ACE LTD, 10-Q filed on 8/4/2011
Quarterly Report
Consolidated Balance Sheets (Unaudited) (USD $)
In Millions
Jun. 30, 2011
Dec. 31, 2010
Investments
 
 
Fixed maturities available for sale, at fair value (amortized cost - $39,862 and $36,542) (includes hybrid financial instruments of $398 and $416)
$ 41,038 
$ 37,539 
Fixed maturities held to maturity, at amortized cost (fair value - $9,078 and $9,461)
9,033 
9,501 
Equity securities, at fair value (cost - $549 and $666)
582 
692 
Short-term investments, at fair value and amortized cost
2,380 
1,983 
Other investments (cost - $1,916 and $1,511)
2,156 
1,692 
Total investments
55,189 
51,407 
Cash
833 
772 
Securities lending collateral
1,593 
1,495 
Accrued investment income
538 
521 
Insurance and reinsurance balances receivable
4,923 
4,233 
Reinsurance recoverables on losses and loss expenses
13,375 
12,871 
Reinsurance recoverable on policy benefits
250 
281 
Deferred policy acquisition costs
1,821 
1,641 
Value of business acquired
796 
634 
Goodwill and other intangible assets
4,858 
4,664 
Prepaid reinsurance premiums
1,711 
1,511 
Deferred tax assets
586 
769 
Investments in partially-owned insurance companies (cost - $349 and $357)
353 
360 
Other assets
2,428 
2,196 
Total assets
89,254 
83,355 
Liabilities
 
 
Unpaid losses and loss expenses
38,951 
37,391 
Unearned premiums
6,913 
6,330 
Future policy benefits
4,384 
3,106 
Insurance and reinsurance balances payable
3,785 
3,282 
Deposit liabilities
700 
421 
Securities lending payable
1,610 
1,518 
Payable for securities purchased
418 
292 
Accounts payable, accrued expenses, and other liabilities
3,288 
2,958 
Income taxes payable
23 
116 
Short-term debt
1,400 
1,300 
Long-term debt
3,360 
3,358 
Trust preferred securities
309 
309 
Total liabilities
65,141 
60,381 
Shareholders' equity
 
 
Common Shares (CHF 30.27 and CHF 30.57 par value, 342,775,070 and 341,094,559 shares issued, 337,912,324 and 334,942,852 shares outstanding)
10,098 
10,161 
Common Shares in treasury (4,862,746 and 6,151,707 shares)
(250)
(330)
Additional paid-in capital
5,484 
5,623 
Retained earnings
6,792 
5,926 
Deferred compensation obligation
Accumulated other comprehensive income (AOCI)
1,989 
1,594 
Common shares issued to employee trust
(2)
(2)
Total shareholders' equity
24,113 
22,974 
Total liabilities and shareholders' equity
$ 89,254 
$ 83,355 
Consolidated Balance Sheets (Unaudited) (Parentheticals) (USD $)
In Millions, except Share data
Jun. 30, 2011
Dec. 31, 2010
Consolidated balance sheets - assets - parenthetical disclosures
 
 
Fixed maturities available for sale, at amortized cost
$ 39,862 
$ 36,542 
Fixed maturities available for sale, hybrid financial instruments
398 
416 
Fixed maturities held to maturity, at fair value
9,078 
9,461 
Equity securities, at cost
549 
666 
Other investments, at cost
1,916 
1,511 
Investments in partially-owned insurance companies, at cost
$ 349 
$ 357 
Consolidated balance sheets - equity - parenthetical disclosures
 
 
Common Shares - shares issued
342,775,070 
341,094,559 
Common Shares - shares outstanding
337,912,324 
334,942,852 
Common Shares in treasury - shares
4,862,746 
6,151,707 
Consolidated Balance Sheets (Unaudited) (Parentheticals in CHF) (CHF)
Jun. 30, 2011
Dec. 31, 2010
Common shares - par value
 30.27 
 
Common Stock Par Value [Member]
 
 
Common shares - par value
 30.27 
 30.57 
Consolidated Statements of Operations and Comprehensive Income (Unaudited) (USD $)
In Millions, except Per Share data
3 Months Ended
Jun. 30,
6 Months Ended
Jun. 30,
2011
2010
2011
2010
Revenue:
 
 
 
 
Net premiums written
$ 3,953 
$ 3,420 
$ 7,399 
$ 6,991 
Change in unearned premiums
(196)
(187)
(333)
(481)
Net premiums earned
3,757 
3,233 
7,066 
6,510 
Net investment income
569 
518 
1,113 
1,022 
Net realized gains (losses):
 
 
 
 
Other-than-temporary impairment (OTTI) losses gross
(9)
(31)
(14)
(81)
Portion of OTTI losses recognized in other comprehensive income (OCI)
13 
45 
Net OTTI losses recognized in income
(8)
(18)
(12)
(36)
Net realized gains (losses) excluding OTTI losses
(65)
27 
(106)
213 
Total net realized gains (losses) including OTTI
(73)
(118)
177 
Total revenues
4,253 
3,760 
8,061 
7,709 
Expenses:
 
 
 
 
Losses and loss expenses
2,226 
1,800 
4,489 
3,721 
Policy benefits
108 
87 
199 
174 
Policy acquisition costs
604 
536 
1,159 
1,090 
Administrative expenses
515 
463 
1,009 
923 
Interest expense
62 
52 
125 
104 
Other (income) expense
(5)
(1)
Total expenses
3,524 
2,941 
6,976 
6,011 
Income before income tax
729 
819 
1,085 
1,698 
Income tax expense (benefit)
122 
142 
219 
266 
Net income (loss)
607 
677 
866 
1,432 
Other comprehensive income (loss):
 
 
 
 
Unrealized appreciation
303 
487 
369 
1,070 
Reclassification adjustment for net realized gains included in net income
(78)
(97)
(134)
(226)
Subtotal
225 
390 
235 
844 
Change in cumulative translation adjustment
69 
(169)
301 
(259)
Change in pension liability
(5)
Other comprehensive income, before income tax
295 
223 
531 
593 
Income tax expense related to OCI items
(88)
(55)
(136)
(122)
Other comprehensive income
207 
168 
395 
471 
Comprehensive income
$ 814 
$ 845 
$ 1,261 
$ 1,903 
Earnings per share:
 
 
 
 
Basic earnings per share
$ 1.79 
$ 1.99 
$ 2.56 
$ 4.22 
Diluted earnings per share
$ 1.77 
$ 1.98 
$ 2.54 
$ 4.21 
Consolidated Statements of Shareholders' Equity (Unaudited) (USD $)
In Millions
Total
Common Shares [Member]
Common Shares in treasury [Member]
Additional paid-in capital [Member]
Retained earnings [Member]
Deferred compensation obligation [Member]
AOCI - Net unrealized appreciation (depreciation) on investments [Member]
AOCI - Cumulative translation adjustment [Member]
AOCI - Pension liability adjustment [Member]
AOCI - Total [Member]
Accumulated Income Tax Expense Benefit [Member]
Common Stock Issued Employee Stock Trust [Member]
Shareholders' equity - beginning of period at Dec. 31, 2009
 
$ 10,503 
$ (3)
$ 5,526 
$ 2,818 
$ 2 
$ 657 
$ 240 
$ (74)
 
 
$ (2)
Consolidated Statements of Shareholders' Equity
 
 
 
 
 
 
 
 
 
 
 
 
Exercise of stock options
 
 
 
 
 
 
 
 
 
 
Common shares issued in treasury, net of net shares redeemed under employee share-based compensation plans
 
 
(26)
 
 
 
 
 
 
 
 
 
Share-based compensation expense and other
 
 
 
68 
 
 
 
 
 
 
 
 
Net income (loss)
1,432 
 
 
 
1,432 
 
 
 
 
 
 
 
Dividends declared on Common Shares-par value reduction
 
(218)
 
 
 
 
 
 
 
 
 
 
Net shares issued (redeemed) under employee-based compensation plans
 
71 
 
(69)
 
 
 
 
 
 
 
 
Accumulated other comprehensive income (loss):
 
 
 
 
 
 
 
 
 
 
 
 
Change in period, net of income tax (expense) benefit of $(60) and $(213)
 
 
 
 
 
 
631 
 
 
 
(213)
 
Change in period, net of income tax (expense) benefit of $(77) and $94
 
 
 
 
 
 
 
(165)
 
 
94 
 
Change in period, net of income tax (expense) benefit of $1 and $(3)
 
 
 
 
 
 
 
 
 
(3)
 
Shareholders' equity - end of period at Jun. 30, 2010
21,410 
10,365 
(29)
5,530 
4,250 
1,288 
75 
(69)
1,294 
 
(2)
Shareholders' equity - beginning of period at Dec. 31, 2010
22,974 
10,161 
(330)
5,623 
5,926 
1,399 
262 
(67)
 
 
(2)
Consolidated Statements of Shareholders' Equity
 
 
 
 
 
 
 
 
 
 
 
 
Exercise of stock options
 
50 
 
20 
 
 
 
 
 
 
 
 
Common shares issued in treasury, net of net shares redeemed under employee share-based compensation plans
 
 
80 
 
 
 
 
 
 
 
 
 
Share-based compensation expense and other
 
 
 
71 
 
 
 
 
 
 
 
 
Dividends declared on Common Shares
 
 
 
 
(119)
 
 
 
 
 
 
 
Net income (loss)
866 
 
 
 
866 
 
 
 
 
 
 
 
Funding of dividends declared from Additional paid-in capital
 
 
 
 
119 
 
 
 
 
 
 
 
Funding of dividends declared to Retained Earnings
 
 
 
(119)
 
 
 
 
 
 
 
 
Dividends declared on Common Shares-par value reduction
 
(113)
 
 
 
 
 
 
 
 
 
 
Net shares issued (redeemed) under employee-based compensation plans
 
 
 
(111)
 
 
 
 
 
 
 
 
Accumulated other comprehensive income (loss):
 
 
 
 
 
 
 
 
 
 
 
 
Change in period, net of income tax (expense) benefit of $(60) and $(213)
 
 
 
 
 
 
175 
 
 
 
(60)
 
Change in period, net of income tax (expense) benefit of $(77) and $94
 
 
 
 
 
 
 
224 
 
 
(77)
 
Change in period, net of income tax (expense) benefit of $1 and $(3)
 
 
 
 
 
 
 
 
(4)
 
 
Shareholders' equity - end of period at Jun. 30, 2011
$ 24,113 
$ 10,098 
$ (250)
$ 5,484 
$ 6,792 
$ 2 
$ 1,574 
$ 486 
$ (71)
$ 1,989 
 
$ (2)
Consolidated Statement of Cash Flows (Unaudited) (USD $)
In Millions
6 Months Ended
Jun. 30,
2011
2010
Cash flows from operating activities:
 
 
Net income (loss)
$ 866 
$ 1,432 
Adjustments to reconcile net income to net cash flows from operating activities
 
 
Net realized (gains) losses
118 
(177)
Amortization of premiums/discounts on fixed maturities
63 
61 
Deferred income taxes
47 
(48)
Unpaid losses and loss expenses (cash flow)
1,001 
(452)
Unearned premiums (cash flow)
478 
818 
Future policy benefits (cash flow)
37 
40 
Insurance and reinsurance balances payable (cash flow)
449 
(16)
Accounts payable, accrued expenses, and other liabilities (cash flow)
33 
Income taxes payable (cash flow)
(91)
60 
Insurance and reinsurance balances receivable (cash flow)
(578)
(316)
Reinsurance recoverable on losses and loss expenses (cash flow)
(296)
346 
Reinsurance recoverable on policy benefits (cash flow)
29 
11 
Deferred policy acquisition costs (cash flow)
(149)
(167)
Prepaid reinsurance premiums (cash flow)
(156)
(411)
Other cash flows from operating activities
242 
477 
Net cash flows from operating activities
2,063 
1,691 
Cash flows used for investing activities:
 
 
Purchases of fixed maturities available for sale
(13,041)
(16,623)
Purchases of to be announced mortgage-backed securities
(642)
(720)
Purchases of fixed maturities held to maturity
(234)
(324)
Purchases of equity securities
(170)
(38)
Sales of fixed maturities available for sale
9,346 
12,866 
Sales of to be announced mortgage-backed securities
639 
684 
Sales of equity securities
347 
311 
Maturities and redemptions of fixed maturities available for sale
1,758 
1,776 
Maturities and redemptions of fixed maturities held to maturity
656 
570 
Net derivative instruments settlements
(46)
131 
Acquisition of subsidiaries (net of cash acquired of $95 in 2011)
(380)
 
Other cash flows from investing activities
(132)
(100)
Net cash flows from (used for) investing activities
(1,899)
(1,467)
Cash flows (used for) from financing activities:
 
 
Dividends paid on Common Shares
(223)
(210)
Common Shares repurchased (cash flow)
(68)
 
Proceeds from issuance of short term debt
3,311 
175 
Repayment of short-term debt
(3,211)
(175)
Proceeds from share-based compensation plans
76 
19 
Net cash flows (used for) from financing activities
(115)
(191)
Effect of foreign currency rate changes on cash and cash equivalents:
 
 
Effect of foreign currency rate changes on cash and cash equivalents
12 
(34)
Cash:
 
 
Net (decrease) increase in cash
61 
(1)
Cash - beginning of period
772 
669 
Cash - end of period
833 
668 
Supplement cash flow disclosures
 
 
Taxes paid (cash flow)
265 
256 
Interest paid (cash flow)
$ 112 
$ 101 
Consolidated Statements of Cash Flows (Unaudited) (Parentheticals) (USD $)
In Millions
6 Months Ended
Jun. 30, 2011
Consolidated Statements Of Cash Flows Parentheticals
 
Cash acquired from acquisition of subsidiary
$ 95 
General
General

1. General

 

ACE Limited is a holding company incorporated in Zurich, Switzerland. ACE Limited and its subsidiaries (collectively, ACE, we, us, or our) provide a broad range of insurance and reinsurance products to insureds worldwide. ACE operates through the following business segments: Insurance – North American, Insurance – Overseas General, Global Reinsurance, and Life.

The interim unaudited consolidated financial statements, which include the accounts of ACE and its subsidiaries, have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) and, in the opinion of management, reflect all adjustments (consisting of normally recurring accruals) necessary for a fair statement of the results and financial position for such periods. All significant intercompany accounts and transactions have been eliminated. The results of operations and cash flows for any interim period are not necessarily indicative of the results for the full year. These consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2010.

Accounting guidance not yet adopted
Accounting guidance not yet adopted

2. Accounting guidance not yet adopted

 

Accounting for costs associated with acquiring or renewing insurance contracts

 

In October 2010, the Financial Accounting Standards Board (FASB) issued new guidance related to the accounting for costs associated with acquiring or renewing insurance contracts. The guidance modifies the definition of acquisition costs to specify that a cost must be directly related to the successful acquisition of a new or renewal insurance contract in order to be deferred. This guidance is effective for interim and annual reporting periods beginning on January 1, 2012, and may be applied prospectively or retrospectively. The amount of acquisition costs we will defer under the new guidance will be less than the amount deferred under our current accounting practice. We are in the process of assessing the impact that this guidance will have on our financial condition and results of operations.

 

Fair value measurements

 

In May 2011, the FASB issued new guidance on fair value measurements to revise the wording used to describe the requirements for measuring fair value and for disclosing information about fair value measurements.  The guidance is not necessarily intended to result in a significant change in the application of the current requirements.  Instead it is intended to clarify the intended application of existing fair value measurement requirements.  It also changes certain principles or requirements for measuring fair value and disclosing information about fair value measurements.  This guidance is effective for interim and annual reporting periods beginning on or after December 15, 2011.  We are in the process of assessing the impact this amendment will have on our financial statements. 

Acquisitions
Acquisitions

3. Acquisitions

 

ACE acquired New York Life's Korea operations on February 1, 2011 and New York Life's Hong Kong operations on April 1, 2011 for approximately $425 million in cash. These acquired businesses, now operating under our Life segment, expand our presence in the North Asia market and complement our life insurance business established in that region. These acquisitions generated approximately $123 million of goodwill, none of which is expected to be deductible for income tax purposes, and approximately $207 million of intangible assets. The most significant intangible asset is the value of business acquired (VOBA). VOBA represents the fair value of the future profits of the in-force long duration contracts and is amortized in relation to the premium or profit emergence of the underlying contracts, depending on the nature of the product, in a manner similar to deferred acquisition costs.

 

Prior year acquisitions

 

On December 28, 2010, ACE acquired all the outstanding common stock of Rain and Hail Insurance Service, Inc. (Rain and Hail) not previously owned by ACE for approximately $1.1 billion in cash. Rain and Hail has served America's farmers since 1919, providing comprehensive multiple peril crop and crop/hail insurance protection to customers in the U.S. and Canada. This acquisition is consistent with ACE's strategy to expand its specialty lines business and provides further diversification of ACE's global product mix. The acquisition of Rain and Hail generated $129 million of goodwill, none of which is expected to be deductible for income tax purposes, and $523 million of other intangible assets. Goodwill and other intangible assets arising from this acquisition are included in the Insurance – North American segment.

On December 1, 2010, ACE acquired Jerneh Insurance Berhad (Jerneh), a general insurance company in Malaysia, for approximately $218 million in cash. The acquisitions of Rain and Hail and Jerneh were financed with cash on hand and the use of reverse repurchase agreements of $1 billion.

Investments
Investments

4. Investments

 

a) Fixed maturities

 

The following tables present the fair value and amortized cost of and the gross unrealized appreciation (depreciation) related to fixed maturities as well as related OTTI recognized in AOCI:

  June 30, 2011
  Amortized Cost Gross Unrealized Appreciation Gross Unrealized Depreciation Fair Value OTTI Recognized in AOCI
                
  (in millions of U.S. dollars)
Available for sale              
U.S. Treasury and agency$ 2,423 $ 80 $ (8) $ 2,495 $ -
Foreign  12,341   389   (51)   12,679   (12)
Corporate securities  13,853   723   (63)   14,513   (14)
Mortgage-backed securities  9,932   259   (180)   10,011   (191)
States, municipalities, and political   1,313   36   (9)   1,340   -
 subdivisions         
  $ 39,862 $ 1,487 $ (311) $ 41,038 $ (217)
Held to maturity              
U.S. Treasury and agency$ 1,067 $ 30 $ (5) $ 1,092 $ -
Foreign  1,051   1   (24)   1,028   -
Corporate securities  2,311   15   (34)   2,292   -
Mortgage-backed securities  3,414   69   (11)   3,472   -
States, municipalities, and political   1,190   10   (6)   1,194   -
 subdivisions         
  $ 9,033 $ 125 $ (80) $ 9,078 $ -

  December 31, 2010
  Amortized Cost Gross Unrealized Appreciation Gross Unrealized Depreciation Fair Value OTTI Recognized in AOCI
                
  (in millions of U.S. dollars)
Available for sale              
U.S. Treasury and agency$ 2,904 $ 74 $ (15) $ 2,963 $ -
Foreign  10,926   340   (80)   11,186   (28)
Corporate securities  12,902   754   (69)   13,587   (29)
Mortgage-backed securities  8,508   213   (205)   8,516   (228)
States, municipalities, and political   1,302   15   (30)   1,287   -
 subdivisions         
  $ 36,542 $ 1,396 $ (399) $ 37,539 $ (285)
Held to maturity              
U.S. Treasury and agency$ 1,105 $ 32 $ (10) $ 1,127 $ -
Foreign  1,049   1   (37)   1,013   -
Corporate securities  2,361   12   (60)   2,313   -
Mortgage-backed securities  3,811   62   (27)   3,846   -
States, municipalities, and political   1,175   5   (18)   1,162   -
 subdivisions         
  $ 9,501 $ 112 $ (152) $ 9,461 $ -

As discussed in Note 4 c), if a credit loss is indicated on an impaired fixed maturity, an OTTI is considered to have occurred and the portion of the impairment not related to credit losses (non-credit OTTI) is recognized in OCI. Included in the OTTI Recognized in AOCI columns above is the cumulative amount of non-credit OTTI recognized in OCI adjusted for subsequent sales, maturities, and redemptions. OTTI Recognized in AOCI does not include the impact of subsequent changes in fair value of the related securities. In periods subsequent to a recognition of OTTI in OCI, changes in the fair value of the related fixed maturities are reflected in Unrealized appreciation (depreciation) in the consolidated statement of shareholders' equity. For the three and six months ended June 30, 2011, $25 million and $8 million, respectively, of net unrealized depreciation related to such securities is included in OCI. For the three and six months ended June 30, 2010, $33 million and $96 million, respectively, of net unrealized appreciation related to such securities is included in OCI. At June 30, 2011 and December 31, 2010, AOCI includes net unrealized depreciation of $109 million and $99 million, respectively, related to securities remaining in the investment portfolio at those dates for which ACE has recognized a non-credit OTTI.

Mortgage-backed securities issued by U.S. government agencies are combined with all other to be announced mortgage derivatives held (refer to Note 7 a) (iv)) and are included in the category, “Mortgage-backed securities”. Approximately 81 percent and 79 percent of the total mortgage-backed securities at June 30, 2011 and December 31, 2010, respectively, are represented by investments in U.S. government agency bonds. The remainder of the mortgage exposure consists of collateralized mortgage obligations and nongovernment mortgage-backed securities, the majority of which provide a planned structure for principal and interest payments and carry a rating of AAA by the major credit rating agencies.

The following table presents fixed maturities by contractual maturity. Expected maturities could differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties.

 June 30 December 31
 2011 2010
 Amortized Cost Fair Value Amortized Cost Fair Value
            
 (in millions of U.S. dollars)
Available for sale; maturity period           
Due in 1 year or less$ 2,046 $ 2,074 $ 1,846 $ 1,985
Due after 1 year through 5 years  12,962   13,446   13,094   13,444
Due after 5 years through 10 years  11,468   11,972   10,276   10,782
Due after 10 years  3,454   3,535   2,818   2,812
   29,930   31,027   28,034   29,023
Mortgage-backed securities  9,932   10,011   8,508   8,516
 $ 39,862 $ 41,038 $ 36,542 $ 37,539
            
Held to maturity; maturity period           
Due in 1 year or less$ 310 $ 312 $ 400 $ 404
Due after 1 year through 5 years  2,127   2,163   1,983   2,010
Due after 5 years through 10 years  2,512   2,468   2,613   2,524
Due after 10 years  670   663   694   677
   5,619   5,606   5,690   5,615
Mortgage-backed securities  3,414   3,472   3,811   3,846
 $ 9,033 $ 9,078 $ 9,501 $ 9,461

b) Equity securities

 

The following table presents the fair value and cost of and gross unrealized appreciation (depreciation) related to equity securities:

 

  June 30  December 31
  2011  2010
      
 (in millions of U.S. dollars)
Cost$ 549 $ 666
Gross unrealized appreciation  37   28
Gross unrealized depreciation  (4)   (2)
Fair value$ 582 $ 692

c) Net realized gains (losses)

 

In accordance with guidance related to the recognition and presentation of OTTI, when an OTTI related to a fixed maturity has occurred, OTTI is required to be recorded in net income if management has the intent to sell the security or it is more likely than not that we will be required to sell the security before the recovery of its amortized cost. Further, in cases where we do not intend to sell the security and it is more likely than not that we will not be required to sell the security, ACE must evaluate the security to determine the portion of the impairment, if any, related to credit losses. If a credit loss is indicated, an OTTI is considered to have occurred and any portion of the OTTI related to credit losses must be reflected in net income while the portion of OTTI related to all other factors is recognized in OCI. For fixed maturities held to maturity, OTTI recognized in OCI is accreted from AOCI to the amortized cost of the fixed maturity prospectively over the remaining term of the securities.

 

Each quarter, securities in an unrealized loss position (impaired securities), including fixed maturities, securities lending collateral, equity securities, and other investments, are reviewed to identify impaired securities to be specifically evaluated for a potential OTTI.

 

For all non-fixed maturities, OTTI is evaluated based on the following:

 

  • the amount of time a security has been in a loss position and the magnitude of the loss position;
  • the period in which cost is expected to be recovered, if at all, based on various criteria including economic conditions and other issuer-specific developments; and
  • ACE's ability and intent to hold the security to the expected recovery period.

 

As a general rule, we also consider that equity securities in an unrealized loss position for twelve consecutive months are impaired.

 

We review each fixed maturity in an unrealized loss position to assess whether the security is a candidate for credit loss. Specifically, we consider credit rating, market price, and issuer-specific financial information, among other factors, to assess the likelihood of collection of all principal and interest as contractually due. Securities for which we determine that credit loss is likely are subjected to further analysis to estimate the credit loss recognized in net income, if any. In general, credit loss recognized in net income equals the difference between the security's amortized cost and the net present value of its projected future cash flows discounted at the effective interest rate implicit in the debt security. All significant assumptions used in determining credit losses are subject to change as market conditions evolve.

 

Projected cash flows for corporate securities (principally senior unsecured bonds) are driven primarily by assumptions regarding probability of default and also the timing and amount of recoveries associated with defaults. We develop these estimates using information based on market observable data, issuer-specific information, and credit ratings. ACE developed its default assumption by using historical default data by Moody's Investors Service (Moody's) rating category to calculate a 1-in-100 year probability of default, which results in a default assumption in excess of the historical mean default rate.

There were no credit losses recognized in net income for corporate securities in 2011. For the three and six months ended June 30, 2010, credit losses recognized in net income for corporate securities were nil and $1 million, respectively.

 

For mortgage-backed securities, credit impairment is assessed using a cash flow model that estimates the cash flows on the underlying mortgages, using the security-specific collateral and transaction structure. The model estimates cash flows from the underlying mortgage loans and distributes those cash flows to various tranches of securities, considering the transaction structure and any subordination and credit enhancements that exist in that structure. The cash flow model incorporates actual cash flows on the mortgage-backed securities through the current period and then projects the remaining cash flows using a number of assumptions, including default rates, prepayment rates, and loss severity rates (the par value of a defaulted security that will not be recovered) on foreclosed properties.

 

Credit losses recognized in net income for mortgage-backed securities for the three and six months ended June 30, 2011 were $2 million and $3 million, respectively. Credit losses recognized in net income for mortgage-backed securities for the three and six months ended June 30, 2010 were $5 million and $22 million, respectively.

 

The following table presents the Net realized gains (losses) and the losses included in Net realized gains (losses) and OCI as a result of conditions which caused management to conclude the decline in fair value of certain investments was “other-than-temporary”:

 Three Months Ended Six Months Ended
 June 30 June 30
 2011 2010 2011 2010
            
 (in millions of U.S. dollars)
Fixed maturities:           
OTTI on fixed maturities, gross$ (6) $ (18) $ (11) $ (68)
OTTI on fixed maturities recognized in OCI (pre-tax)  1   13   2   45
OTTI on fixed maturities, net  (5)   (5)   (9)   (23)
Gross realized gains excluding OTTI  108   128   217   296
Gross realized losses excluding OTTI  (29)   (46)   (85)   (115)
Total fixed maturities  74   77   123   158
            
Equity securities:           
Gross realized gains excluding OTTI  4   32   12   77
Gross realized losses excluding OTTI  -   -   (1)   -
Total equity securities  4   32   11   77
            
OTTI on other investments  (3)   (13)   (3)   (13)
Foreign exchange gains (losses)  (30)   61   (109)   52
Investment and embedded derivative instruments  (48)   5   (68)   24
Fair value adjustments on insurance derivative  (70)   (301)   1   (205)
S&P put options and futures  3   143   (68)   84
Other derivative instruments  (2)   4   (3)   (5)
Other  (1)   1   (2)   5
Net realized gains (losses) $ (73) $ 9 $ (118) $ 177

The following table presents a roll forward of pre-tax credit losses related to fixed maturities for which a portion of OTTI was recognized in OCI:

 

 Three Months Ended Six Months Ended
 June 30 June 30
 2011 2010 2011 2010
            
  (in millions of U.S. dollars)
Balance of credit losses related to securities still held- beginning of period$ 96 $ 163 $ 137 $ 174
Additions where no OTTI was previously recorded  2   5   2   22
Additions where an OTTI was previously recorded  -   -   1   1
Reductions for securities sold during the period  (4)   (31)   (46)   (60)
Balance of credit losses related to securities still held- end of period$ 94 $ 137 $ 94 $ 137

d) Gross unrealized loss

 

At June 30, 2011, there were 4,348 fixed maturities out of a total of 21,493 fixed maturities in an unrealized loss position. The largest single unrealized loss in the fixed maturities was $8 million. Fixed maturities in an unrealized loss position at June 30, 2011, comprised both investment grade and below investment grade securities for which fair value declined primarily due to widening credit spreads since the date of purchase.

 

The following tables present, for all securities in an unrealized loss position (including securities on loan), the aggregate fair value and gross unrealized loss by length of time the security has continuously been in an unrealized loss position:

 0 – 12 Months Over 12 Months Total
 Fair Value Gross Unrealized Loss Fair Value Gross Unrealized Loss Fair Value Gross Unrealized Loss
                  
June 30, 2011(in millions of U.S. dollars)
U.S. Treasury and agency$ 551 $ (13.3) $ - $ - $ 551 $ (13.3)
Foreign  3,136   (60.7)   264   (14.1)   3,400   (74.8)
Corporate securities  3,709   (73.2)   152   (23.9)   3,861   (97.1)
Mortgage-backed securities  2,638   (35.1)   825   (155.4)   3,463   (190.5)
States, municipalities, and political subdivisions  663   (10.8)   62   (4.6)   725   (15.4)
Total fixed maturities  10,697   (193.1)   1,303   (198.0)   12,000   (391.1)
Equity securities  44   (3.3)   1   (0.4)   45   (3.7)
Other investments  19   (1.0)   -   -   19   (1.0)
Total $ 10,760 $ (197.4) $ 1,304 $ (198.4) $ 12,064 $ (395.8)

 0 – 12 Months Over 12 Months Total
 Fair Value Gross Unrealized Loss Fair Value Gross Unrealized Loss Fair Value Gross Unrealized Loss
                  
December 31, 2010(in millions of U.S. dollars)
U.S. Treasury and agency$ 864 $(24.6) $ - $ - $ 864 $(24.6)
Foreign  4,409  (79.0)   312   (37.6)   4,721  (116.6)
Corporate securities  3,553  (85.1)   273   (43.9)   3,826  (129.0)
Mortgage-backed securities  3,904  (67.3)   1,031   (165.1)   4,935  (232.4)
States, municipalities, and political subdivisions  1,115  (36.2)   79   (11.9)   1,194  (48.1)
Total fixed maturities  13,845  (292.2)   1,695   (258.5)   15,540  (550.7)
Equity securities  45  (1.9)   1   (0.3)   46  (2.2)
Other investments  66  (8.7)   -   -   66  (8.7)
Total $ 13,956 $(302.8) $ 1,696 $ (258.8) $ 15,652 $(561.6)

e) Restricted assets

 

ACE is required to maintain assets on deposit with various regulatory authorities to support its insurance and reinsurance operations. These requirements are generally promulgated in the statutory regulations of the individual jurisdictions. The assets on deposit are available to settle insurance and reinsurance liabilities. We also use trust funds in certain large reinsurance transactions where the trust funds are set up for the benefit of the ceding companies and generally take the place of letter of credit (LOC) requirements. We also have investments in segregated portfolios primarily to provide collateral or guarantees for LOCs and derivative transactions. Included in restricted assets at June 30, 2011 and December 31, 2010, are fixed maturities and short-term investments totaling $12.8 billion and $12.0 billion, respectively, and cash of $97 million and $104 million, respectively.

 

The following table presents the components of restricted assets:

     June 30  December 31
     2011  2010
    (in millions of U.S. dollars)
Trust funds   $ 9,143 $ 8,200
Deposits with U.S. regulatory authorities     1,254   1,384
Deposits with non-U.S. regulatory authorities     2,264   2,289
Other pledged assets     273   190
    $ 12,934 $ 12,063
Fair value measurements
Fair value measurements

5. Fair value measurements

 

a)       Fair value hierarchy

 

Fair value of financial assets and financial liabilities is estimated based on the framework established in the fair value accounting guidance. The guidance defines fair value as the price to sell an asset or transfer a liability in an orderly transaction between market participants and establishes a three-level valuation hierarchy in which inputs into valuation techniques used to measure fair value are classified. The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. The three levels of the hierarchy are as follows:

 

  • Level 1 – Unadjusted quoted prices for identical assets or liabilities in active markets;
  • Level 2 – Includes, among other items, inputs other than quoted prices that are observable for the asset or liability such as interest rates and yield curves, quoted prices for similar assets and liabilities in active markets, and quoted prices for identical or similar assets and liabilities in markets that are not active; and
  • Level 3 – Inputs that are unobservable and reflect management's judgments about assumptions that market participants would use in pricing an asset or liability.

 

We categorize financial instruments within the valuation hierarchy at the balance sheet date based upon the lowest level of inputs that are significant to the fair value measurement. Accordingly, transfers between levels within the valuation hierarchy occur when there are significant changes to the inputs, such as increases or decreases in market activity, changes to the availability of current prices, changes to the transparency to underlying inputs, and whether there are significant variances in quoted prices. Transfers in and/or out of any level are assumed to occur at the end of the period.

 

We use one or more pricing services to obtain fair value measurements for the majority of the investment securities we hold. Based on management's understanding of the methodologies used by these pricing services, all applicable investments have been valued in accordance with GAAP. The following is a description of the valuation techniques and inputs used to determine fair value for financial instruments carried at fair value, as well as the general classification of such financial instruments pursuant to the valuation hierarchy.

 

Fixed maturities

We use pricing services to estimate fair value measurements for the majority of our fixed maturities. The pricing services use market quotations for fixed maturities that have quoted prices in active markets; such securities are classified within Level 1. For fixed maturities other than U.S. Treasury securities that generally do not trade on a daily basis, the pricing services prepare estimates of fair value measurements using their pricing applications, which include available relevant market information, benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing. Additional valuation factors that may be taken into account are nominal spreads, dollar basis, and liquidity adjustments. The pricing services evaluate each asset class based on relevant market and credit information, perceived market movements, and sector news. The market inputs used in the pricing evaluation, listed in the approximate order of priority include: benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, reference data, and industry and economic events. The extent of the use of each input is dependent on the asset class and the market conditions. Additionally, given the asset class, the priority of the use of inputs may change or some market inputs may not be relevant. The overwhelming majority of fixed maturities are classified within Level 2 because the most significant inputs used in the pricing techniques are observable. Fixed maturities for which pricing is unobservable are classified within Level 3.

 

Equity securities

Equity securities with active markets are classified within Level 1 as fair values are based on quoted market prices. For non-public equity securities, fair values are based on market valuations and are classified within Level 2. Equity securities for which pricing is unobservable are classified within Level 3.

 

Short-term investments

Short-term investments, which comprise securities due to mature within one year of the date of purchase that are traded in active markets, are classified within Level 1 as fair values are based on quoted market prices. Securities such as commercial paper and discount notes are classified within Level 2 because these securities are typically not actively traded due to their approaching maturity and, as such, their cost approximates par value.

 

Other investments

Fair values for the majority of Other investments including investments in partially-owned investment companies, investment funds, and limited partnerships are based on their respective net asset values or equivalent (NAV). The majority of these investments, for which NAV was used as a practical expedient to measure fair value, are classified within Level 3 because either ACE will never have the contractual option to redeem the investment or will not have the contractual option to redeem the investments in the near term. The remainder of such investments are classified within Level 2. Equity securities and fixed maturities held in rabbi trusts maintained by ACE for deferred compensation plans as well as other portfolios, and included in Other investments, are classified within the valuation hierarchy on the same basis as other equity securities and fixed maturities.

 

Securities lending collateral

The underlying assets included in Securities lending collateral are fixed maturities which are classified in the valuation hierarchy on the same basis as other fixed maturities. Excluded from the valuation hierarchy is the corresponding liability related to ACE's obligation to return the collateral plus interest.

 

Investment derivative instruments

Actively traded investment derivative instruments, including futures, options, and exchange-traded forward contracts are classified within Level 1 as fair values are based on quoted market prices.

 

Guaranteed living benefits

The liability for Guaranteed Living Benefits (GLB) arises from life reinsurance programs covering living benefit guarantees whereby we assume the risk of Guaranteed Minimum Income Benefits (GMIB) and Guaranteed Minimum Accumulation Benefits (GMAB) associated with variable annuity contracts. For GLB reinsurance, ACE estimates fair value using an internal valuation model which includes current market information and estimates of policyholder behavior. All of the treaties contain claim limits, which are factored into the valuation model. The fair value depends on a number of inputs, including changes in interest rates, changes in equity markets, credit risk, current account value, changes in market volatility, expected annuitization rates, changes in policyholder behavior, and changes in policyholder mortality. 

 

The most significant policyholder behavior assumptions include lapse rates and the GMIB annuitization rates. Assumptions regarding lapse rates and GMIB annuitization rates differ by treaty but the underlying methodologies to determine rates applied to each treaty are comparable. The assumptions regarding lapse and GMIB annuitization rates determined for each treaty are based on a dynamic calculation that uses several underlying factors.

 

A lapse rate is the percentage of in-force policies surrendered in a given calendar year. All else equal, as lapse rates increase, ultimate claim payments will decrease. In general, the base lapse function assumes low lapse rates (ranging from about 1 percent to 6 percent per annum) during the surrender charge period of the GMIB contract, followed by a “spike” lapse rate (ranging from about 10 percent to 30 percent per annum) in the year immediately following the surrender charge period, and then reverting to an ultimate lapse rate (generally around 10 percent per annum), typically over a 2-year period.  This base rate is adjusted downward for policies with more valuable guarantees (policies with guaranteed values far in excess of their account values) by multiplying the base lapse rate by a factor ranging from 15 percent to 75 percent.  Additional lapses due to partial withdrawals and older policyholders with tax-qualified contracts (due to required minimum distributions) are also included.

 

The GMIB annuitization rate is the percentage of policies for which the policyholder will elect to annuitize using the guaranteed benefit provided under the GMIB. All else equal, as GMIB annuitization rates increase, ultimate claim payments will increase, subject to treaty claim limits. In general ACE assumes that GMIB annuitization rates will be higher for policies with more valuable guarantees (policies with guaranteed values far in excess of their account values). In addition, we also assume that GMIB annuitization rates are higher in the first year immediately following the waiting period (the first year the policies are eligible to annuitize using the GMIB) in comparison to all subsequent years. We do not yet have a robust set of annuitization experience because most of our clients' policyholders are not yet eligible to annuitize using the GMIB.  However, for certain clients there are several years of annuitization experience. For these clients the annuitization function reflects the actual experience and has a maximum annuitization rate per annum of 8 percent (a higher maximum applies in the first year a policy is eligible to annuitize using the GMIB - it is over 13 percent).  For most clients, there is no currently observable relevant annuitization behavior data and so we use a weighted-average (with a heavier weighting on the observed experience noted previously) of three different annuitization functions with maximum annuitization rates per annum of 8 percent, 12 percent, and 30 percent, respectively (with significantly higher rates in the first year a policy is eligible to annuitize using the GMIB). The GMIB reinsurance treaties include claim limits to protect ACE in the event that actual annuitization behavior is significantly higher than expected.

 

The effect of changes in key market factors on assumed lapse and annuitization rates reflect emerging trends using data available from cedants. For treaties with limited experience, rates are established in line with data received from other ceding companies adjusted as appropriate with industry estimates. The model and related assumptions are continuously re-evaluated by management and enhanced, as appropriate, based upon additional experience obtained related to policyholder behavior and availability of more information, such as market conditions, market participant assumptions, and demographics of in-force annuities. Based on our first and second quarter 2011 review, no changes were made to actuarial or behavior assumptions. We made minor technical refinements to the model with a favorable net income impact of approximately $0.3 million and $6.3 million for the three and six months ended June 30, 2011, respectively.

 

We view the variable annuity reinsurance business as having a similar risk profile to that of catastrophe reinsurance, with the probability of a cumulative long-term economic net loss relatively small at the time of pricing. However, adverse changes in market factors and policyholder behavior will have an adverse impact on net income, which may be material. Because of the significant use of unobservable inputs including policyholder behavior, GLB reinsurance is classified within Level 3.

 

Other derivative instruments

We maintain positions in other derivative instruments including exchange-traded equity futures contracts and option contracts designed to limit exposure to a severe equity market decline, which would cause an increase in expected claims and, therefore, reserves for Guaranteed Minimum Death Benefits (GMDB) and GLB reinsurance business. Our position in exchange-traded equity futures contracts is classified within Level 1. The fair value of the majority of the remaining positions in other derivative instruments is based on significant observable inputs including equity security and interest rate indices. Accordingly, these are classified within Level 2. Our position in credit default swaps is typically included within Level 3.

The following tables present, by valuation hierarchy, the financial instruments measured at fair value on a recurring basis:

 Level 1 Level 2 Level 3 Total
            
 (in millions of U.S. dollars)
June 30, 2011           
Assets:           
Fixed maturities available for sale           
U.S. Treasury and agency$ 1,245 $ 1,250 $ - $ 2,495
Foreign  207   12,445   27   12,679
Corporate securities  43   14,328   142   14,513
Mortgage-backed securities  -   9,977   34   10,011
States, municipalities, and political subdivisions  -   1,339   1   1,340
   1,495   39,339   204   41,038
            
Equity securities  567   5   10   582
Short-term investments  1,266   1,114   -   2,380
Other investments  239   237   1,680   2,156
Securities lending collateral  -   1,593   -   1,593
Investment derivative instruments  3   -   -   3
Other derivative instruments  (37)   41   4   8
Total assets measured at fair value$ 3,533 $ 42,329 $ 1,898 $ 47,760
            
Liabilities:           
GLB(1)$ - $ - $ 524 $ 524
            
(1)Our GLB reinsurance product meets the definition of a derivative instrument for accounting purposes and is accordingly carried at fair value. Excluded from the table above is the portion of the GLB derivative liability classified as future policy benefits in the consolidated balance sheets. Refer to Note 6 for additional information.

 Level 1 Level 2 Level 3 Total
            
 (in millions of U.S. dollars)
December 31, 2010           
Assets:           
Fixed maturities available for sale           
U.S. Treasury and agency$ 1,564 $ 1,399 $ - $ 2,963
Foreign  187   10,973   26   11,186
Corporate securities  31   13,441   115   13,587
Mortgage-backed securities  -   8,477   39   8,516
States, municipalities, and political subdivisions  -   1,285   2   1,287
   1,782   35,575   182   37,539
            
Equity securities  676   3   13   692
Short-term investments  903   1,080   -   1,983
Other investments  39   221   1,432   1,692
Securities lending collateral  -   1,495   -   1,495
Investment derivative instruments  11   -   -   11
Other derivative instruments  (25)   46   4   25
Total assets measured at fair value$ 3,386 $ 38,420 $ 1,631 $ 43,437
            
Liabilities:           
GLB(1)$ - $ - $ 507 $ 507
            
(1)Our GLB reinsurance product meets the definition of a derivative instrument for accounting purposes and is accordingly carried at fair value. Excluded from the table above is the portion of the GLB derivative liability classified as future policy benefits in the consolidated balance sheets. Refer to Note 6 for additional information.

There were no significant gross transfers between Level 1 and Level 2 during the three and six months ended June 30, 2011 and 2010.

Fair value of alternative investments

 

Included in Other investments in the fair value hierarchy at June 30, 2011 and December 31, 2010 are investment funds, limited partnerships, and partially-owned investment companies measured at fair value using NAV as a practical expedient. At June 30, 2011 and December 31, 2010, there were no probable or pending sales related to any of the investments measured at fair value using NAV.

 

The following table presents, by investment category, the fair value and maximum future funding commitments related to these investments. The table also shows the expected liquidation period from June 30, 2011.

    June 30, 2011 December 31, 2010
  Expected Liquidation Period Fair Value Maximum Future Funding Commitments Fair Value Maximum Future Funding Commitments
        
               
    (in millions of U.S. dollars)
               
Financial 5 to 9 Years $ 207 $ 163 $ 192 $ 151
Real estate 3 to 9 Years   261   89   168   92
Distressed 6 to 9 Years   221   219   243   43
Mezzanine 6 to 9 Years   126   299   135   173
Traditional  3 to 8 Years   457   410   376   291
Vintage 1 to 3 Years   27   6   27   3
Investment funds Not Applicable   338   -   329   -
    $ 1,637 $ 1,186 $ 1,470 $ 753
               

Included in all categories in the above table except for Investment funds are investments for which ACE will never have the contractual option to redeem but receives distributions based on the liquidation of the underlying assets. Included in the “Expected Liquidation Period” column above is the range in years over which ACE expects the majority of underlying assets in the respective categories to be liquidated. Further, for all categories except for Investment funds, ACE does not have the ability to sell or transfer the investments without the consent from the general partner of individual funds.

 

Financial

Financial consists of investments in private equity funds targeting financial services companies such as financial institutions and insurance services around the world.

 

Real estate

Real estate consists of investments in private equity funds targeting global distress opportunities, value added U.S. properties, and global mezzanine debt securities in the commercial real estate market.

 

Distressed

Distressed consists of investments in private equity funds targeting distressed debt/credit and equity opportunities in the U.S.

 

Mezzanine

Mezzanine consists of investments in private equity funds targeting private mezzanine debt of large-cap and mid-cap companies in the U.S. and worldwide.

 

Traditional

Traditional consists of investments in private equity funds employing traditional private equity investment strategies such as buyout and venture with different geographical focuses including Brazil, Asia, Europe, and the U.S.

 

Vintage

Vintage consists of investments in private equity funds made before 2002 and where the funds' commitment periods had already expired.

 

Investment funds

ACE's investment funds employ various investment strategies such as long/short equity and arbitrage/distressed.  Included in this category are investments for which ACE has the option to redeem at agreed upon value as described in each investment fund's subscription agreement. Depending on the terms of the various subscription agreements, investment fund investments may be redeemed monthly, quarterly, semi-annually, or annually. If ACE wishes to redeem an investment fund investment, it must first determine if the investment fund is still in a lock-up period (a time when ACE cannot redeem its investment so that the investment fund manager has time to build the portfolio).  If the investment fund is no longer in its lock-up period, ACE must then notify the investment fund manager of its intention to redeem by the notification date prescribed by the subscription agreement.  Subsequent to notification, the investment fund can redeem ACE's investment within several months of the notification. Notice periods for redemption of the investment funds range between 5 and 120 days. ACE can redeem its investment funds without consent from the investment fund managers.

Level 3 financial instruments

 

The following tables present a reconciliation of the beginning and ending balances of financial instruments measured at fair value using significant unobservable inputs (Level 3):

  Three Months Ended June 30, 2011
 Assets Liabilities
  Available-for-Sale Debt Securities     
  Foreign Corporate securities Mortgage-backed securities States, municipalities, and political subdivisions Equity securities Other investments Other derivative instruments  GLB(1)
  (in millions of U.S. dollars)
Balance- Beginning of Period$ 26$ 113$ 81$ 1$ 10$ 1,564$ 4 $ 449
Transfers into Level 3  5  29  3  -  -  -  -   -
Transfers out of Level 3  (6)  -  (35)  -  -  -  -   -
Change in Net Unrealized Gains (Losses) included in OCI  -  -  -  -  -  9  -   -
Net Realized Gains/Losses   1  (1)  -  -  2  (3)  -   75
Purchases  5  3  -  -  2  243  -   -
Issuances  -  -  -  -  -  -  -   -
Sales  (2)  (1)  (12)  -  (4)  (55)  -   -
Settlements  (2)  (1)  (3)  -  -  (78)  -   -
Balance-End of Period$ 27$ 142$ 34$ 1$ 10$ 1,680$ 4 $ 524
                  
Net Realized Gains/Losses Attributable to Changes in Fair Value at the Balance Sheet Date$ -$ -$ -$ -$ -$ (3)$ - $ 75
(1)Our GLB reinsurance product meets the definition of a derivative instrument for accounting purposes and is accordingly carried at fair value. Excluded from the table above is the portion of the GLB derivative liability classified as future policy benefits in the consolidated balance sheets. Refer to Note 6 for additional information.
                  
  Three Months Ended June 30, 2010
 Assets Liabilities
  Available-for-Sale Debt Securities     
  Foreign Corporate securities Mortgage-backed securities States, municipalities, and political subdivisions Equity securities Other investments Other derivative instruments  GLB(1)
  (in millions of U.S. dollars)
Balance-Beginning of Period$ 21$ 133$ 12$ 2$ 13$ 1,236$ 14 $ 347
Transfers into (Out of) Level 3  6  -  -  -  -  -  -   -
Change in Net Unrealized Gains (Losses) included in OCI  1  3  -  -  (1)  14  -   -
Net Realized Gains/Losses   -  (1)  -  -  1  (14)  12   301
Purchases, Sales, Issuances, and Settlements, Net  -  (14)  -  1  3  (9)  (12)   
Balance- End of Period$ 28$ 121$ 12$ 3$ 16$ 1,227$ 14 $ 648
                  
Net Realized Gains/Losses Attributable to Changes in Fair Value at the Balance Sheet Date$ -$ -$ -$ -$ -$ (14)$ 12 $ 301
(1)Our GLB reinsurance product meets the definition of a derivative instrument for accounting purposes and is accordingly carried at fair value. Excluded from the table above is the portion of the GLB derivative liability classified as future policy benefits in the consolidated balance sheets. The liability for GLB reinsurance was $776 million at June 30, 2010, and $469 million at March 31, 2010, which includes a fair value derivative adjustment of $648 million and $347 million, respectively.

  Six Months Ended June 30, 2011
 Assets Liabilities
  Available-for-Sale Debt Securities     
  Foreign Corporate securities Mortgage-backed securities States, municipalities, and political subdivisions Equity securities Other investments Other derivative instruments  GLB(1)
  (in millions of U.S. dollars)
Balance-Beginning of Period$ 26$ 115$ 39$ 2$ 13$ 1,432$ 4   507
Transfers into Level 3  9  34  4  -  -  -  -   -
Transfers out of Level 3  (7)  (4)  (35)  -  -  -  -   -
Change in Net Unrealized Gains (Losses) included in OCI  (1)  1  -  -  (1)  51  -   -
Net Realized Gains/Losses   1  (2)  -  -  4  (3)  1   17
Purchases  5  22  46  -  2  333  -   -
Sales  (3)  (20)  (15)  -  (8)  (55)  -   -
Settlements  (3)  (4)  (5)  (1)  -  (78)  (1)   -
Balance-End of Period$ 27$ 142$ 34$ 1$ 10$ 1,680$ 4 $ 524
                  
Net Realized Gains/Losses Attributable to Changes in Fair Value at the Balance Sheet Date$ -$ -$ -$ -$ -$ (3)$ 1 $ 17
(1)Our GLB reinsurance product meets the definition of a derivative instrument for accounting purposes and is accordingly carried at fair value. Excluded from the table above is the portion of the GLB derivative liability classified as future policy benefits in the consolidated balance sheets. Refer to Note 6 for additional information.
                  
  Six Months Ended June 30, 2010
 Assets Liabilities
  Available-for-Sale Debt Securities     
  Foreign Corporate securities Mortgage-backed securities States, municipalities, and political subdivisions Equity securities Other investments Other derivative instruments  GLB(1)
  (in millions of U.S. dollars)
Balance- Beginning of Period$ 59$ 168$ 21$ 3$ 12$ 1,149$ 14 $ 443
Transfers into (Out of) Level 3  (31)  (35)  -  -  -  -  -   -
Change in Net Unrealized Gains (Losses) included in OCI  1  6  -  -  -  33  -   -
Net Realized Gains/Losses   (1)  (1)  -  -  1  (13)  12   205
Purchases, Sales, Issuances, and Settlements, Net  -  (17)  (9)  -  3  58  (12)   
Balance- End of Period$ 28$ 121$ 12$ 3$ 16$ 1,227$ 14 $ 648
                  
Net Realized Gains/Losses Attributable to Changes in Fair Value at the Balance Sheet Date$ -$ -$ -$ -$ -$ (13)$ 12 $ 205
(1)Our GLB reinsurance product meets the definition of a derivative instrument for accounting purposes and is accordingly carried at fair value. Excluded from the table above is the portion of the GLB derivative liability classified as future policy benefits. The liability for GLB reinsurance was $776 million at June 30, 2010, and $559 million at December 31, 2009, which includes a fair value derivative adjustment of $648 million and $443 million, respectively.

b) Financial instruments disclosed, but not carried, at fair value

 

ACE uses various financial instruments in the normal course of its business. Our insurance contracts are excluded from fair value of financial instruments accounting guidance, and therefore excluded from the discussion below.

 

The carrying values of cash, other assets, other liabilities, and other financial instruments not included below approximated their fair values.

 

Investments in partially-owned insurance companies

Fair values for investments in partially-owned insurance companies are based on ACE's share of the net assets based on the financial statements provided by those companies.

 

Short- and long-term debt and trust preferred securities

Where practical, fair values for short-term debt, long-term debt, and trust preferred securities are estimated using discounted cash flow calculations based principally on observable inputs including incremental borrowing rates, which reflect ACE's credit rating, for similar types of borrowings with maturities consistent with those remaining for the debt being valued.

 

The following table presents carrying values and fair values of financial instruments not measured at fair value:

   June 30, 2011 December 31, 2010
   Carrying Value Fair Value Carrying Value Fair Value
   (in millions of U.S. dollars)
Assets:        
Fixed maturities held to maturity        
U.S. Treasury and agency$ 1,067$ 1,092$ 1,105$ 1,127
Foreign  1,051  1,028  1,049  1,013
Corporate securities  2,311  2,292  2,361  2,313
Mortgage-backed securities  3,414  3,472  3,811  3,846
States, municipalities, and political subdivisions  1,190  1,194  1,175  1,162
 Total assets  9,033  9,078  9,501  9,461
Liabilities:        
Short-term debt  1,400  1,400  1,300  1,300
Long-term debt  3,360  3,719  3,358  3,846
Trust preferred securities  309  385  309  376
 Total liabilities$ 5,069$ 5,504$ 4,967$ 5,522
Assumed life reinsurance programs involving minimum benefits guarantees under annuity contracts
Reinsurance

6. Assumed life reinsurance programs involving minimum benefit guarantees under annuity contracts

 

The following table presents income and expenses relating to GMDB and GLB reinsurance. GLBs include GMIBs as well as some GMABs originating in Japan.

 Three Months Ended Six Months Ended
 June 30 June 30
 2011 2010 2011 2010
            
 (in millions of U.S. dollars)
GMDB           
Net premiums earned$ 25 $ 27 $ 51 $ 56
Policy benefits and other reserve adjustments$ 21 $ 22 $ 43 $ 46
GLB           
Net premiums earned$ 41 $ 40 $ 82 $ 81
Policy benefits and other reserve adjustments  6   6   12   13
Net realized gains (losses)  (75)   (301)   (17)   (205)
Gain (loss) recognized in income$ (40) $ (267) $ 53 $ (137)
            
Net cash received$ 40 $ 40 $ 81 $ 80
Net increase in liability$ (80) $ (307) $ (28) $ (217)

At June 30, 2011, reported liabilities for GMDB and GLB reinsurance were $181 million and $676 million, respectively, compared with $185 million and $648 million, respectively, at December 31, 2010. The reported liability for GLB reinsurance of $676 million at June 30, 2011, and $648 million at December 31, 2010, includes a fair value derivative adjustment of $524 million and $507 million, respectively. Included in Net realized gains (losses) in the table above are gains (losses) related to foreign exchange and other fair value derivative adjustments. Reported liabilities for both GMDB and GLB reinsurance are determined using internal valuation models. Such valuations require considerable judgment and are subject to significant uncertainty. The valuation of these products is subject to fluctuations arising from, among other factors, changes in interest rates, changes in equity markets, changes in credit markets, changes in the allocation of the investments underlying annuitant's account values, and assumptions regarding future policyholder behavior. These models and the related assumptions are continually reviewed by management and enhanced, as appropriate, based upon improvements in modeling assumptions and availability of more information, such as market conditions and demographics of in-force annuities.

 

a) GMDB reinsurance

At June 30, 2011 and December 31, 2010, the net amount at risk from GMDB reinsurance programs was $3.1 billion and $2.9 billion, respectively.  For GMDB reinsurance programs, the net amount at risk is defined as the present value of future claim payments under the following assumptions:

 

  • policy account values and guaranteed values are fixed at the valuation date (June 30, 2011 and December 31, 2010, respectively);

  • there are no lapses or withdrawals;

  • mortality according to 100 percent of the Annuity 2000 mortality table; and

  • future claims are discounted in line with the discounting assumption used in the calculation of the benefit reserve averaging between 1 and 2 percent.

 

At June 30, 2011, if all of the cedants' policyholders covered under GMDB reinsurance agreements were to die immediately, the total claim amount payable, taking into account all appropriate claims limits, would be approximately $1.5 billion. As a result of the annual claim limits on the GMDB reinsurance agreements, the claims payable are lower in this case than if all the policyholders were to die over time, all else equal.

 

b) GLB reinsurance

At June 30, 2011 and December 31, 2010, the net amount at risk from GLB reinsurance programs was $789 million and $719 million, respectively. For GLB reinsurance programs, the net amount at risk is defined as the present value of future claim payments under the following assumptions:

 

  • policy account values and guaranteed values are fixed at the valuation date (June 30, 2011 and December 31, 2010, respectively);

  • there are no deaths, lapses, or withdrawals;

  • policyholders annuitize at a frequency most disadvantageous to ACE (in other words, annuitization at a level that maximizes claims taking into account the treaty limits) under the terms of the reinsurance contracts;

  • for annuitizing policyholders, the GMIB claim is calculated using interest rates in line with those used in calculating the reserve; and

  • future claims are discounted in line with the discounting assumption used in the calculation of the benefit reserve averaging between 0 and 1 percent.

 

The average attained age of all policyholders under all benefits reinsured, weighted by the guaranteed value of each reinsured policy, is approximately 67 years.

Commitments, contingencies, and guarantees
Commitments, contingencies, and guarantees

7. Commitments, contingencies, and guarantees

 

a) Derivative instruments

 

Derivative instruments employed

 

ACE maintains positions in derivative instruments such as futures, options, swaps, and foreign currency forward contracts for which the primary purposes are to manage duration and foreign currency exposure, yield enhancement, or to obtain an exposure to a particular financial market. Along with convertible bonds and to be announced mortgage-backed securities (TBA), discussed below, these are the most numerous and frequent derivative transactions.

 

ACE maintains positions in convertible bond investments that contain embedded derivatives. In addition, we purchase TBAs as part of our investing activities. These securities are included within the fixed maturities available for sale (FM AFS) portfolio.

 

Under reinsurance programs covering GLBs, ACE assumes the risk of GLBs, including GMIB and GMAB, associated with variable annuity contracts. The GMIB risk is triggered if, at the time the contract holder elects to convert the accumulated account value to a periodic payment stream (annuitize), the accumulated account value is not sufficient to provide a guaranteed minimum level of monthly income. The GMAB risk is triggered if, at contract maturity, the contract holder's account value is less than a guaranteed minimum value. The GLB reinsurance product meets the definition of a derivative instrument. Benefit reserves in respect of GLBs are classified as Future policy benefits (FPB) while the fair value derivative adjustment is classified within Accounts payable, accrued expenses, and other liabilities (AP). ACE also maintains positions in exchange-traded equity futures contracts and options on equity market indices to limit equity exposure in the GMDB and GLB blocks of business.

 

In relation to certain debt issuances, ACE, from time to time, has entered into interest rate swap transactions for the purpose of either fixing or reducing borrowing costs. Although the use of these interest rate swaps has the economic effect of fixing or reducing borrowing costs on a net basis, gross interest expense on the related debt issuances is included in Interest expense while the settlements related to the interest rate swaps are reflected in Net realized gains (losses) in the consolidated statements of operations. At June 30, 2011 and December 31, 2010, ACE had no in force interest rate swaps, having exited such positions upon the repayment of related debt issuances during the fourth quarter of 2010.

 

ACE buys credit default swaps to mitigate global credit risk exposure, primarily related to reinsurance recoverables.

 

All derivative instruments are carried at fair value with changes in fair value recorded in Net realized gains (losses) in the consolidated statements of operations. None of the derivative instruments are designated as hedges for accounting purposes.

 

The following table presents the balance sheet locations, fair values in an asset or (liability) position, and notional values/payment provisions of our derivative instruments:

 

  June 30, 2011 December 31, 2010
 Consolidated Balance Sheet Location Fair Value Notional Value/ Payment Provision  Fair Value Notional Value/ Payment Provision
           
  (in millions of U.S. dollars)
Investment and embedded derivative instruments          
Foreign currency forward contractsAP$ 1$ 753 $ 3$ 729
Futures contracts on money market instrumentsAP  2  10,098   3  4,297
Futures contracts on notes and bondsAP  -  1,158   5  676
Options on money market instrumentsAP  -  528   -  1
Convertible bondsFM AFS  398  367   416  382
TBAsFM AFS  123  117   101  98
  $ 524$ 13,021 $ 528$ 6,183
Other derivative instruments          
Futures contracts on equitiesAP$ (37)$ 1,110 $ (25)$ 1,069
Options on equity market indicesAP  41  250   46  250
Credit default swapsAP  4  350   4  350
OtherAP  -  6   -  17
  $ 8$ 1,716 $ 25$ 1,686
           
GLB(1)AP/FPB$ (676)$ 789 $ (648)$ 719

(1) Includes both future policy benefits reserves and fair value derivative adjustment. Refer to Note 6 for additional information. Note that the payment provision related to GLB is the net amount at risk. The concept of a notional value does not apply to the GLB reinsurance contracts.

 

The following table presents net realized gains (losses) related to derivative instrument activity in the consolidated statement of operations:

 

    Three Months Ended Six Months Ended
    June 30 June 30
    2011 2010 2011 2010
               
    (in millions of U.S. dollars)
Investment and embedded derivative instruments            
Foreign currency forward contracts   $ (3) $ 23 $ (18) $ 36
All other futures contracts and options     (24)   2   (27)   10
Convertible bonds     (21)   (20)   (22)   (22)
TBAs     -   -   (1)   -
    $ (48) $ 5 $ (68) $ 24
GLB and other derivative instruments            
GLB   $ (75) $ (301) $ (17) $ (205)
Futures contracts on equities     -   117   (63)   66
Options on equity market indices     3   26   (5)   18
Interest rate swaps     -   (8)   -   (17)
Credit default swaps     (2)   11   (3)   11
Other     -   1   -   1
    $ (74) $ (154) $ (88) $ (126)
    $ (122) $ (149) $ (156) $ (102)

Derivative instrument objectives

 

(i) Foreign currency exposure management

 

A foreign currency forward contract (forward) is an agreement between participants to exchange specific foreign currencies at a future date. ACE uses forwards to minimize the effect of fluctuating foreign currencies.

 

(ii) Duration management and market exposure

 

Futures

 

Futures contracts give the holder the right and obligation to participate in market movements, determined by the index or underlying security on which the futures contract is based. Settlement is made daily in cash by an amount equal to the change in value of the futures contract times a multiplier that scales the size of the contract. Exchange-traded bond and note futures contracts are used in fixed maturity portfolios as substitutes for ownership of the bonds and notes without significantly increasing the risk in the portfolio. Investments in futures contracts may be made only to the extent that there are assets under management not otherwise committed. Exchange-traded equity futures contracts are used to limit exposure to a severe equity market decline, which would cause an increase in expected claims and therefore, reserves for GMDB and GLB reinsurance business.

 

Options

 

An option contract conveys to the holder the right, but not the obligation, to purchase or sell a specified amount or value of an underlying security at a fixed price. Option contracts are used in the investment portfolio as protection against unexpected shifts in interest rates, which would affect the duration of the fixed maturity portfolio. By using options in the portfolio, the overall interest rate sensitivity of the portfolio can be reduced. Option contracts may also be used as an alternative to futures contracts in the synthetic strategy as described above. Another use for option contracts is to limit exposure to a severe equity market decline, which would cause an increase in expected claims and therefore, reserves for GMDB and GLB reinsurance business. The price of an option is influenced by the underlying security, expected volatility, time to expiration, and supply and demand.

 

The credit risk associated with the above derivative financial instruments relates to the potential for non-performance by counterparties. Although non-performance is not anticipated, in order to minimize the risk of loss, management monitors the creditworthiness of its counterparties and obtains collateral. The performance of exchange-traded instruments is guaranteed by the exchange on which they trade. For non-exchange-traded instruments, the counterparties are principally banks which must meet certain criteria according to our investment guidelines.

 

Interest rate swaps

 

An interest rate swap is a contract between two counterparties in which interest payments are made based on a notional principal amount, which itself is never paid or received. Under the terms of an interest rate swap, one counterparty makes interest payments based on a fixed interest rate and the other counterparty's payments are based on a floating rate. Interest rate swap contracts are used occasionally in the investment portfolio as protection against unexpected shifts in interest rates, which would affect the fair value of the fixed maturity portfolio. By using interest rate swaps in the portfolio, the overall duration or interest rate sensitivity of the portfolio can be reduced. Interest rate swaps are also employed related to certain debt issuances for the purpose of either fixing and/or reducing borrowing costs.

 

Credit default swaps

 

A credit default swap is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. Under a credit default swap agreement, a protection buyer pays a periodic fee to a protection seller in exchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay) related to the reference entity. When a credit event is triggered, the protection seller pays the protection buyer the difference between the fair value of assets and the principal amount. We have purchased a credit default swap to mitigate our global credit risk exposure to one of our reinsurers.

 

(iii) Convertible security investments

 

A convertible bond is a debt instrument that can be converted into a predetermined amount of the issuer's equity at certain times prior to the bond's maturity. The convertible option is an embedded derivative within the fixed maturity host instruments which are classified in the investment portfolio as available for sale. ACE purchases convertible bonds for their total return and not specifically for the conversion feature.

 

(iv) TBA

 

By acquiring a TBA, a commitment is made to purchase a future issuance of mortgage-backed securities. For the period between purchase of the TBA and issuance of the underlying security, the position is accounted for as a derivative in the consolidated financial statements. ACE purchases TBAs both for their total return and for the flexibility they provide related to our mortgage-backed security strategy.

 

(v) GLB

 

Under the GLB program, as the assuming entity, ACE is obligated to provide coverage until the expiration or maturity of the underlying annuities. Premiums received under the reinsurance treaties are classified as premium. Expected losses allocated to premiums received are classified as future policy benefits and valued similar to GMDB reinsurance. Other changes in fair value, principally arising from changes in expected losses allocated to expected future premiums, are classified as Net realized gains (losses). Fair value represents management's estimate of exit price and thus, includes a risk margin. We may recognize a realized loss for other changes in fair value due to adverse changes in the capital markets (e.g., declining interest rates and/or declining equity markets) and changes in actual or estimated future policyholder behavior (e.g., increased annuitization or decreased lapse rates) although we expect the business to be profitable. We believe this presentation provides the most meaningful disclosure of changes in the underlying risk within the GLB reinsurance programs for a given reporting period.

b) Other investments

 

Included in Other investments are investments in limited partnerships and partially-owned investment companies with a carrying value of $1,299 million. In connection with these investments, we have commitments that may require funding of up to $1,186 million over the next several years.

c) Taxation

 

In 2010, ACE reached final settlement with the Internal Revenue Service (IRS) Appeals Division regarding its federal tax returns for 2002, 2003, and 2004. As a result of the settlement, the amount of unrecognized tax benefits was reduced by approximately $21 million. Additionally, in June 2010, the IRS completed its field examination of ACE's federal tax returns for 2005, 2006, and 2007 and has proposed several adjustments principally involving transfer pricing and other insurance-related matters. In July 2010, we filed a written protest with the IRS, and the case is currently being reviewed by the IRS Appeals Division. The IRS commenced its field examination of ACE's federal tax returns for 2008 and 2009 during January 2011. While it is reasonably possible that a significant change in the unrecognized tax benefits could occur in the next 12 months, we believe that the outcome of the appeal and the current examination will not have a material impact on our financial condition or results of operations. With few exceptions, our significant U.K. subsidiaries remain subject to examination for tax years 2007 and later.

 

d) Legal proceedings

 

(i) Claims and other litigation

 

ACE's insurance subsidiaries are subject to claims litigation involving disputed interpretations of policy coverage and, in some jurisdictions, direct actions by allegedly-injured persons seeking damages from policyholders. These lawsuits, involving claims on policies issued by ACE's subsidiaries, which are typical to the insurance industry in general and in the normal course of business, are considered in ACE's loss and loss expense reserves. In addition to claims litigation, ACE and its subsidiaries are subject to lawsuits and regulatory actions in the normal course of business that do not arise from, or directly relate to, claims on insurance policies. This category of business litigation typically involves, amongst other things, allegations of underwriting errors or misconduct, employment claims, regulatory activity, or disputes arising from business ventures. In the opinion of ACE's management, ACE's ultimate liability for these matters is not likely to have a material adverse effect on ACE's consolidated financial condition, although it is possible that the effect could be material to ACE's consolidated results of operations for an individual reporting period.

 

(ii) Business practices litigation

 

ACE, ACE INA Holdings Inc., and ACE USA, Inc., along with a number of other insurers and brokers, were named in a series of federal putative nationwide class actions brought by insurance policyholders. The Judicial Panel on Multidistrict Litigation (JPML) consolidated these cases in the District of New Jersey. On August 1, 2005, plaintiffs in the New Jersey consolidated proceedings filed two consolidated amended complaints – one concerning commercial insurance and the other concerning employee benefit plans. The employee benefit plans litigation against ACE has been dismissed.

 

In the commercial insurance complaint, the plaintiffs named ACE, ACE INA Holdings Inc., ACE USA, Inc., ACE American Insurance Co., Illinois Union Insurance Co., and Indemnity Insurance Co. of North America. They allege that certain brokers and insurers, including certain ACE entities, conspired to increase premiums and allocate customers through the use of “B” quotes and contingent commissions. In addition, they allege that the broker defendants received additional income by improperly placing their clients' business with insurers through related wholesale entities that acted as intermediaries between brokers and insurers. Plaintiffs also allege that broker defendants tied the purchase of primary insurance to the placement of such coverage with reinsurance carriers through the broker defendants' reinsurance broker subsidiaries. The complaint asserts the following causes of action against ACE: Federal Racketeer Influenced and Corrupt Organizations Act (RICO), federal antitrust law, state antitrust law, aiding and abetting breach of fiduciary duty, and unjust enrichment.

 

In 2006 and 2007, the Court dismissed plaintiffs' first two attempts to properly plead a case without prejudice and permitted plaintiffs one final opportunity to re-plead. The amended complaint, filed on May 22, 2007, purported to add several new ACE defendants: ACE Group Holdings, Inc., ACE US Holdings, Inc., Westchester Fire Insurance Company, INA Corporation, INA Financial Corporation, INA Holdings Corporation, ACE Property and Casualty Insurance Company, and Pacific Employers Insurance Company. Plaintiffs also added a new antitrust claim against Marsh, ACE, and other insurers based on the same allegations as the other claims but limited to excess casualty insurance. In 2007