1. General

ACE Limited (ACE or the Company) is a holding company which, until July 18, 2008, was incorporated with limited liability under the Cayman Islands Companies Law. In March 2008, the Board of Directors (the Board) approved a proposal to move the Company’s jurisdiction of incorporation from the Cayman Islands to Zurich, Switzerland (the Continuation).  In July 2008, during ACE’s annual general meeting, the Company’s shareholders approved the Continuation and ACE became a Swiss company effective July 18, 2008. 

The Company, through its various subsidiaries, provides 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. Refer to Note 17.

On April 1, 2008, ACE acquired all outstanding shares of Combined Insurance Company of America and certain of its subsidiaries (Combined Insurance) from Aon Corporation for $2.56 billion. Combined Insurance is a leading underwriter and distributor of specialty individual supplemental accident and health insurance products targeted to middle income consumers and small businesses in North America, Europe, Asia Pacific, and Latin America. ACE recorded the acquisition using the purchase method of accounting. Refer to Note 3.

2. Significant accounting policies

In June 2009, the Financial Accounting Standards Board (FASB) issued The FASB Accounting Standards CodificationTM embodied in Accounting Standards Codification (ASC) Topic 105, Generally Accepted Accounting Principles (the Codification). The Codification, which was launched on July 1, 2009, became the single source of authoritative nongovernmental U.S. GAAP, superseding existing FASB, American Institute of Certified Public Accountants, Emerging Issues Task Force, and related literature. The Codification establishes one level of authoritative guidance. All other literature is considered non-authoritative. The Codification was effective for financial statements issued for interim and annual periods ending after September 15, 2009.

a) Basis of presentation

The accompanying consolidated financial statements, which include the accounts of the Company 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. Certain items in the prior year financial statements have been reclassified to conform to the current year presentation.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, 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. The Company’s principal estimates include:

• unpaid loss and loss expense reserves, including asbestos and environmental (A&E) reserves;
  
• future policy benefits reserves;
  
• the valuation of value of business acquired (VOBA) and amortization of deferred policy acquisition costs and VOBA;
  
• reinsurance recoverable, including a provision for uncollectible reinsurance;
  
• the assessment of risk transfer for certain structured insurance and reinsurance contracts;
  
• the valuation of the investment portfolio and assessment of other-than-temporary impairments (OTTI);
  
• the valuation of deferred tax assets;
  
• the valuation of derivative instruments related to guaranteed minimum income benefits (GMIB); and
  
• the valuation of goodwill.
  

While the amounts included in the consolidated financial statements reflect the Company’s best estimates and assumptions, these amounts could ultimately be materially different from the amounts recorded in the consolidated financial statements.

b) Premiums

Premiums are generally recognized as written upon inception of the policy. For multi-year policies for which premiums written are payable in annual installments, only the current annual premium is included as written at policy inception due to the ability of the insured/reinsured to commute or cancel coverage within the term of the policy. The remaining annual premiums are included as written at each successive anniversary date within the multi-year term.

For property and casualty (P&C) insurance and reinsurance products, premiums written are primarily earned on a pro-rata basis over the terms of the policies to which they relate. Unearned premiums represent the portion of premiums written applicable to the unexpired portion of the policies in force. For retrospectively-rated policies, written premiums are adjusted to reflect expected ultimate premiums consistent with changes to reported losses, or other measures of exposure as stated in the policy, and earned over the coverage period of the policy. For retrospectively-rated multi-year policies, the amount of premiums recognized in the current period is computed, using a with-and-without method, as the difference between the ceding enterprise's total contract costs before and after the experience under the contract as at the reporting date. Accordingly, for retrospectively-rated multi-year policies, additional premiums are generally written and earned when losses are incurred.

Mandatory reinstatement premiums assessed on reinsurance policies are earned in the period of the loss event that gave rise to the reinstatement premiums.  All remaining unearned premiums are recognized over the remaining coverage period. 

Premiums from long duration contracts such as traditional certain term life, whole life, endowment, and certain long duration personal accident and health (A&H) policies are generally recognized as revenue when due from policyholders. Traditional life policies include those contracts with fixed and guaranteed premiums and benefits. Benefits and expenses are matched with such income to result in the recognition of profit over the life of the contracts.

Retroactive loss portfolio transfer (LPT) contracts in which the insured loss events occurred prior to the inception of the contract are evaluated to determine whether they meet the established criteria for reinsurance accounting. If reinsurance accounting is appropriate, written premiums are fully earned and corresponding losses and loss expenses recognized at the inception of the contract. The contracts can cause significant variances in gross premiums written, net premiums written, net premiums earned, and net incurred losses in the years in which they are written. Reinsurance contracts sold not meeting the established criteria for reinsurance accounting are recorded using the deposit method as described below in Note 2 k).

Reinsurance premiums assumed are based on information provided by ceding companies supplemented by the Company’s own estimates of premium when the Company has not received ceding company reports. The information used in establishing these estimates is reviewed and adjustments are recorded in the period in which they are determined. These premiums are earned over the coverage terms of the related reinsurance contracts and range from one to three years.

c) Policy acquisition costs

Policy acquisition costs consist of commissions, premium taxes, and underwriting and other costs that vary with, and are primarily related to, the production of premium. A VOBA intangible asset is established upon the acquisition of blocks of long duration contracts and represents the present value of estimated net cash flows for the contracts in force at the time of the acquisition. Acquisition costs and VOBA, collectively policy acquisition costs, are deferred and amortized over the period in which the related premiums are earned. For P&C contracts, this is generally ratably over the period in which premiums are earned. For long duration contracts, the Company amortizes policy acquisition costs over the estimated life of the contracts in proportion to premium revenue recognized. Policy acquisition costs are reviewed to determine if they are recoverable from future income, including investment income. If such costs are unrecoverable, they are expensed in the period this determination is made.

Advertising costs are expensed as incurred except for direct-response campaigns, principally related to A&H business produced by the Insurance – Overseas General segment, which are deferred and recognized over the expected future benefit period in accordance with the provisions of ASC Topic 720, Advertising Costs. For individual direct-response marketing campaigns that the Company can demonstrate have specifically resulted in incremental sales to customers and such sales have probable future economic benefits, incremental costs directly related to the marketing campaigns are capitalized. Deferred marketing costs are reviewed regularly for recoverability and amortized over five years, the expected economic future benefit period. The expected future benefit period is evaluated periodically based on historical results and adjusted prospectively. The amount of deferred marketing costs reported in deferred policy acquisition costs was $333 million, $300 million, and $282 million at December 31, 2009, 2008, and 2007, respectively. The amortization expense for deferred marketing costs was $135 million, $124 million, and $91 million for the years ended December 31, 2009, 2008, and 2007, respectively.

d) Reinsurance

The Company assumes and cedes reinsurance with other insurance companies to provide greater diversification of business and minimize the net loss potential arising from large risks. Ceded reinsurance contracts do not relieve the Company of its primary obligation to its policyholders.

For both ceded and assumed reinsurance, risk transfer requirements must be met in order to obtain reinsurance status for accounting purposes, principally resulting in the recognition of cash flows under the contract as premiums and losses. To meet risk transfer requirements, a reinsurance contract must include insurance risk, consisting of both underwriting and timing risk, and a reasonable possibility of a significant loss for the assuming entity. To assess risk transfer for certain contracts, ACE generally develops expected discounted cash flow analyses at contract inception. If risk transfer requirements are not met, a contract is accounted for using the deposit method. Deposit accounting requires that consideration received or paid be recorded in the balance sheet as opposed to premiums written or losses incurred in the statement of operations and any non-refundable fees earned based on the terms of the contract. Refer to Note 2 k).

Reinsurance recoverable includes the balances due from reinsurance companies for paid and unpaid losses and loss expenses and policy benefits that will be recovered from reinsurers, based on contracts in force, and is presented net of a provision for uncollectible reinsurance determined based upon a review of the financial condition of the reinsurers and other factors. The method for determining the reinsurance recoverable on unpaid losses and loss expenses incurred but not reported (IBNR) involves actuarial estimates consistent with those used to establish the associated liability for unpaid losses and loss expenses as well as a determination of the Company’s ability to cede unpaid losses and loss expenses under its existing reinsurance contracts. The provision for uncollectible reinsurance is based on an estimate of the amount of the reinsurance recoverable balance that the Company will ultimately be unable to recover due to reinsurer insolvency, a contractual dispute, or any other reason. The valuation of this provision includes several judgments including certain aspects of the allocation of reinsurance recoverable on IBNR claims by reinsurer and a default analysis to estimate uncollectible reinsurance. The primary components of the default analysis are reinsurance recoverable balances by reinsurer, net of collateral, and default factors used to determine the portion of a reinsurer’s balance deemed uncollectible. The definition of collateral for this purpose requires some judgment and is generally limited to assets held in an ACE-only beneficiary trust, letters of credit, and liabilities held with the same legal entity for which ACE believes there is a contractual right of offset. The determination of the default factor is principally based on the financial strength rating of the reinsurer. Default factors require considerable judgment and are determined using the current financial strength rating, or rating equivalent, of each reinsurer as well as other key considerations and assumptions. The more significant considerations include, but are not necessarily limited to, the following:

• For reinsurers that maintain a financial strength rating from a major rating agency, and for which recoverable balances are considered representative of the larger population (i.e., default probabilities are consistent with similarly rated reinsurers and payment durations conform to averages), the financial rating is based on a published source and the default factor is based on published default statistics of a major rating agency applicable to the reinsurer’s particular rating class. When a recoverable is expected to be paid in a brief period of time by a highly rated reinsurer, such as certain property catastrophe claims, a default factor may not be applied;
  
• For balances recoverable from reinsurers that are both unrated by a major rating agency and for which management is unable to determine a credible rating equivalent based on a parent, affiliate, or peer company, the Company determines a rating equivalent based on an analysis of the reinsurer that considers an assessment of the creditworthiness of the particular entity, industry benchmarks, or other factors as considered appropriate. The Company then applies the applicable default factor for that rating class. For balances recoverable from unrated reinsurers for which the ceded reserve is below a certain threshold, the Company generally applies a default factor of 25 percent, consistent with published statistics of a major rating agency;
  
• For balances recoverable from reinsurers that are either insolvent or under regulatory supervision, the Company establishes a default factor and resulting provision for uncollectible reinsurance based on reinsurer-specific facts and circumstances. Upon initial notification of an insolvency, the Company generally recognizes expense for a substantial portion of all balances outstanding, net of collateral, through a combination of write-offs of recoverable balances and increases to the provision for uncollectible reinsurance. When regulatory action is taken on a reinsurer, the Company generally recognizes a default factor by estimating an expected recovery on all balances outstanding, net of collateral. When sufficient credible information becomes available, the Company adjusts the provision for uncollectible reinsurance by establishing a default factor pursuant to information received; and
  
• For other recoverables, management determines the provision for uncollectible reinsurance based on the specific facts and circumstances of that dispute.
  

The methods used to determine the reinsurance recoverable balance and related provision for uncollectible reinsurance are regularly reviewed and updated and any resulting adjustments are reflected in earnings in the period identified.

Prepaid reinsurance premiums represent the portion of premiums ceded to reinsurers applicable to the unexpired coverage terms of the reinsurance contracts in force.

The value of reinsurance business assumed of $111 million and $123 million at December 31, 2009 and 2008, respectively, included in Other assets in the accompanying consolidated balance sheets, represents the excess of estimated ultimate value of the liabilities assumed under retroactive reinsurance contracts over consideration received. The value of reinsurance business assumed is amortized and recorded to losses and loss expenses based on the payment pattern of the losses assumed and ranges between 3 and 40 years. The unamortized value is reviewed regularly to determine if it is recoverable based upon the terms of the contract, estimated losses and loss expenses, and anticipated investment income. Unrecoverable amounts are expensed in the period identified.

e) Investments

Fixed maturity investments are classified as either available for sale or held to maturity. The available for sale portfolio is reported at fair value. The held to maturity portfolio includes securities for which the Company has the ability and intent to hold to maturity or redemption and is reported at amortized cost. Equity securities are classified as available for sale and are recorded at fair value. Short-term investments comprise securities due to mature within one year of the date of purchase. Short-term investments include certain cash and cash equivalents, which are part of investment portfolios under the management of external investment managers.

Other investments principally comprise life insurance policies, policy loans, trading securities, other direct equity investments, investment funds, and limited partnerships.

• Life insurance policies are carried at policy cash surrender value.
  
• Policy loans are carried at outstanding balance.
  
• Trading securities are recorded on a trade date basis and carried at fair value. Unrealized gains and losses on trading securities are reflected in net income.
  
• Other investments over which ACE can exercise significant influence are accounted for using the equity method.
  
• All other investments over which ACE cannot exercise significant influence are carried at fair value with changes in fair value recognized through other comprehensive income. For these investments, investment income and realized gains are recognized as related distributions are received.
  
• Partially-owned investment companies comprise entities in which the Company holds an ownership interest in excess of three percent. These investments as well as ACE’s investments in investment funds where its ownership interest is in excess of three percent are accounted for under the equity method as ACE exerts significant influence. These investments apply investment company accounting to determine operating results, and ACE retains the investment company accounting in applying the equity method. This means that investment income, realized gains or losses, and unrealized gains or losses are included in the portion of equity earnings reflected in Other (income) expense.
  

Upon adopting the provisions of ASC Topic 815, Derivative and Hedging, (Topic 815) on January 1, 2007, ACE elected to apply the option related to hybrid financial instruments to $277 million of convertible bond investments that contain embedded derivatives within ACE’s available for sale portfolio. Since the convertible bonds were previously carried at fair value, the election did not have an effect on shareholders’ equity. However, the election resulted in a reduction of accumulated other comprehensive income and an increase in retained earnings of $12 million as at January 1, 2007. The Company recognizes these hybrid financial instruments at fair value with changes in fair value reflected in Net realized gains (losses).

Investments in partially-owned insurance companies primarily represent direct investments in which the Company has significant influence and, as such, meet the requirements for equity accounting. The Company reports its share of the net income or loss of the partially-owned insurance companies in Other (income) expense. Investments in partially-owned insurance companies over which the Company does not exert significant influence are carried at fair value.

Realized gains or losses on sales of investments are determined on a first-in, first-out basis. Unrealized appreciation (depreciation) on investments is included as a separate component of accumulated other comprehensive income in shareholders’ equity. The Company regularly reviews its investments for OTTI. Refer to Note 4.

With respect to securities where the decline in value is determined to be temporary and the security’s value is not written down, a subsequent decision may be made to sell that security and realize a loss. Subsequent decisions on security sales are the result of changing or unforeseen facts and circumstances (e.g., arising from a large insured loss such as a catastrophe), deterioration of the credit-worthiness of the issuer or its industry, or changes in regulatory requirements. The Company believes that subsequent decisions to sell such securities are consistent with the classification of the majority of the portfolio as available for sale.

The Company utilizes derivative instruments including futures, options, swaps, and foreign currency forward contracts for the purpose of managing certain investment portfolio risk and exposures. Refer to Note 10. Derivatives are reported at fair value and recorded in the accompanying consolidated balance sheets in Accounts payable, accrued expenses, and other liabilities with changes in fair value included in Net realized gains (losses) in the consolidated statements of operations. Collateral held by brokers equal to a percentage of the total value of open futures contracts is included in Short-term investments.

Net investment income includes interest and dividend income and amortization of fixed maturity market premiums and discounts and is net of investment management and custody fees. For mortgage-backed securities, and any other holdings for which there is a prepayment risk, prepayment assumptions are evaluated and revised as necessary. Any adjustments required due to the resultant change in effective yields and maturities are recognized prospectively. Prepayment fees or call premiums that are only payable when a security is called prior to its maturity are earned when received and reflected in Net investment income. 

The Company participates in a securities lending program operated by a third party banking institution whereby certain assets are loaned to qualified borrowers and from which the Company earns an incremental return. Borrowers provide collateral, in the form of either cash or approved securities, of 102 percent of the fair value of the loaned securities.  Each security loan is deemed to be an overnight transaction.  Cash collateral is invested in a collateral pool which is managed by the banking institution.  The collateral pool is subject to written investment guidelines with key objectives which include the safeguard of principal and adequate liquidity to meet anticipated redemptions. The fair value of the loaned securities is monitored on a daily basis, with additional collateral obtained or refunded as the fair value of the loaned securities changes. The collateral is held by the third party banking institution, and the collateral can only be accessed in the event that the institution borrowing the securities is in default under the lending agreement. As a result of these restrictions, the Company considers its securities lending activities to be non-cash investing and financing activities. An indemnification agreement with the lending agent protects the Company in the event a borrower becomes insolvent or fails to return any of the securities on loan. The fair value of the securities on loan is included in fixed maturities and equity securities. The securities lending collateral is reported as a separate line in total assets with a related liability reflecting the Company’s obligation to return the collateral plus interest.

Similar to securities lending arrangements, securities sold under reverse repurchase agreements are accounted for as collateralized investments and borrowings and are recorded at the contractual repurchase amounts plus accrued interest. Assets to be repurchased are the same, or substantially the same, as the assets transferred and the transferor, through right of substitution, maintains the right and ability to redeem the collateral on short notice. The fair value of the underlying securities is included in fixed maturities and equity securities. In contrast to securities lending programs, the use of cash received is not restricted. The Company reports its obligation to return the cash as short-term debt. Refer to Note 9.

Refer to Note 15 for a discussion on the determination of fair value for the Company’s various investment securities.

f) Cash

Cash includes cash on hand and deposits with an original maturity of three months or less at time of purchase. Cash held by external money managers is included in Short-term investments.

g) Goodwill and other intangible assets

Goodwill represents the excess of the cost of acquisitions over the fair value of net assets acquired and is not amortized. Goodwill is assigned at acquisition to the applicable reporting unit of the acquired entities giving rise to the goodwill. Goodwill impairment tests are performed annually, or more frequently if circumstances indicate a possible impairment.  The Company estimates a reporting unit’s fair value using a consistently applied combination of the following models: an earnings multiple, a book value multiple, a discounted cash flow or an allocated market capitalization model. The Company’s earnings and book value models apply multiples of comparable publicly traded companies to forecasted earnings or book value of each reporting unit and consider current market transactions. The discounted cash flow model applies a discount to estimated cash flows including a terminal value calculation. The market capitalization model allocates the Company’s market capitalization to each reporting unit. Where appropriate, the Company considers the impact of a control premium. Goodwill recorded in connection with investments in partially-owned insurance companies is recorded in Investments in partially-owned insurance companies and is also measured for impairment annually.

Indefinite lived intangible assets are not subject to amortization. Finite lived intangible assets are amortized over their useful lives, generally ranging from 5 to 15 years. The carrying amounts of intangible assets are regularly reviewed for indicators of impairment. Impairment is recognized if the carrying amount is not recoverable from its undiscounted cash flows and is measured as the difference between the carrying amount and fair value.

h) Unpaid losses and loss expenses

A liability is established for the estimated unpaid losses and loss expenses under the terms of, and with respect to, the Company’s policies and agreements. These amounts include provision for both reported claims (case reserves) and IBNR claims. The methods of determining such estimates and establishing the resulting liability are reviewed regularly and any adjustments are reflected in operations in the period in which they become known. Future developments may result in losses and loss expenses materially greater or less than recorded amounts.

Except for net loss and loss expense reserves of $76 million net of discount held at December 31, 2009, representing structured settlements for which the timing and amount of future claim payments are reliably determinable, the Company does not discount its P&C loss reserves. Structured settlements represent contracts purchased from life insurance companies primarily to settle workers’ compensation claims, where payments to the claimant by the life insurance company are expected to be made in the form of an annuity. The Company retains the liability to the claimant in the event that the life insurance company fails to pay. At December 31, 2009, the Company has a gross liability of $659 million for the amount due to claimants and reinsurance recoverables of $583 million for amounts due from the life insurance companies. For structured settlement contracts where payments are guaranteed regardless of claimant life expectancy, the amounts recoverable from the life insurance companies are included in Other Assets, as they do not meet the requirements for reinsurance accounting. At December 31, 2009, there was $76 million included in Other Assets relating to structured settlements.

Included in unpaid losses and loss expenses are liabilities for A&E claims and expenses. These unpaid losses and loss expenses are principally related to claims arising from remediation costs associated with hazardous waste sites and bodily-injury claims related to asbestos products and environmental hazards. The estimation of these liabilities is particularly sensitive to changes in the legal environment, including specific settlements that may be used as precedents to settle future claims. However, ACE does not anticipate future changes in laws and regulations in setting its A&E reserve levels.

Prior period development arises from changes to loss estimates recognized in the current year that relate to loss reserves first reported in previous calendar years and excludes the effect of losses from the development of earned premiums from previous accident years. With respect to crop business, reports are regularly received from the Company’s managing general agent relating to the previous crop year(s) in subsequent calendar years and this typically results in adjustments to the previously reported premiums, losses and loss expenses, and profit share commission.  Commencing with the quarter ended September 30, 2009, prior period development for the crop business includes adjustments to both crop losses and loss expenses and the related crop profit share commission. For purposes of analysis and disclosure, management views prior period development to be changes in the nominal value of loss estimates from period to period and excludes changes in loss estimates that do not arise from the emergence of claims, such as those related to uncollectible reinsurance, interest, unallocated loss adjustment expenses, or foreign currency. Accordingly, specific items excluded from prior period development include the following: gains/losses related to foreign currency translation; losses recognized from the early termination or commutation of reinsurance agreements that principally relate to the time value of money; changes in the value of reinsurance business assumed reflected in losses incurred but principally related to the time value of money; and losses that arise from changes in estimates of earned premiums from prior accident years. Except for foreign currency revaluation, which is disclosed separately, these items are included in current year losses.

i) Future policy benefits

The development of long duration contract reserves requires management to make estimates and assumptions regarding expenses, mortality, persistency, and investment yields. Such estimates are primarily based on historical experience and information provided by ceding companies and include a margin for adverse deviation. Interest rates used in calculating reserves range from one percent to seven percent at December 31, 2009 and 2008. Actual results could differ materially from these estimates. Management monitors actual experience, and where circumstances warrant, will revise its assumptions and the related reserve estimates. These revisions are recorded in the period they are determined.

j) Assumed reinsurance programs involving minimum benefit guarantees under annuity contracts

The Company reinsures various death and living benefit guarantees associated with variable annuities issued primarily in the United States and Japan. Each reinsurance treaty covers variable annuities written during a limited period, typically not exceeding two years. The Company generally receives a monthly premium during the accumulation phase of the covered annuities (in-force) based on a percentage of either the underlying accumulated account values or the underlying accumulated guaranteed values. Depending on an annuitant’s age, the accumulation phase can last many years. To limit the Company’s exposure under these programs, all reinsurance treaties include aggregate claim limits and many include an aggregate deductible.

The guarantees which are payable on death, referred to as guaranteed minimum death benefits (GMDB), principally cover shortfalls between accumulated account value at the time of an annuitant’s death and either i) an annuitant’s total deposits; ii) an annuitant’s total deposits plus a minimum annual return; or iii) the highest accumulated account value attained at any policy anniversary date. In addition, a death benefit may be based on a formula specified in the variable annuity contract that uses a percentage of the growth of the underlying contract value. Liabilities for GMDBs are based on cumulative assessments or premiums to date multiplied by a benefit ratio that is determined by estimating the present value of benefit payments and related adjustment expenses divided by the present value of cumulative assessment or expected fees during the contract period.  In the event the Company was to anticipate an ultimate loss on the business over the in-force period of the underlying annuities, an additional liability would be established to recognize such losses.

Under reinsurance programs covering living benefit guarantees, the Company assumes the risk of GMIBs 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 Company’s GMIB reinsurance product meets the definition of a derivative for accounting purposes and is carried at fair value with changes in fair value recognized in income and classified as described below. As the assuming entity, the Company is obligated to provide coverage until the expiration of the underlying annuities. Premiums received under the reinsurance treaties are classified as premium. Expected losses allocated to premiums received are classified as 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 exit price and thus includes a risk margin. The Company may recognize a realized loss for other changes in fair value due to adverse changes in the capital markets (i.e., declining interest rates and/or declining equity markets) and changes in policyholder behavior (i.e., increased annuitization or decreased lapse rates) although the Company expects the business to be profitable. The Company believes this presentation provides the most meaningful disclosure of changes in the underlying risk within the GMIB reinsurance programs for a given reporting period. Refer to Note 5 c).

k) Deposit assets and liabilities

Deposit assets arise from ceded reinsurance contracts purchased that do not transfer significant underwriting or timing risk. Under deposit accounting, consideration received or paid, excluding non-refundable fees, is recorded as a deposit asset or liability in the balance sheet as opposed to ceded premiums and losses in the statement of operations. Interest income on deposits, representing the consideration received or to be received in excess of cash payments related to the deposit contract, is earned based on an effective yield calculation. The calculation of the effective yield is based on the amount and timing of actual cash flows as at the balance sheet date and the estimated amount and timing of future cash flows. The effective yield is recalculated periodically to reflect revised estimates of cash flows. When a change in the actual or estimated cash flows occurs, the resulting change to the carrying amount of the deposit asset is reported as income or expense. Deposit assets of $55 million and $77 million at December 31, 2009 and 2008, respectively, are reflected in Other assets in the balance sheets and the accretion of deposit assets related to interest pursuant to the effective yield calculation is reflected in Net investment income in the statement of operations.

Non-refundable fees are earned based on contract terms. Non-refundable fees paid but unearned are reflected in Other assets in the balance sheet and earned fees are reflected in Other (income) expense in the statement of operations.

Deposit liabilities include reinsurance deposit liabilities of $281 million and $310 million and contract holder deposit funds of $51 million and $35 million at December 31, 2009 and 2008, respectively. The reinsurance deposit liabilities arise from contracts sold for which there is not a significant transfer of risk. At contract inception, the deposit liability equals net cash received. An accretion rate is established based on actuarial estimates whereby the deposit liability is increased to the estimated amount payable over the contract term. The deposit accretion rate is the rate of return required to fund expected future payment obligations. The Company periodically reassesses the estimated ultimate liability and related expected rate of return. Changes to the amount of the deposit liability are reflected as an adjustment to earnings to reflect the cumulative effect of the period the contract has been in force, and by an adjustment to the future accretion rate of the liability over the remaining estimated contract term.

Contract holder deposit funds represent a liability for investment contracts sold that do not meet the definition of an insurance contract and are sold with a guaranteed rate of return. The liability equals accumulated policy account values, which consist of the deposit payments plus credited interest, less withdrawals and amounts assessed through the end of the period.

l) Translation of foreign currencies

The Company determines the functional currency for each of its foreign operations, which are generally the currency of the local operating environment. Transactions in currencies other than a foreign operation’s functional currency are remeasured into the functional currency and the resulting foreign exchange gains and losses are reflected in Net realized gains (losses) in the consolidated statements of operations. Functional currency assets and liabilities are translated into the reporting currency, U.S. dollars, using period end rates of exchange and the related translation adjustments are recorded as a separate component of accumulated other comprehensive income. Functional statement of operations amounts expressed in functional currencies are translated using average exchange rates. Gains and losses resulting from foreign currency transactions are recorded in Net realized gains (losses).

m) Income taxes

Income taxes have been provided for in accordance with the provisions of ASC Topic 740, Income Taxes, (Topic 740) for those operations which are subject to income taxes. Deferred tax assets and liabilities result from temporary differences between the amounts recorded in the consolidated financial statements and the tax basis of the Company’s assets and liabilities. Refer to Note 8. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance against deferred tax assets is recorded if it is more likely than not that all, or some portion, of the benefits related to deferred tax assets will not be realized. The valuation allowance assessment considers tax planning strategies, where applicable.

Beginning with the adoption of the provisions included in Topic 740 relating to uncertainty in income taxes, as at January 1, 2007, the Company recognized uncertain tax positions deemed more likely than not of being sustained upon examination.  Recognized income tax positions are measured at the largest amount that is greater than 50 percent likely of being realized. Changes in recognition or measurement are reflected in the period in which the change in judgment occurs.

n) Earnings per share

Basic earnings per share is calculated using the weighted-average shares outstanding including participating securities with non-forfeitable rights to dividends such as unvested restricted stock. All potentially dilutive securities including stock options are excluded from the basic earnings per share calculation. In calculating diluted earnings per share, the weighted-average shares outstanding is increased to include all potentially dilutive securities. Basic and diluted earnings per share are calculated by dividing net income available to common shareholders by the applicable weighted-average number of shares outstanding during the year.

o) Cash flow information

Purchases, sales, and maturities of short-term investments are recorded net for purposes of the consolidated statements of cash flows and are classified with cash flows related to fixed maturities.  Premiums received and losses paid associated with the GMIB reinsurance product, which as discussed previously meets the definition of a derivative instrument for accounting purposes, are included within cash flows from operating activities in the consolidated statement of cash flows.  Cash flows, such as settlements and collateral requirements, associated with all other derivative instruments are included on a net basis within cash flows from investing activities in the consolidated statement of cash flows.  

p) Derivatives

The Company recognizes all derivatives as either assets or liabilities in the consolidated balance sheets measured at fair value. The Company participates in derivative instruments in two principal ways:

(i) To sell protection to customers as an insurance or reinsurance contract that meets the definition of a derivative under the provisions of Topic 815. For 2009 and 2008, the reinsurance of GMIBs was the Company’s primary product falling into this category; and
(ii) To mitigate financial risks, principally arising from investment holdings, products sold, or assets and liabilities held in foreign currencies. For these instruments, changes in assets or liabilities measured at fair value are recorded as realized gains or losses in the consolidated statement of operations.

The Company did not designate any derivatives as accounting hedges during 2009, 2008, or 2007.

q) Share-based compensation

The Company measures and records compensation cost for all share-based payment awards at grant-date fair value. Compensation costs are recognized for share-based payment awards with only service conditions that have graded vesting schedules on a straight-line basis over the requisite service period for each separately vesting portion of the award as if the award was, in substance, multiple awards. Refer to Note 13.

r) New accounting pronouncements

Adopted in 2009

Business combinations

ASC Topic 805, Business Combinations, (Topic 805) contains certain provisions to be applied prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. These provisions establish standards that provide a definition of the “acquirer” and broaden the application of the acquisition method. They also establish how an acquirer recognizes and measures the assets, liabilities, and any noncontrolling interest in the “acquiree”; recognizes and measures goodwill or a gain from a bargain purchase; and require disclosures that enable users to evaluate the nature and financial effects of the business combination. The adoption of these provisions may have a material impact on any future business combinations consummated by ACE, but did not have any effect on previously consummated business acquisitions.

Topic 805 also contains certain provisions specifically related to accounting for assets acquired and liabilities assumed in a business combination that arise from contingencies that are effective for all business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. These provisions amend practices related to initial recognition and measurement, subsequent measurement, and disclosure of assets and liabilities arising from contingencies acquired in business combinations and require acquired contingencies to be recognized at acquisition date fair value if fair value can be reasonably estimated during the allocation period. Otherwise, acquired contingencies would typically be accounted for in accordance with ASC Topic 450, Contingencies. The adoption of these provisions may have a material impact on any future business combinations consummated by ACE, but did not have any effect on previously consummated business acquisitions.

ASC Topic 350, Intangibles-Goodwill and Other, (Topic 350) contains certain provisions related to accounting for defensive intangible assets effective for intangible assets acquired on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. These provisions require fair value be assigned to acquired defensive intangible assets and a useful life be assigned to a defensive intangible asset based on the period over which the reporting entity expects the asset to contribute directly or indirectly to future cash flows. The adoption of these provisions may have a material impact on any future intangible assets acquired by ACE, but did not have any effect on any previously acquired intangible assets.

Noncontrolling interests

ASC Topic 810, Consolidation, (Topic 810) contains certain provisions effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. These provisions establish accounting and reporting standards that require that ownership interests in subsidiaries held by parties other than the parent be presented in the consolidated statement of shareholders’ equity separately from the parent’s equity; the consolidated net income attributable to the parent and noncontrolling interest be presented on the face of the consolidated statements of operations; changes in a parent’s ownership interest while the parent retains controlling financial interest in its subsidiary be accounted for consistently; and disclosure that identifies and distinguishes between the interests of the parent and noncontrolling owners. The adoption of these provisions did not have a material impact on ACE’s financial condition or results of operations.

Disclosures about derivative instruments and hedging activities

Topic 815 contains certain provisions effective for fiscal years, and interim periods within those fiscal years, beginning on or after November 15, 2008. These provisions establish reporting standards that require enhanced disclosures about how and why derivative instruments are used, how derivative instruments are accounted for, and how derivative instruments affect an entity’s financial position, financial performance, and cash flows. ACE adopted these provisions effective January 1, 2009. Refer to Note 10.

Determination of the useful life of intangible assets

Topic 350 contains certain provisions related to the determination of the useful life of intangible assets effective for financial statements issued for fiscal years beginning after December 15, 2008, that must be applied prospectively to intangible assets acquired after the effective date. These provisions amend the factors considered in developing assumptions used to determine the useful life of an intangible asset with the intention of improving the consistency between the useful life of a recognized intangible asset and the period of expected cash flows used to measure the fair value of the asset under Topic 805 and other applicable accounting literature. The adoption of these provisions may have a material impact on any future intangible assets acquired by ACE, but did not have a material impact on the useful lives of any previously acquired intangible asset.

Earnings per share

ASC Topic 260, Earnings Per Share, (Topic 260) contains certain provisions effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2008. These provisions provide additional guidance in the calculation of earnings per share and require unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) to be included in the computation of earnings per share pursuant to the two-class method. The adoption of these provisions did not have a material impact on ACE’s financial condition or results of operations.

Equity method accounting

ASC Topic 323, Investments-Equity Method and Joint Ventures, contains certain provisions effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. These provisions provide guidance for equity method accounting for specific topics and require an equity method investor account for share issuances, and resulting dilutive effect, by an investee as if the investor had sold a proportionate share of its investment with the resulting gain or loss recognized in earnings. In connection with the adoption of these provisions, ACE recognized a $57 million pre-tax loss upon a June 2009 share issuance by Assured Guaranty Ltd. (AGO). Refer to Note 4 e).

Fair value measurements

ASC Topic 820, Fair Value Measurements and Disclosures, (Topic 820) includes provisions effective for interim and annual periods ending after June 15, 2009. These provisions provide additional guidance for estimating fair value when the volume and level of activity for the asset or liability have significantly decreased. The adoption of these provisions did not have a material impact on ACE’s financial condition or results of operations.

Fair value disclosures

ASC Topic 825, Financial Instruments, (Topic 825) includes new provisions that require disclosures about fair value of financial instruments for interim reporting periods as well as in annual financial statements.  ACE adopted these provisions which were effective for interim and annual periods ending after June 15, 2009.

Fair value of alternative investments

In September 2009, the FASB issued Accounting Standards Update (ASU) No. 2009-12, Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent ) (ASU 2009-12). The provisions of ASU 2009-12 amend Topic 820 to provide additional guidance on estimating the fair value of certain alternative investments. These provisions create a practical expedient to measure the fair value of an alternative investment on the basis of the net asset value per share of the investment. These provisions also improve transparency by requiring additional disclosures about the attributes of alternative investments to enable users of the financial statements to understand the nature and risks of the investments. ASU 2009-12 was effective for interim and annual reporting periods beginning October 1, 2009. The adoption of these provisions did not have an impact on ACE’s financial condition or results of operations.

Other-than-temporary impairments

ASC Topic 320, Investments-Debt and Equity Securities, (Topic 320) contains certain provisions effective for interim and annual periods ending after June 15, 2009, that amends OTTI guidance in existing GAAP for debt securities to make the guidance more operational and to improve the presentation and disclosure of OTTI on debt and equity securities in the financial statements. The adoption of these provisions did not have a material impact on ACE’s financial condition. Refer to Note 4.

Subsequent events

ASC Topic 855, Subsequent Events, contains certain provisions effective for interim and annual periods ending after June 15, 2009. These provisions set forth: 1) the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements; 2) the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements; and 3) the disclosures that an entity should make about events or transactions that occurred after the balance sheet date. The adoption of these provisions did not impact ACE’s financial condition or results of operations.

To be adopted after 2009
 
Consolidation of variable interest entities and accounting for transfers of financial assets

In June 2009, the FASB issued Financial Accounting Standard (FAS) No. 166, Accounting for Transfers of Financial Assets—an amendment of FASB Statement No. 140 (FAS 166) and FAS No. 167, Amendments to FASB Interpretation No. 46(R) (FAS 167). FAS 166 amends ASC Topic 860, Transfers and Servicing, by removing the exemption from consolidation for Qualifying Special Purpose Entities. This Statement also limits the circumstances in which a financial asset, or portion of a financial asset, should be derecognized when the transferor has not transferred the entire original financial asset to an entity that is not consolidated with the transferor in the financial statements being presented and/or when the transferor has continuing involvement with the transferred financial asset. FAS 167 amends Topic 810 to eliminate the quantitative approach previously required for determining the primary beneficiary of a variable interest entity and requires ongoing qualitative reassessments of whether an enterprise is the primary beneficiary of a variable interest entity.   FAS 166 and FAS 167 are effective for interim and annual reporting periods beginning on January 1, 2010. ACE does not expect the adoption of these provisions to have a material impact on ACE’s financial condition or results of operations.

Fair value measurements and disclosures

In January 2010, the FASB issued ASU No. 2010-06, Improving Disclosures about Fair Value Measurements (ASU 2010-06). The provisions of ASU 2010-06 amend Topic 820 to require reporting entities to make new disclosures about recurring and nonrecurring fair value measurements including significant transfers into and out of Level 1 and Level 2 fair value measurements and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair value measurements. ASU 2010-6 was effective for annual reporting periods beginning after December 15, 2009, except for Level 3 reconciliation disclosures which are effective for annual periods beginning after December 15, 2010.

3. Acquisition

On April 1, 2008, ACE acquired all outstanding shares of Combined Insurance from Aon Corporation for $2.56 billion. The consolidated financial statements include the results of Combined Insurance from April 1, 2008. Combined Insurance is a leading underwriter and distributor of specialty individual supplemental accident and health insurance products targeted to middle income consumers and small businesses in North America, Europe, Asia Pacific, and Latin America. This acquisition has diversified the Company’s A&H distribution capabilities by adding a significant agent base, while almost doubling the A&H franchise. 

ACE recorded the acquisition using the purchase method of accounting. The acquisition generated $1 billion of VOBA which represented the fair value of the future profits of the in-force contracts. VOBA is the most significant intangible asset attributable to the acquisition and is amortized over a period of approximately 30 years in relation to the profit emergence of the underlying contracts, in a manner similar to deferred acquisition costs. The VOBA calculation was based on many factors including mortality, morbidity, persistency, investment yields, expenses, and the discount rate with the discount rate being the most significant factor. The acquisition also generated $879 million of goodwill (all of which is expected to be deductible for income tax purposes) and $43 million of other intangible assets based on ACE’s final purchase price allocation. Goodwill was apportioned to the Life and Insurance – Overseas General segments in the amounts of $747 million and $132 million, respectively. Refer to Note 6. ACE financed the transaction through a combination of available cash ($811 million), reverse repurchase agreements ($1 billion), and new private and public long-term debt ($750 million). Refer to Note 9.
 
The following table summarizes ACE’s best estimate of fair value of the assets acquired and liabilities assumed related to the acquisition of Combined Insurance at April 1, 2008. Upon the adoption of the provisions (described in Note 15) of Topic 820 on January 1, 2008, ACE elected to defer the fair value guidance applicable to valuing nonfinancial assets and nonfinancial liabilities that are not recognized or disclosed at fair value on a recurring basis. Accordingly, the provisions embodied in that ASC topic were not used to determine the fair values of the nonfinancial assets acquired and the nonfinancial liabilities assumed in this business combination.

The following table presents unaudited pro forma information for the years ended December 31, 2008 and 2007, assuming the acquisition of Combined Insurance occurred on January 1st of each of the respective years. The pro forma financial information is presented for informational purposes only and is not necessarily indicative of the operating results that would have occurred had the acquisition been consummated at the beginning of each period presented, nor is it necessarily indicative of future operating results. Significant assumptions used to determine pro forma operating results include amortization of VOBA and other intangible assets and recognition of interest expense associated with debt financing used to effect the acquisition. Earnings per share calculations have been amended due to the impact of the adoption of the previously discussed new principles included within Topic 260.

4. Investments

a) Fixed maturities

The following tables present the fair values and amortized costs of and the gross unrealized appreciation (depreciation) related to fixed maturities as well as OTTI recognized in Accumulated other comprehensive income.

As discussed in Note 4 d), if a credit loss is indicated on an impaired fixed maturity investment, an OTTI is considered to have occurred and the portion of the impairment not related to credit losses (non-credit OTTI) is recognized in Other comprehensive income. Included in “OTTI Recognized in Accumulated Other Comprehensive Income” is the cumulative amount of non-credit OTTI recognized in comprehensive income adjusted for subsequent sales, maturities, and redemptions. “OTTI Recognized in Accumulated Other Comprehensive Income” does not include the impact of subsequent changes in fair value of the related securities. In periods subsequent to a recognition of OTTI in Other comprehensive income, changes in the fair value of the related fixed maturity investments are reflected in Unrealized appreciation (depreciation) in the statement of comprehensive income. For the year ended December 31, 2009, $196 million of net unrealized appreciation related to such securities is included in Other comprehensive income. At December 31, 2009, Accumulated other comprehensive income includes net unrealized depreciation of $162 million related to securities remaining in the investment portfolio 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 10 a) (iv)) and are included in the category, “Mortgage-backed securities”. Approximately 69 percent and 63 percent of the total mortgage-backed securities at December 31, 2009 and 2008, 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.

Fixed maturities at December 31, 2009 and 2008, by contractual maturity, are shown below. 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.

b) Transfers of securities

As part of the Company’s fixed income diversification strategy, ACE decided to hold to maturity certain commercial mortgage-backed securities that have shorter term durations. Because the Company has the intent to hold these securities to maturity, during the quarter ended June 30, 2009, a transfer of such securities with a fair value of $704 million was made from Fixed maturities available for sale to Fixed maturities held to maturity. The $4 million unrealized depreciation at the date of the transfer continues to be reported as a component of Accumulated other comprehensive income and is being amortized over the remaining life of the securities as an adjustment of yield in a manner consistent with the amortization of any premium or discount.
  

c) Equity securities

The fair value, cost of, and gross unrealized appreciation (depreciation) on equity securities at December 31, 2009 and 2008, are as follows:

d) Net realized gains (losses)

The Company adopted provisions included in Topic 320 related to the recognition and presentation of OTTI as at April 1, 2009. Under these provisions, when an OTTI related to a fixed maturity security has occurred, ACE is required to record the OTTI in net income if the Company has the intent to sell the security or it is more likely than not that it will be required to sell the security. Further, in cases where the Company does not intend to sell the security and it is more likely than not that it 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 other comprehensive income. For fixed maturities held to maturity, OTTI recognized in other comprehensive income is accreted from accumulated other comprehensive income to the amortized cost of the fixed maturity prospectively over the remaining term of the securities. For fixed maturities, prior to this adoption, ACE was required to record OTTI in net income unless the Company had the intent and ability to hold the impaired security to recovery. These newly adopted provisions do not have any impact on the accounting for OTTI for any other type of investment.

The cumulative effect of the adoption resulted in a reduction to Accumulated other comprehensive income and an increase to Retained earnings of $242 million as at April 1, 2009. These adjustments reflect the net of tax amount ($305 million pre-tax) of OTTI recognized in net income prior to the adoption related to fixed maturities held at the adoption date that have not suffered a credit loss, the Company does not intend to sell, and it is more likely than not that ACE will not be required to sell before the recovery of their amortized cost.

Retained earnings and Deferred tax assets as at April 1, 2009, were also reduced by $47 million as a result of an increase in the Company’s valuation allowance against deferred tax assets, which is a direct effect of the adoption.  Specifically, as a result of the reassessment of credit losses required by this adoption, ACE determined that certain previously impaired fixed maturity securities had suffered credit losses in excess of previously estimated amounts, which may give rise to additional future capital losses for tax purposes.   Given the amount of available capital gains against which such additional capital losses could be offset, at the date of adoption, the Company expected that a portion of capital loss carry forwards would expire unused.  Accordingly, ACE determined that an additional valuation allowance was necessary given that it was considered more likely than not that a portion of deferred tax assets related to previously impaired fixed income securities would not be realized.    

Each quarter, the Company reviews its securities in an unrealized loss position (impaired securities), including fixed maturity securities, securities lending collateral, equity securities, and other investments, to identify those impaired securities to be specifically evaluated for a potential OTTI.

For impaired fixed maturities, if the Company has the intent to sell the security or it is more likely than not that it will be required to sell the security, an OTTI is considered to have occurred. In cases where the Company does not intend to sell the security and it is more likely than not that it will not be required to sell the security, ACE evaluates the security to determine if a credit loss has occurred primarily based on a combination of qualitative and quantitative factors including a discounted cash flow model, where necessary. If a credit loss is indicated, an OTTI is considered to have occurred. Prior to the adoption, when evaluating fixed maturities for OTTI, the Company principally considered its ability and intent to hold the impaired security to the expected recovery period, the issuer's financial condition, and the Company’s assessment (using available market information such as credit ratings) of the issuer’s ability to make future scheduled principal and interest payments on a timely basis. The factors that the Company now considers when determining if a credit loss exists related to a fixed maturity security are discussed in “Evaluation of potential credit losses related to fixed maturities” below.

The Company reviews all non-fixed maturity investments for OTTI 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
  
• the Company’s ability and intent to hold the security to the expected recovery period.
  

ACE, as a general rule, also considers that equity securities in an unrealized loss position for twelve consecutive months are impaired.

Evaluation of potential credit losses related to fixed maturities

ACE reviews each fixed maturity security in an unrealized loss position to assess whether the security is a candidate for credit loss. Specifically, ACE considers 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 ACE determines 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. The specific methodologies and significant assumptions used by asset class are discussed below. All significant assumptions used in determining credit losses are subject to change as market conditions evolve.

U.S. Treasury and agency obligations (including agency mortgage-backed securities), foreign government obligations, and states, municipalities, and political subdivisions obligations

U.S. Treasury and agency obligations (including agency mortgage-backed securities), foreign government obligations, and states, municipalities, and political subdivisions obligations represent less than $80 million of gross unrealized loss at December 31, 2009. These securities were evaluated for credit loss primarily using qualitative assessments of the likelihood of credit loss considering credit rating of the issuers and level of credit enhancement, if any. ACE concluded that the high level of credit worthiness of the issuers coupled with credit enhancement, where applicable, supports recognizing no credit loss in net income.

Corporate securities

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. ACE develops 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. ACE believes that use of a default assumption in excess of the historical mean is reasonable in light of recent market conditions. Default assumptions by Moody’s rating category are as follows (historical mean default rate provided for comparison):

Consistent with management’s approach to developing default rate assumptions considering recent market conditions, ACE assumed a 25 percent recovery rate (the par value of a defaulted security that will be recovered) across all rating categories rather than using Moody’s historical mean recovery rate of 40 percent. ACE believes that use of a recovery rate assumption lower than the historical mean is reasonable in light of recent market conditions.

Application of the methodology and assumptions described above resulted in credit losses recognized in net income for corporate securities from the date of adoption to December 31, 2009, of $59 million, substantially all of which relates to below investment grade securities.

Mortgage-backed securities

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.

ACE develops specific assumptions using market data, where available, and includes internal estimates as well as estimates published by rating agencies and other third-party sources. ACE projects default rates by mortgage sector considering current underlying mortgage loan performance, generally assuming:

• lower loss severity for Prime sector bonds versus ALT-A, Sub-prime, and Option ARM sector bonds; and
  
• lower loss severity for older vintage securities versus more recent vintage securities, which reflects the recent decline in underwriting standards.
  

These estimates are extrapolated along a default timing curve to estimate the total lifetime pool default rate. Other assumptions used contemplate the actual collateral attributes, including geographic concentrations, rating agency loss projections, rating actions, and current market prices. If cash flow projections indicate that losses will exceed the credit enhancement for a given tranche, then the Company does not expect to recover its amortized cost basis and recognizes an estimated credit loss in net income.

The significant assumptions used to estimate future cash flows for specific mortgage-backed securities evaluated for potential credit loss at December 31, 2009, by sector and vintage are as follows:

(1) Prime, ALT-A, and Sub-prime sector bonds are categorized based on credit worthiness of the borrower. Option ARM sector bonds are categorized based on the type of mortgage product, rather than credit worthiness of the borrower.
(2) Default rate and loss severity rate assumptions vary within a given sector and vintage depending upon the geographic concentration of the collateral underlying the bond and the level of serious delinquencies, among other factors.

Application of the methodology and assumptions described above resulted in credit losses recognized in net income for mortgage-backed securities from the date of adoption to December 31, 2009, of $56 million. Given the variation in ratings between major rating agencies for the securities for which a credit loss was recognized in net income, ACE does not believe it is useful to provide the credit loss split between investment grade and below investment grade.

The following table shows, for the years ended December 31, 2009, 2008, and 2007, the Net realized gains (losses), the losses included in Net realized gains (losses) and Other comprehensive income as a result of conditions which caused the Company to conclude the decline in fair value of certain investments was “other-than-temporary”, and the change in net unrealized appreciation (depreciation) on investments. The impairments recorded in net income related to fixed maturities for the year ended December 31, 2009, were primarily due to securities with below investment grade credit ratings and intent to sell securities in an unrealized loss position. Impairments related to all other investments were primarily due to duration and severity of decline below cost.

The following table provides, for the nine month period from the date of adoption to December 31, 2009, a roll forward of pre-tax credit losses related to fixed maturities for which a portion of OTTI was recognized in Other comprehensive income.

e) Investment in AGO

AGO, a Bermuda-based holding company provides, through its operating subsidiaries, credit enhancement products to the public finance, structured finance, and mortgage markets. On July 1, 2009, AGO acquired Financial Security Assurance Holdings Ltd. from Dexia Holdings Inc., a subsidiary of Dexia S.A.  The purchase price included approximately $546 million in cash and approximately 22.3 million AGO common shares, according to AGO’s public filings. AGO financed the cash portion of the purchase price partly through a June 2009 issuance of 38.5 million common shares before the exercise of any overallotment option (June 2009 issuance), according to AGO’s public filings. Prior to the June 2009 issuance, ACE included its investment in AGO in Investments in partially-owned insurance companies using the equity method of accounting. Effective with the June 2009 issuance, ACE was deemed to no longer exert significant influence over AGO for accounting purposes and accounts for the investment in AGO as an available-for-sale equity security.  ACE accounted for AGO’s June 2009 issuance, and resulting dilutive effect, as if the Company had sold a proportionate share of the investment, and recognized a $57 million pre-tax loss in Net realized gains (losses). During the fourth quarter, ACE further reduced it’s ownership in AGO. At December 31, 2009, the fair value of the Company’s investment in AGO was $283 million and a $56 million unrealized gain on this investment is reflected in Accumulated other comprehensive income.

f) Other investments

Other investments at December 31, 2009 and 2008, are as follows:

Investment funds include one highly diversified funds investment as well as several direct funds that employ a variety of investment styles such as long/short equity and arbitrage/distressed. Included in limited partnerships and partially-owned investment companies are 47 individual limited partnerships covering a broad range of investment strategies including large cap buyouts, specialist buyouts, growth capital, distressed, mezzanine, real estate, and co-investments.  The underlying portfolio consists of various public and private debt and equity securities of publicly traded and privately held companies and real estate assets.  The underlying investments across various partnerships, geographies, industries, asset types, and investment strategies provide risk diversification within the limited partnership portfolio and the overall investment portfolio.  Trading securities are comprised of $31 million of equity securities and $11 million of fixed maturities at December 31, 2009, compared with $37 million and $9 million, respectively, at December 31, 2008. The Company maintains rabbi trusts, the holdings of which include all of these trading securities in addition to life insurance policies. Refer to Note 12 f).

g) Investments in partially-owned insurance companies

Investments in partially-owned insurance companies at December 31, 2009 and 2008, are comprised of the following:

Huatai Insurance Company and Huatai Life Insurance Company are China-based entities which provide a range of P&C, life, and investment products.

h) Gross unrealized loss

At December 31, 2009, there were 3,925 fixed maturities out of a total of 18,398 fixed maturities in an unrealized loss position. The largest single unrealized loss in the fixed maturities was $26 million.  The tightening of credit spreads for the year, particularly during the second and third quarters of 2009, resulted in a reduction to net unrealized losses. In addition, greater global demand-driven purchases of fixed income investments and a greater demand for risk-based assets contributed to this reduction. The fixed maturities in an unrealized loss position at December 31, 2009, were comprised of both investment grade and below investment grade securities for which fair value declined primarily due to widening credit spreads since the date of purchase and included non-agency mortgage-backed securities that suffered a decline in value since their original date of purchase.   

The following tables summarize, for all securities in an unrealized loss position at December 31, 2009 and 2008 (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.