors, including market conditions, the Company’s capital position, legal requirements and other factors. Under the terms of this share repurchase program, the first three million of common shares repurchased will remain in treasury and will be used by the Company to satisfy share delivery obligations under its equity-based compensation plans. Any additional common shares repurchased will be designated for cancellation at acquisition and will be canceled upon shareholder approval. Shares repurchased and designated for cancellation are constructively retired and recorded as a share cancellation.






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ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


The Company’s share repurchases were as follows:
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2014
 
2013
 
2014
 
2013
Common shares repurchased
654,851

 
1,282,164

 
4,616,543

 
4,103,499

Total cost of shares repurchased
$
24,996

 
$
40,574

 
$
164,528

 
$
123,145

Average price per share
$
38.17

 
$
31.64

 
$
35.64

 
$
30.01


10. EMPLOYEE BENEFIT PLANS

a) Restricted stock units and performance-based equity awards

Restricted stock units ("RSUs") vest pro-rata over four years from the date of grant. The compensation expense for the RSUs is based on the fair market value of Allied World Switzerland’s common shares at the date of grant. The Company estimates the expected forfeitures of RSUs at the date of grant and recognizes compensation expense only for those awards that the Company expects to vest. The forfeiture assumption is ultimately adjusted to the actual forfeiture rate.

Performance-based equity awards represent the right to receive a number of common shares in the future, based upon the achievement of established performance criteria during an applicable performance period. For the performance-based equity awards granted in 2014, 2013 and 2012, the Company anticipates that the performance goals are likely to be achieved. Based on the performance goals, the performance-based equity awards granted in 2014, 2013 and 2012 are expensed at 100%, 100% and 135%, respectively, of the fair value of Allied World Switzerland's common shares on the date of grant. The expense is recognized over the performance period.

The activity related to the Company’s RSUs awards is as follows:
 
Nine Months Ended September 30, 2014
 
Number of Awards
 
Weighted
Average
Grant Date
Fair Value
Outstanding at beginning of period
143,697

 
$
21.69

RSUs granted
454,176

 
33.56

RSUs forfeited
(8,061
)
 
(31.71
)
RSUs fully vested
(77,700
)
 
(21.68
)
Outstanding at end of period
512,112

 
$
32.06


The activity related to the Company’s performance-based equity awards is as follows:
 
Nine Months Ended September 30, 2014
 
Number of Awards
 
Weighted
Average
Grant Date
Fair Value
Outstanding at beginning of period
804,519

 
$
23.21

Performance-based equity awards granted
166,302

 
33.56

Additional awards granted due to achievement of performance criteria
104,895

 
20.50

Performance-based equity awards forfeited
(1,848
)
 
(25.28
)
Performance-based equity awards fully vested
(454,440
)
 
(20.50
)
Outstanding at end of period
619,428

 
$
27.51




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ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


b) Cash-equivalent stock awards

As part of the Company’s annual year-end compensation awards, the Company granted both awards classified as equity and cash-equivalent stock awards. The cash-equivalent awards were granted to employees who received RSUs and performance-based equity awards in tandem with stock-based awards. The cash-equivalent RSU awards vest pro-rata over four years from the date of grant. The cash-equivalent performance-based equity awards vest after a three-year performance period. The amount payable per unit awarded will be equal to the price per share of Allied World Switzerland’s common shares, and as such the Company measures the value of the award each reporting period based on the period-ending share price. The effects of changes in the share price at each period-end during the service period are recognized as changes in compensation expense ratably over the service period. The liability is included in “accounts payable and accrued liabilities” in the consolidated balance sheets and changes in the liability are recorded in “general and administrative expenses” in the consolidated income statements.

The activity related to the Company's cash-equivalent RSUs and performance-based awards is as follows:
 
RSU's
 
Performance-based Awards
Nine Months Ended September 30, 2014
Number of Awards
 
Weighted Average Grant Date Fair Value
 
Number of Awards
 
Weighted Average Grant Date Fair Value
Outstanding at beginning of period
2,049,084

 
$
24.69

 
1,031,961

 
23.67

Granted
438,162

 
33.56

 
249,438

 
33.56

Additional awards granted due to achievement of performance criteria

 

 
104,895

 
20.50

Forfeited
(50,106
)
 
(26.75
)
 
(2,769
)
 
(25.28
)
Fully vested
(752,668
)
 
(22.51
)
 
(454,440
)
 
(20.50
)
Outstanding at end of period
1,684,472

 
$
27.98

 
929,085

 
$
27.51


c) Total Stock Related Compensation Expense

The following table shows the total stock-related compensation expense relating to the stock options, RSUs and cash equivalent awards.
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2014
 
2013
 
2014
 
2013
Stock options
$
424

 
$
647

 
$
1,564