AWH-2015.6.30-10Q
Table of Contents

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 ____________________________________
Form 10-Q
(Mark One)
  þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: June 30, 2015
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to              
Commission file number: 001-32938
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
(Exact Name of Registrant as Specified in Its Charter)
Switzerland
98-0681223
(State or Other Jurisdiction of
(I.R.S. Employer
Incorporation or Organization)
Identification No.)
Gubelstrasse 24, Park Tower, 15th Floor, 6300 Zug, Switzerland
(Address of Principal Executive Offices and Zip Code)

41-41-768-1080
(Registrant’s Telephone Number, Including Area Code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No ¨

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

Large accelerated filer þ
Accelerated filer ¨
Non-accelerated filer ¨
Smaller reporting company ¨
 
 
(Do not check if a smaller reporting company)            
                                                     
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No þ
As of July 15, 2015, 90,796,360 common shares were outstanding.

Table of Contents

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

-i-
Table of Contents

PART I
FINANCIAL INFORMATION
Item 1.
Financial Statements.
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
as of June 30, 2015 and December 31, 2014
(Expressed in thousands, except share and per share amounts)
 
June 30,
2015
 
December 31,
2014
 
 
ASSETS:
 
 
 
Fixed maturity investments trading, at fair value (amortized cost: 2015: $6,424,975; 2014: $6,035,240)
$
6,431,543

 
$
6,069,010

Equity securities trading, at fair value (cost: 2015: $757,592; 2014: $791,206)
815,641

 
844,163

Other invested assets
896,790

 
955,509

Total investments
8,143,974

 
7,868,682

Cash and cash equivalents
661,847

 
589,339

Restricted cash
107,069

 
80,971

Insurance balances receivable
944,539

 
664,815

Funds held
462,493

 
724,021

Prepaid reinsurance
399,169

 
360,732

Reinsurance recoverable
1,433,109

 
1,340,256

Reinsurance recoverable on paid losses
88,421

 
86,075

Accrued investment income
31,739

 
28,456

Net deferred acquisition costs
208,034

 
151,546

Goodwill
357,729

 
278,258

Intangible assets
136,368

 
46,298

Balances receivable on sale of investments
122,660

 
47,149

Net deferred tax assets
19,818

 
33,615

Other assets
190,025

 
121,350

Total assets
$
13,306,994

 
$
12,421,563

LIABILITIES:
 
 
 
Reserve for losses and loss expenses
$
6,363,948

 
$
5,881,165

Unearned premiums
1,894,484

 
1,555,313

Reinsurance balances payable
231,350

 
180,060

Balances due on purchases of investments
205,430

 
5,428

Senior notes
798,962

 
798,802

Other long-term debt
24,472

 
19,213

Dividends payable
23,606

 
21,669

Accounts payable and accrued liabilities
139,941

 
181,622

Total liabilities
$
9,682,193

 
$
8,643,272

SHAREHOLDERS’ EQUITY:
 
 
 
Common shares: 2015 and 2014: par value CHF 4.10 per share (2015: 95,523,230; 2014: 100,775,256 shares issued and 2015: 90,796,360; 2014: 96,195,482 shares outstanding)
386,702

 
408,020

Treasury shares, at cost (2015: 4,726,870; 2014: 4,579,774)
(159,186
)
 
(143,075
)
Accumulated other comprehensive loss
(3,272
)
 
—

Retained earnings
3,400,557

 
3,513,346

Total shareholders’ equity
3,624,801

 
3,778,291

Total liabilities and shareholders’ equity
$
13,306,994

 
$
12,421,563

See accompanying notes to the consolidated financial statements.

1
Table of Contents

ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME
for the three and six months ended June 30, 2015 and 2014
(Expressed in thousands, except share and per share amounts)
 
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
2015
 
2014
 
2015
 
2014
REVENUES:
 
 
 
 
 
 
 
Gross premiums written
$
825,970

 
$
760,405

 
$
1,706,584

 
$
1,661,798

Premiums ceded
(222,301
)
 
(206,481
)
 
(330,387
)
 
(336,260
)
Net premiums written
603,669

 
553,924

 
1,376,197

 
1,325,538

Change in unearned premiums
42,707

 
(16,677
)
 
(161,273
)
 
(258,006
)
Net premiums earned
646,376

 
537,247

 
1,214,924

 
1,067,532

Net investment income
42,760

 
36,793

 
87,311

 
84,412

Net realized investment (losses) gains
(20,182
)
 
85,217

 
24,843

 
139,422

Other income
924

 
—

 
1,778

 
—

Total revenue
669,878

 
659,257

 
1,328,856

 
1,291,366

EXPENSES:
 
 
 
 
 
 
 
Net losses and loss expenses
431,521

 
314,855

 
756,697

 
590,141

Acquisition costs
100,618

 
74,279

 
179,317

 
142,001

General and administrative expenses
108,363

 
96,188

 
205,501

 
176,528

Other expenses
1,235

 
—

 
3,058

 
—

Amortization of intangible assets
2,819

 
634

 
3,452

 
1,267

Interest expense
14,466

 
14,592

 
28,803

 
29,126

Foreign exchange loss
1,265

 
651

 
11,162

 
700

Total expenses
660,287

 
501,199

 
1,187,990

 
939,763

Income before income taxes
9,591

 
158,058

 
140,866

 
351,603

Income tax expense
133

 
6,195

 
7,052

 
22,768

NET INCOME
9,458

 
151,863

 
133,814

 
328,835

Other comprehensive loss: foreign currency translation adjustment, net of tax
(3,272
)
 
—

 
(3,272
)
 
—

COMPREHENSIVE INCOME
$
6,186

 
$
151,863

 
$
130,542

 
$
328,835

PER SHARE DATA
 
 
 
 
 
 
 
Basic earnings per share
$
0.10

 
$
1.55

 
$
1.42

 
$
3.33

Diluted earnings per share
$
0.10

 
$
1.52

 
$
1.40

 
$
3.27

Weighted average common shares outstanding
92,441,730

 
97,809,639

 
94,178,989

 
98,672,618

Weighted average common shares and common share equivalents outstanding
93,984,226

 
99,724,802

 
95,830,455

 
100,691,568

Dividends paid per share
$
0.225

 
$
0.167

 
$
0.450

 
$
0.333


See accompanying notes to the consolidated financial statements.

2
Table of Contents

ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
for the six months ended June 30, 2015 and 2014
(Expressed in thousands)
 
 
Share
Capital
 
Treasury
Shares
 
Accumulated
Other
Comprehensive
Income
 
Retained
Earnings
 
Total
December 31, 2014
$
408,020

 
$
(143,075
)
 
$
—

 
$
3,513,346

 
$
3,778,291

Net income
—

 
—

 
—

 
133,814

 
133,814

Dividends
—

 
—

 
—

 
(45,114
)
 
(45,114
)
Stock compensation
—

 
15,458

 
—

 
(9,075
)
 
6,383

Share repurchases
—

 
(245,301
)
 
—

 
—

 
(245,301
)
Shares canceled
(21,318
)
 
213,732

 
—

 
(192,414
)
 
—

Foreign currency translation adjustment
—

 
—

 
(3,272
)
 
—

 
(3,272
)
June 30, 2015
$
386,702

 
$
(159,186
)
 
$
(3,272
)
 
$
3,400,557

 
$
3,624,801

 
 
 
 
 
 
 
 
 
 
December 31, 2013
$
418,988

 
$
(79,992
)
 
$
—

 
$
3,180,830

 
$
3,519,826

Net income
—

 
—

 
—

 
328,835

 
328,835

Dividends
—

 
—

 
—

 
(38,345
)
 
(38,345
)
Stock compensation
—

 
14,734

 
—

 
(2,756
)
 
11,978

Share repurchases
—

 
(139,532
)
 
—

 
—

 
(139,532
)
Shares canceled
(16,081
)
 
139,532

 
—

 
(123,451
)
 
—

June 30, 2014
$
402,907

 
$
(65,258
)
 
$
—

 
$
3,345,113

 
$
3,682,762

 
See accompanying notes to the consolidated financial statements.

3
Table of Contents

ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
for the six months ended June 30, 2015 and 2014
(Expressed in thousands)
 
Six Months Ended 
 June 30,
 
2015
 
2014
CASH FLOWS PROVIDED BY OPERATING ACTIVITIES:
 
 
 
Net income
$
133,814

 
$
328,835

Adjustments to reconcile net income to cash provided by operating activities:
 
 
 
Net realized gains on sales of investments
(58,224
)
 
(99,781
)
Mark to market adjustments
35,592

 
(59,113
)
Stock compensation expense
7,871

 
7,631

Undistributed income of equity method investments
15,987

 
13,744

Changes in:
 
 
 
Reserve for losses and loss expenses, net of reinsurance recoverables
132,927

 
101,911

Unearned premiums, net of prepaid reinsurance
160,437

 
258,006

Insurance balances receivable
(162,313
)
 
(298,440
)
Reinsurance recoverable on paid losses
(2,346
)
 
(12,445
)
Funds held
261,528

 
217,985

Reinsurance balances payable
11,479

 
51,159

Net deferred acquisition costs
(17,622
)
 
(36,598
)
Net deferred tax assets
(2,691
)
 
1,934

Accounts payable and accrued liabilities
(54,603
)
 
(53,397
)
Other items, net
(34,434
)
 
27,507

Net cash provided by operating activities
427,402

 
448,938

CASH FLOWS USED IN INVESTING ACTIVITIES:
 
 
 
Purchases of trading securities
(2,854,825
)
 
(3,905,650
)
Purchases of other invested assets
(73,131
)
 
(181,419
)
Sales of trading securities
2,953,661

 
3,705,229

Sales of other invested assets
85,502

 
184,166

Purchases of fixed assets
(17,984
)
 
(5,601
)
Change in restricted cash
(26,098
)
 
21,638

Net cash paid for acquisitions
(141,503
)
 
(2,565
)
Net cash used in investing activities
(74,378
)
 
(184,202
)
CASH FLOWS USED IN FINANCING ACTIVITIES:
 
 
 
Dividends paid
(43,191
)
 
(33,207
)
Proceeds from the exercise of stock options
7,389

 
6,313

Share repurchases
(246,443
)
 
(137,810
)
Proceeds from other long-term debt
3,928

 
—

Net cash used in financing activities
(278,317
)
 
(164,704
)
Effect of exchange rate changes on foreign currency cash
(2,199
)
 
3,170

NET INCREASE IN CASH AND CASH EQUIVALENTS
72,508

 
103,202

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
589,339

 
531,936

CASH AND CASH EQUIVALENTS, END OF PERIOD
$
661,847

 
$
635,138

Supplemental disclosure of cash flow information:
 
 
 
Cash paid for income taxes
$
1,922

 
$
18,061

Cash paid for interest expense
$
27,000

 
$
27,000

See accompanying notes to the consolidated financial statements.

4
Table of Contents

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

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

During the fourth quarter of 2014, the Company reorganized how it manages its business, and as a result it realigned its executive management team and changed its reportable segments to correspond to the reorganization. The Company's Bermuda insurance operations, except for the trade credit line of business, which had previously been included in the international insurance segment, was combined with the U.S. insurance segment, with the new segment renamed the "North American Insurance" segment. The remaining direct insurance operations of the international insurance segment were renamed the "Global Markets Insurance" segment. The Reinsurance segment remained unchanged. The newly created segments are included in Note 12 and prior periods have been recast to conform to the new presentation.

2. BASIS OF PREPARATION AND CONSOLIDATION

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

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The significant estimates reflected in the Company’s financial statements, include, but are not limited to:

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

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

These unaudited condensed consolidated financial statements, including these notes, should be read in conjunction with the Company’s audited consolidated financial statements, and related notes thereto, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014.
3. NEW ACCOUNTING PRONOUNCEMENTS
In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update 2014-09, "Revenue from Contracts with Customers" ("ASU 2014-09"). ASU 2014-09 provides a framework, through a five-step process, for recognizing revenue from customers, improves comparability and consistency of recognizing revenue across entities, industries, jurisdictions and capital markets, and requires enhanced disclosures. Certain contracts with customers are specifically excluded from the scope of ASU 2014-09, including, among others, insurance contracts accounted for under Accounting Standard Codification 944, Financial Services - Insurance. ASU 2014-09 is effective on January 1, 2017 with

5
Table of Contents
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


retrospective adoption required for the comparative periods. The FASB has approved a one-year deferral of the effective date of ASU 2014-09, such that it will become effective on January 1, 2018. The Company is currently assessing the impact the adoption of ASU 2014-09 will have on future financial statements and related disclosures.
In February 2015, the FASB issued Accounting Standards Update 2015-02, "Amendments to the Consolidation Analysis" ("ASU 2015-02"). ASU 2015-02 amends certain aspects of the consolidation guidance in U.S. GAAP. In particular, it will modify the evaluation of whether limited partnerships and similar legal entities are variable interest entities ("VIEs") or voting interest entities and also eliminates the presumption that a general partner should consolidate a limited partnership, if certain conditions are met. The new guidance will also affect the consolidation analysis of the Company's interests in VIEs, particularly those that have fee arrangements and related party relationships. ASU 2015-02 is effective on January 1, 2016 and adoption is required retrospectively either through a modified retrospective approach by recording a cumulative-effect adjustment to shareholders' equity as of the beginning of the year of adoption or retrospectively for all comparative periods. The Company is currently assessing the impact the adoption of ASU 2015-02 will have on future financial statements and related disclosures.
In May 2015, the FASB issued Accounting Standards Update 2015-07, "Fair Value Measurements (Topic 820): Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent)" ("ASU 2015-07"). ASU 2015-07 removes the requirement to categorize within the fair value hierarchy investments for which fair value is measured using the net asset value per share practical expedient. The Company has applied the net asset value per share practical expedient to all of its private equity and hedge funds in determining fair value. The Company early adopted ASU 2015-07 during the quarter ended June 30, 2015, and as a result removed the fair value category for its investments that are measured using the net asset value per share practical expedient that is disclosed in Note 7.
In May 2015, the FASB issued Accounting Standards Update 2015-09, "Financial Services - Insurance (Topic 944): Disclosures about Short-Duration Contracts" ("ASU 2015-09"). ASU 2015-09 provides enhanced disclosures, on an annual basis, related to the reserve for losses and loss expenses. The enhanced disclosures required by ASU 2015-09 include (1) net incurred and paid claims development information by accident year, (2) a reconciliation of incurred and paid claims development information to the aggregate carrying amount of the reserve for losses and loss expenses, (3) for each accident year presented of incurred claims development information, the total of reserves for incurred but not reported (IBNR), including expected development on reported claims, included in the reserve for losses and loss expenses and a description of the reserving methodologies and changes to the reserving methodologies, and (4) for each accident year presented of incurred claims development information, quantitative information about claims frequency, as well as a description of methodologies used for determining claim frequency information. ASU 2015-09 is effective for annual periods beginning after December 15, 2015, and as such the disclosures will first be presented in the Company's Annual Report on Form 10-K for the year ended December 31, 2016. The Company is currently assessing the impact the adoption of ASU 2015-09 will have on future disclosures.

4. ACQUISITIONS

a) Hong Kong and Singapore Branches of Royal & Sun Alliance Insurance plc

On April 1, 2015, the Company completed its acquisitions of certain assets and assumed certain liabilities of the Hong Kong and Singapore operations of Royal & Sun Alliance Insurance plc ("RSA") to further expand its international insurance operations. The assets acquired and liabilities assumed constituted a business, and as such the Company accounted for the acquisitions of the RSA branches under the acquisition method in accordance with U.S. GAAP. The initial cash consideration for the branches was $193,889. There were post-closing adjustments based on the net asset value of the acquired branches at the date of acquisitions that resulted in a decrease in the initial consideration of $31,160. The post-closing adjustments are still being agreed upon with RSA and as such the assets acquired and liabilities assumed are still preliminary and will be adjusted during the measurement period. In addition, completion of the valuation of the assets acquired and liabilities assumed is currently in process and will be finalized during the measurement period. As part of the acquisitions, the Company has incurred a total of $7,985 in acquisition related expenses mostly related to advisory, legal and valuation services rendered, which were recorded in “other expense” in the unaudited condensed consolidated statements of operations and comprehensive income (“consolidated income statements”).


6
Table of Contents
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


The following table summarizes the consideration paid for the Hong Kong and Singapore branches of RSA and the preliminary amounts of the assets acquired and liabilities assumed at the acquisition date.
Consideration:
 
Fair Value
Cash for initial consideration
 
$
193,889

Receivable for post-closing adjustments
 
(31,160
)
Fair value of consideration transferred
 
162,729

 
 
 
Recognized amounts of identifiable assets acquired and liabilities assumed:
 
 
Fixed maturity investments
 
245,997

Cash and cash equivalents
 
46,853

Insurance balances receivable
 
113,922

Prepaid reinsurance
 
17,491

Reinsurance recoverable
 
57,350

Value of business acquired

37,104

Intangible assets
 
90,600

Other assets
 
10,041

Reserve for losses and loss expenses
 
(310,198
)
Unearned premiums
 
(150,530
)
Reinsurance balances payable
 
(35,734
)
Net deferred tax liabilities
 
(16,488
)
Accounts payable and accrued liabilities
 
(19,918
)
Total identifiable net assets acquired
 
86,490

 
 
 
Goodwill
 
76,239

Total net assets acquired
 
$
162,729

Of the $76,239 of goodwill acquired, $52,427 and $23,812 related to the Singapore and Hong Kong branches, respectively. All of the goodwill has been allocated to the Global Markets Insurance segment as all of the results of the international insurance operations are included in that segment and the expected synergies from these acquisitions are to be realized in that segment.
The Company recognized identifiable finite lived intangible assets, including an intangible asset for the value of businesses acquired (“VOBA”), which will be amortized over a weighted average period of 12 years. The following is a breakdown of the intangible assets acquired.
 
 
Singapore
 Branch
 
Estimated Useful Life
 
Hong Kong Branch
 
Estimated Useful Life
 
Total
VOBA
 
$
19,845

 
2 years
 
$
17,259

 
1.5 years
 
$
37,104

Customer renewals
 
8,600

 
4 years
 
6,800

 
7 years
 
15,400

Distribution channels
 
48,500

 
18 years
 
26,700

 
18 years
 
75,200

 
 
$
76,945

 
 
 
$
50,759

 
 
 
$
127,704

The following is an explanation of identifiable finite lived intangible assets acquired:
•
VOBA: Represents the difference between the expected future losses and expenses and the associated unearned premium reserve. This intangible asset will be amortized consistent with how the associated unearned premiums will be earned and will be recorded in “acquisition costs” in the consolidated income statements.

7
Table of Contents
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


•
Customer renewals: The value of inforce policies renewing taking into consideration the net cash flows generated from these renewals. The amortization expense for this intangible asset will be recorded in “amortization of intangible assets” in the consolidated income statements.
•
Distribution channels: The value of access to contractual and non-contractual relationships (e.g., brokers and affinity relationships) taking into consideration the net cash flows generated from these relationships. The amortization expense for this intangible asset will be recorded in “amortization of intangible assets” in the consolidated income statements.

The following summarizes the results of the Hong Kong and Singapore branches that have been included in the Company’s consolidated income statement since the acquisitions closed on April 1, 2015.
 
 
From April 1, 2015 to June 30, 2015
Total revenue
 
$
53,391

Net loss
 
$
(2,758
)
The following unaudited pro forma information presents the combined results of the Company and the acquired Hong Kong and Singapore RSA branches for the six months ended June 30, 2015 and 2014, with pro forma adjustments related to the acquisition method of accounting as if the acquisitions had been consummated as of January 1, 2014, which is the beginning of the earliest period presented. This unaudited pro forma information is not necessarily indicative of what would have occurred had the acquisitions and related transactions been made on the dates indicated, or of future results of the Company.
 
 
Six Months Ended June 30, 2015
 
Six Months Ended June 30, 2014
Total revenue
 
$
1,376,757

 
$
1,427,933

Net income
 
$
123,307

 
$
340,961

b) Acquisition of Labuan branch of RSA

On April 30, 2015, the Company also acquired the assets and assumed the liabilities of the Labuan operations of RSA. This transaction closed on April 30, 2015 for consideration of one British pound sterling. The Company recorded goodwill of $1,396 related to this acquisition. The goodwill has been allocated to the Global Markets Insurance segment.
c) Acquisition of Latin American Underwriters Holdings, Ltd.
In January 2015, the Company acquired Latin American Underwriters Holdings Ltd. (“LAU”) for $5,105. LAU had previously underwritten trade credit insurance and political risk coverages solely for the Company since 2010. As part of the acquisition, the Company recorded goodwill of $2,467 and customer relationship intangibles of $3,610, which have a five-year useful life. The Company also recorded $1,000 of contingent consideration related to certain earn-out payments. The goodwill has been allocated to the Global Markets Insurance segment.



8
Table of Contents
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


5. INVESTMENTS

a) Trading Securities

Securities accounted for at fair value with changes in fair value recognized in the consolidated income statements by category are as follows:
 
June 30, 2015
 
December 31, 2014
 
Fair Value
 
Amortized Cost
 
Fair Value
 
Amortized Cost
U.S. government and government agencies
$
1,280,844

 
$
1,277,547

 
$
1,610,502

 
$
1,610,880

Non-U.S. government and government agencies
411,550

 
421,778

 
188,199

 
196,332

States, municipalities and political subdivisions
348,823

 
348,288

 
170,567

 
165,615

Corporate debt:
 
 
 
 
 
 
 
Financial institutions
1,055,836

 
1,053,576

 
1,024,667

 
1,018,777

Industrials
1,226,827

 
1,238,948

 
1,029,729

 
1,037,820

Utilities
121,571

 
122,793

 
110,997

 
111,599

Mortgage-backed
1,263,019

 
1,234,126

 
1,263,517

 
1,219,712

Asset-backed
723,073

 
727,919

 
670,832

 
674,505

Total fixed maturity investments
$
6,431,543

 
$
6,424,975

 
$
6,069,010

 
$
6,035,240

 
June 30, 2015
 
December 31, 2014
 
Fair Value
 
Original Cost
 
Fair Value
 
Original Cost
Equity securities
$
815,641

 
$
757,592

 
$
844,163

 
$
791,206

Other invested assets
769,173

 
685,897

 
812,543

 
725,069

 
$
1,584,814

 
$
1,443,489

 
$
1,656,706

 
$
1,516,275


Other invested assets, included in the table above, include investments in private equity funds, hedge funds and a high yield loan fund that are accounted for at fair value, but excludes other private securities described below in Note 5(b) that are accounted for using the equity method of accounting.


9
Table of Contents
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


b) Other Invested Assets

Details regarding the carrying value, redemption characteristics and unfunded investment commitments of the other invested assets portfolio as of June 30, 2015 and December 31, 2014 were as follows:

Investment Type
Carrying Value as of June 30, 2015
 
Investments
with
Redemption
Restrictions
 
Estimated
Remaining
Restriction
Period
 
Investments
without
Redemption
Restrictions
 
Redemption
Frequency(1)
 
Redemption
Notice
Period(1)
 
Unfunded
Commitments
Private equity
$
198,302

 
$
198,302

 
2 - 8 Years
 
$
—

 
 
 
 
 
$
180,988

Mezzanine debt
183,002

 
183,002

 
5 - 9 Years
 
—

 
 
 
 
 
255,333

Distressed
6,088

 
6,088

 
3 Years
 
—

 
 
 
 
 
5,561

Real estate
—

 
—

 
9 Years
 
—

 
 
 
 
 
150,000

Total private equity
387,392

 
387,392

 
 
 
—

 
 
 
 
 
591,882

Distressed
170,858

 
—

 
 
 
—

 
Based on net asset value
 
60 Days
 
—

Equity long/short
60,103

 
—

 

 
60,103

 
Quarterly
 
30 -60 Days
 
—

Relative value credit
120,939

 
—

 
 
 
120,939

 
Quarterly
 
60 Days
 
—

Total hedge funds
351,900

 
—

 
 
 
181,042

 
 
 
 
 
—

High yield loan fund
29,881

 
—

 
 
 
29,881

 
Monthly
 
30 days
 
—

Total other invested assets at fair value
769,173

 
387,392

 
 
 
210,923

 
 
 
 
 
591,882

Other private securities
127,617

 
—

 
 
 
127,617

 
 
 
 
 
—

Total other invested assets
$
896,790

 
$
387,392

 
 
 
$
338,540

 
 
 
 
 
$
591,882


Investment Type
Carrying Value as of December 31, 2014
 
Investments
with
Redemption
Restrictions
 
Estimated
Remaining
Restriction
Period
 
Investments
without
Redemption
Restrictions
 
Redemption
Frequency(1)
 
Redemption
Notice
Period(1)
 
Unfunded
Commitments
Private equity
$
184,576

 
$
184,576

 
2 - 8 Years
 
$
—

 
 
 
 
 
$
223,802

Mezzanine debt
166,905

 
166,905

 
5 - 9 Years
 
—

 
 
 
 
 
204,232

Distressed
5,869

 
5,869

 
3 Years
 
—

 
 
 
 
 
5,180

Real estate
—

 
—

 
9 Years
 
—

 
 
 
 
 
50,000

Total private equity
357,350

 
357,350

 
 
 
—

 
 
 
 
 
483,214

Distressed
170,169

 
170,169

 
1 Year
 
—

 
Based on net asset value
 
60 Days
 
—

Equity long/short
84,198

 
—

 
 
 
84,198

 
Quarterly
 
30 -60 Days
 
—

Multi-strategy
51,507

 
—

 
 
 
51,507

 
Quarterly
 
45 -90 Days
 
—

Relative value credit
119,156

 
—

 
 
 
119,156

 
Quarterly
 
60 Days
 
—

Total hedge funds
425,030

 
170,169

 
 
 
254,861

 
 
 
 
 
—

High yield loan fund
30,163

 
—

 
 
 
30,163

 
Monthly
 
30 days
 
—

Total other invested assets at fair value
812,543

 
527,519

 
 
 
285,024

 
 
 
 
 
483,214

Other private securities
142,966

 
—

 
 
 
142,966

 
 
 
 
 
—

Total other invested assets
$
955,509

 
$
527,519

 
 
 
$
427,990

 
 
 
 
 
$
483,214

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

10
Table of Contents
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


In general, the Company has invested in hedge funds that require at least 30 days’ notice of redemption and may be redeemed on a monthly, quarterly, semi-annual, annual or longer basis, depending on the fund. Certain hedge funds have lock-up periods ranging from one to three years from initial investment. A lock-up period refers to the initial amount of time an investor is contractually required to invest before having the ability to redeem. Funds that provide for periodic redemptions may, depending on the funds’ governing documents, have the ability to deny or delay a redemption request, called a “gate.” The fund may implement this restriction because the aggregate amount of redemption requests as of a particular date exceeds a specified level, generally ranging from 15% to 25% of the fund’s net assets. The gate is a method for executing an orderly redemption process to reduce the possibility of adversely affecting investors in the fund. Typically, the imposition of a gate delays a portion of the requested redemption, with the remaining portion settled in cash sometime after the redemption date. Certain funds may impose a redemption fee on early redemptions. Interests in private equity funds cannot be redeemed because the investments include restrictions that do not allow for redemption until termination of the fund.

The following describes each investment type:

•
Private equity funds: Primary funds may invest in companies and general partnership interests. Secondary funds buy limited partnership interests from existing limited partners of primary private equity funds. As owners of private equity funds seek liquidity, they can sell their existing investments, plus any remaining commitment, to secondary market participants. These funds cannot be redeemed because the investments include restrictions that do not allow for redemption until termination of the fund.
•
Mezzanine debt funds: Mezzanine debt funds primarily focus on providing capital to upper middle market and middle market companies and private equity sponsors, in connection with leveraged buyouts, mergers and acquisitions, recapitalizations, growth financings and other corporate transactions. The most common position in the capital structure will be between the senior secured debt holder and the equity; however, the funds will utilize a flexible approach when structuring investments, which may include secured debt, subordinated debt, preferred stock and/or private equity. These funds cannot be redeemed because the investments include restrictions that do not allow for redemption until termination of the fund.
•
Distressed funds: In distressed debt investing, managers take positions in the debt of companies experiencing significant financial difficulties, including bankruptcy, or in certain positions of the capital structure of structured securities. The manager relies on the fundamental analysis of these securities, including the claims on the assets and the likely return to bondholders. Certain funds cannot be redeemed because the investments include restrictions that do not allow for redemption until termination of the fund.
•
Real estate funds: Private real estate funds invest directly in commercial real estate (multifamily units, industrial buildings, office spaces and retail stores) and some residential property.  Real estate managers have diversified portfolios that generally follow core, core-plus, value-added or opportunistic strategies.  These funds cannot be redeemed because the investments include restrictions that do not allow for redemption until termination of the fund.
•
Equity long/short funds: In equity long/short funds, managers take long positions in companies they deem to be undervalued and short positions in companies they deem to be overvalued. Long/short managers may invest in countries, regions or sectors and vary by their use of leverage and by their targeted net long position.
•
Relative value credit funds: These funds seek to take exposure to credit-sensitive securities, long and/or short, based upon credit analysis of issuers and securities and credit market views.
•
Multi-strategy funds: These funds may utilize many strategies employed by specialized funds including distressed investing, equity long/short, merger arbitrage, convertible arbitrage, fixed income arbitrage and macro trading.
•
High yield loan fund: A long-only private mutual fund that invests in high yield fixed income securities.
•
Other private securities: These securities include strategic non-controlling minority investments in private asset management companies and other insurance related investments that are accounted for using the equity method of accounting.

11
Table of Contents
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


c) Net Investment Income
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
2015
 
2014
 
2015
 
2014
Fixed maturity investments
$
41,205

 
$
35,936

 
$
77,463

 
$
72,235

Equity securities
4,862

 
5,912

 
8,425

 
9,165

Other invested assets: hedge funds and private equity
4,583

 
2,527

 
12,963

 
6,519

Other invested assets: other private securities
(3,789
)
 
(3,417
)
 
(2,923
)
 
3,999

Cash and cash equivalents
439

 
571

 
901

 
1,010

Expenses
(4,540
)
 
(4,736
)
 
(9,518
)
 
(8,516
)
Net investment income
$
42,760

 
$
36,793

 
$
87,311

 
$
84,412


The loss from other invested assets: other private securities for the three months ended June 30, 2015 included an other-than-temporary impairment of $6,261 related to one of the Company's equity method investments. The Company recorded the other-than-temporary impairment as the fair value of this investment was below its carrying value. The loss from other invested assets: other private securities for the three months ended June 30, 2014 was due to a loss of $9,348 recorded for the same equity method investment due to impairment charges that it recorded. At the time, the Company determined the fair value of this investment and concluded that the fair value exceeded the Company's carrying value and as such no other-than-temporary impairment was recorded.

d) Components of Realized Gains and Losses

 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
2015
 
2014
 
2015
 
2014
Gross realized gains on sale of invested assets
$
36,079

 
$
55,714

 
$
81,368

 
$
118,006

Gross realized losses on sale of invested assets
(10,059
)
 
(4,025
)
 
(23,063
)
 
(16,273
)
Net realized and unrealized gains (losses) on derivatives
13,920

 
(13,720
)
 
2,288

 
(26,640
)
Mark-to-market (losses) gains:
 
 
 
 
 
 
 
Fixed maturity investments, trading
(52,688
)
 
36,426

 
(27,171
)
 
58,882

Equity securities, trading
(329
)
 
21,316

 
5,091

 
(289
)
Other invested assets, trading
(7,105
)
 
(10,494
)
 
(13,670
)
 
5,736

Net realized investment (losses) gains
$
(20,182
)
 
$
85,217

 
$
24,843

 
$
139,422


e) Pledged Assets

As of June 30, 2015 and December 31, 2014, $2,936,338 and $3,585,792, respectively, of cash and cash equivalents and investments were deposited, pledged or held in trust accounts in favor of ceding companies and other counterparties or government authorities to comply with reinsurance contract provisions, insurance laws and other contract provisions.

In addition, as of June 30, 2015 and December 31, 2014, a further $577,508 and $571,750, respectively, of cash and cash equivalents and investments were pledged as collateral for the Company’s letter of credit facilities. See Note 10(f) to the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014 for details on the Company’s credit facilities.

       

12
Table of Contents
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


6. DERIVATIVE INSTRUMENTS

As of June 30, 2015 and December 31, 2014, none of the Company’s derivatives were designated as hedges for accounting purposes. The following table summarizes information on the location and amounts of derivative fair values on the unaudited condensed consolidated balance sheets (“consolidated balance sheets”):
 
 
June 30, 2015
 
December 31, 2014
 
Asset
Derivative 
Notional
Amount
 
Asset
Derivative 
Fair Value 
 
Liability
Derivative 
Notional
Amount
 
Liability
Derivative 
Fair Value
 
Asset
Derivative 
Notional
Amount
 
Asset
Derivative 
Fair Value
 
Liability
Derivative 
Notional
Amount
 
Liability
Derivative
Fair Value 
Foreign exchange contracts
$
7,358

 
$
76

 
$
316

 
$
—

 
$
33,875

 
$
1,274

 
$
167,376

 
$
991

Interest rate swaps
648,700

 
228

 
—

 
—

 
—

 
—

 
571,500

 
683

Total derivatives
$
656,058

 
$
304

 
$
316

 
$
—

 
$
33,875

 
$
1,274

 
$
738,876

 
$
1,674


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

The following table provides the net realized and unrealized gains (losses) on derivatives not designated as hedges recorded on the consolidated income statements:
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
2015
 
2014
 
2015
 
2014
Foreign exchange contracts
$
1,194

 
$
(1,598
)
 
$
(6,158
)
 
$
(2,466
)
Total included in foreign exchange loss
1,194

 
(1,598
)
 
(6,158
)
 
(2,466
)
Foreign exchange contracts
(256
)
 
(286
)
 
794

 
(844
)
Interest rate futures and swaps
14,176

 
(13,434
)
 
1,494

 
(25,796
)
Total included in net realized investment (losses) gains
13,920

 
(13,720
)
 
2,288

 
(26,640
)
Total realized and unrealized gains (losses) on derivatives
$
15,114

 
$
(15,318
)
 
$
(3,870
)
 
$
(29,106
)

Derivative Instruments Not Designated as Hedging Instruments

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

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

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

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

13
Table of Contents
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


7. FAIR VALUE OF FINANCIAL INSTRUMENTS

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

The following table shows the fair value of the Company’s financial instruments and where in the fair value hierarchy the fair value measurements are included as of the dates indicated below:
June 30, 2015
 
Carrying
Amount
 
Total
Fair Value
 
Level 1
 
Level 2
 
Level 3
Fixed maturity investments:
 
 
 
 
 
 
 
 
 
 
U.S. government and government agencies
 
$
1,280,844

 
$
1,280,844

 
$
1,222,556

 
$
58,288

 
$
—

Non-U.S. government and government agencies
 
411,550

 
411,550

 
—

 
411,550

 
—

States, municipalities and political subdivisions
 
348,823

 
348,823

 
—

 
348,823

 
—

Corporate debt
 
2,404,234

 
2,404,234

 
—

 
2,404,234

 
—

Mortgage-backed
 
1,263,019

 
1,263,019

 
—

 
1,163,382

 
99,637

Asset-backed
 
723,073

 
723,073

 
—

 
639,165

 
83,908

Total fixed maturity investments
 
6,431,543

 
6,431,543

 
1,222,556

 
5,025,442

 
183,545

Equity securities
 
815,641

 
815,641

 
757,834

 
—

 
57,807

Other invested assets(1)
 
769,173

 
769,173

 
—

 
—

 
769,173

Total investments
 
$
8,016,357

 
$
8,016,357

 
$
1,980,390

 
$
5,025,442

 
$
1,010,525

Derivative assets:
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
 
$
76

 
$
76

 
$
—

 
$
76

 
$
—

Interest rate swaps
 
228

 
228

 
—

 
228

 
—

Senior notes
 
798,962

 
$
865,809

 
$
—

 
$
865,809

 
$
—

Other long-term debt
 
24,472

 
$
29,927

 
$
—

 
$
29,927

 
$
—


14
Table of Contents
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


December 31, 2014
 
Carrying
Amount
 
Total
Fair Value
 
Level 1
 
Level 2
 
Level 3
Fixed maturity investments:
 
 
 
 
 
 
 
 
 
 
U.S. government and government agencies
 
$
1,610,502

 
$
1,610,502

 
$
1,499,347

 
$
111,155

 
$
—

Non-U.S. government and government agencies
 
188,199

 
188,199

 
—

 
188,199

 
—

States, municipalities and political subdivisions
 
170,567

 
170,567

 
—

 
170,567

 
—

Corporate debt
 
2,165,393

 
2,165,393

 
—

 
2,165,393

 
—

Mortgage-backed
 
1,263,517

 
1,263,517

 
—

 
1,081,734

 
181,783

Asset-backed
 
670,832

 
670,832

 
—

 
615,419

 
55,413

Total fixed maturity investments
 
6,069,010

 
6,069,010

 
1,499,347

 
4,332,467

 
237,196

Equity securities
 
844,163

 
844,163

 
800,833

 
—

 
43,330

Other invested assets(1)
 
812,543

 
812,543

 
—

 
—

 
—

Total investments
 
$
7,725,716

 
$
7,725,716

 
$
2,300,180

 
$
4,332,467

 
$
280,526

Derivative assets:
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
 
$
1,274

 
$
1,274

 
$
—

 
$
1,274

 
$
—

Derivative liabilities:
 
 
 
 
 
 
 
 
 
 
Foreign exchange contracts
 
$
991

 
$
991

 
$
—

 
$
991

 
$
—

Interest rate swaps
 
$
683

 
$
683

 
$
—

 
$
683

 
$
—

Senior notes
 
$
798,802

 
$
879,317

 
$
—

 
$
879,317

 
$
—

Other long-term debt
 
$
19,213

 
$
22,583

 
$
—

 
$
22,583

 
$
—

_______________________
(1) In accordance with U.S. GAAP, other invested assets, excluding other private securities, are measured at fair value using the net asset value per share (or its equivalent) practical expedient and have not been classified in the fair value hierarchy.

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

Recurring Fair Value of Financial Instruments

U.S. government and government agencies: Comprised primarily of bonds issued by the U.S. Treasury, the Federal Home Loan Bank, the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association. The fair values of the Company’s U.S. government securities are based on quoted market prices in active markets and are included in the Level 1 fair value hierarchy. The Company believes the market for U.S. Treasury securities is an actively traded market given the high level of daily trading volume. The fair values of U.S. government agency securities are priced using the spread above the risk-free yield curve. As the yields for the risk-free yield curve and the spreads for these securities are observable market inputs, the fair values of U.S. government agency securities are included in the Level 2 fair value hierarchy.

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

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

Corporate debt: Comprised of bonds issued by or loan obligations of corporations that are diversified across a wide range of issuers and industries. The fair values of corporate debt that are short-term are priced using spread above the LIBOR yield curve, and the fair values of corporate debt that are long-term are priced using the spread above the risk-free yield curve. The spreads are sourced from broker-dealers, trade prices and the new issue market. As the significant inputs used to price corporate bonds are observable market inputs, the fair values of corporate debt are included in the Level 2 fair value hierarchy.


15
Table of Contents
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


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

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

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

Other invested assets: Comprised of funds invested in a range of diversified strategies. In accordance with U.S. GAAP, the fair values of the funds are based on the net asset value of the funds as reported by the fund manager.

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

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

Other long-term debt: Comprised of the mortgage and credit facility associated with the purchase of office space in Switzerland. The fair value of the other long-term debt is based on the value of the debt using current interest rates. The fair value of the other long-term debt is included in the Level 2 fair value hierarchy.

Non-recurring Fair Value of Financial Instruments

The Company measures the fair value of certain assets on a non-recurring basis, generally quarterly, annually or when events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. These assets include investments accounted for using the equity method, goodwill and intangible assets. The Company uses a variety of techniques to measure the fair value of these assets when appropriate, as described below:

Investments accounted for using the equity method: When the Company determines that the carrying value of these assets may not be recoverable, the Company records the assets at fair value with the loss recognized in income. In such cases, the Company measures the fair value of these assets using discounted expected future cash flow and market multiple models. During the three months ended June 30, 2014, the Company recorded a write-down to fair value of one of its equity method investments. The fair value of the equity method investment was $6,000 as of June 30, 2015 and was determined using both expected future cash flows and market multiple models.

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



16
Table of Contents
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


Rollforward of Level 3 Financial Instruments

The following is a reconciliation of the beginning and ending balance of financial instruments using significant unobservable inputs (Level 3):
Three Months Ended June 30, 2015
Mortgage-backed
 
Asset-backed
 
Equities
Opening balance
$
132,698

 
$
92,932

 
$
48,767

Realized and unrealized (losses) gains included in net income
(2,256
)
 
(462
)
 
9,040

Purchases
4,206

 
2,170

 
—

Sales
(35,279
)
 
(7,230
)
 
—

Transfers into Level 3 from Level 2
268

 
17,376

 
—

Transfers out of Level 3 into Level 2 (1)
—

 
(20,878
)
 
—

Ending balance
$
99,637

 
$
83,908

 
$
57,807

Three Months Ended June 30, 2014
 
 
 
 
 
Opening balance
$
134,061

 
$
81,234

 
$
34,786

Realized and unrealized gains included in net income
2,721

 
450

 
77

Purchases
20,928

 
9,409

 
—

Sales
(26,734
)
 
(3,743
)
 
—

Transfers into Level 3 from Level 2
17,437

 
—

 
—

Transfers out of Level 3 into Level 2 (1)
(1,612
)
 
(16,118
)
 
—

Ending balance
$
146,801

 
$
71,232

 
$
34,863

Six Months Ended June 30, 2015
Mortgage-backed
 
Asset-backed
 
Equities
Opening balance
$
181,783

 
$
55,413

 
$
43,330

Realized and unrealized (losses) gains included in net income
(669
)
 
(564
)
 
14,477

Purchases
6,393

 
23,304

 
—

Sales
(88,138
)
 
(9,899
)
 
—

Transfers into Level 3 from Level 2
268

 
43,907

 
—

Transfers out of Level 3 into Level 2 (1)
—

 
(28,253
)
 
—

Ending balance
$
99,637

 
$
83,908

 
$
57,807

Six Months Ended June 30, 2014
 
 
 
 
 
Opening balance
$
147,338

 
$
93,413

 
$
73,904

Realized and unrealized gains (losses) included in net income
4,479

 
(355
)
 
(9,744
)
Purchases
50,840

 
16,938

 
—

Sales
(54,419
)
 
(8,225
)
 
(29,297
)
Transfers into Level 3 from Level 2
103

 
—

 
—

Transfers out of Level 3 into Level 2 (1)
(1,540
)
 
(30,539
)
 
—

Ending balance
$
146,801

 
$
71,232

 
$
34,863

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

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

17
Table of Contents
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)



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

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

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

8. RESERVE FOR LOSSES AND LOSS EXPENSES

The reserve for losses and loss expenses consists of the following:
 
June 30,
2015
 
December 31,
2014
Outstanding loss reserves
$
1,732,855

 
$
1,514,051

Reserves for losses incurred but not reported
4,631,093

 
4,367,114

Reserve for losses and loss expenses
$
6,363,948

 
$
5,881,165


















18
Table of Contents
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


The table below is a reconciliation of the beginning and ending liability for unpaid losses and loss expenses. Losses incurred and paid are reflected net of reinsurance recoverables.
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
2015
 
2014
 
2015
 
2014
Gross liability at beginning of period
$
5,905,110

 
$
5,856,798

 
$
5,881,165

 
$
5,766,529

Reinsurance recoverable at beginning of period
(1,350,311
)
 
(1,280,525
)
 
(1,340,256
)
 
(1,234,504
)
Net liability at beginning of period
4,554,799

 
4,576,273

 
4,540,909

 
4,532,025

Acquisition of net reserve for losses and loss expenses
256,991

 
—

 
256,991

 
—

Net losses incurred related to:
 
 
 
 
 
 
 
Current year
453,360

 
359,994

 
842,177

 
684,141

Prior years
(21,839
)
 
(45,139
)
 
(85,480
)
 
(94,000
)
Total incurred
431,521

 
314,855

 
756,697

 
590,141

Net paid losses related to:
 
 
 
 
 
 
 
Current year
28,006

 
23,065

 
34,563

 
26,808

Prior years
285,832

 
235,335

 
578,930

 
463,929

Total paid
313,838

 
258,400

 
613,493

 
490,737

Foreign exchange revaluation
1,366

 
1,208

 
(10,265
)
 
2,507

Net liability at end of period
4,930,839

 
4,633,936

 
4,930,839

 
4,633,936

Reinsurance recoverable at end of period
1,433,109

 
1,301,742

 
1,433,109

 
1,301,742

Gross liability at end of period
$
6,363,948

 
$
5,935,678

 
$
6,363,948

 
$
5,935,678


The net reserve for losses and loss expenses acquired of $256,991 represents the net reserves acquired from the Hong Kong and Singapore branches of RSA of $252,848 and the net reserves from the Labuan branch of RSA of $4,143.

For the three months ended June 30, 2015, the Company had net unfavorable prior year reserve development in the North American Insurance segment and recorded net favorable prior year reserve development in the Global Markets Insurance and Reinsurance segments. The net unfavorable prior year reserve development in the North American Insurance segment included unfavorable prior year reserve development related to the professional liability and healthcare lines of business. The net favorable prior year reserve development in the Global Markets Insurance and Reinsurance segments was due to actual loss emergence being lower than initially expected across several lines of business.

For the six months ended June 30, 2015, the Company had net favorable prior year reserve development in each of its operating segments. The net unfavorable prior year reserve development in the North American Insurance segment for the 2012 through 2014 loss years was primarily related to our healthcare line of business and was due to adverse development on several claims above our previous expectations. The net favorable prior year reserve development in our Reinsurance segment for the 2014 loss year was primarily due to benign property loss activity, and therefore reported losses were less than our expectations across several lines of business.

For the three months ended June 30, 2014, the Company had net unfavorable prior year reserve development in the North American Insurance segment and recorded net favorable prior year reserve development in the Global Markets Insurance and Reinsurance segments. The net unfavorable prior year reserve development in the North American Insurance segment primarily related to the healthcare line of business, as well as adverse development on reported claims in the lawyers errors and omissions ("E&O") and primary casualty classes of business. The net favorable prior year reserve development in the Global Markets Insurance and Reinsurance segments was due to actual loss emergence being lower than initially expected.

For the six months ended June 30, 2014, the Company had net favorable prior year reserve development in each of its operating segments. The net favorable prior year reserve development in the North American Insurance segment included unfavorable prior year reserve development related to the healthcare line of business due to higher than expected loss frequency and severity in the medical malpractice class of business. The North American Insurance segment also experienced adverse development on reported claims in the lawyers E&O class of business and the primary casualty class of business in the 2013

19
Table of Contents
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


loss year. The net favorable prior year reserve development in the Global Markets Insurance and Reinsurance segments was due to actual loss emergence being lower than initially expected.

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

9. INCOME TAXES

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

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

Certain subsidiaries of Allied World Switzerland file U.S. federal income tax returns and various U.S. state income tax returns, as well as income tax returns in Canada, Hong Kong, Ireland, Singapore and the United Kingdom. The U.S. Internal Revenue Service is currently conducting an audit of the 2012 tax return of the Company's U.S. subsidiaries. To the best of the Company’s knowledge, there are no other income tax examinations pending by any other tax authority.

Management has deemed all material tax positions to have a greater than 50% likelihood of being sustained based on technical merits if challenged. The Company does not expect any material unrecognized tax benefits within 12 months of June 30, 2015.

10. SHAREHOLDERS’ EQUITY

a) Authorized shares

The issued share capital consists of the following:
 
June 30,
2015
 
December 31,
2014
Common shares issued and fully paid, 2015 and 2014: CHF 4.10 per share
95,523,230

 
100,775,256

Share capital at end of period
$
386,702

 
$
408,020


20
Table of Contents
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


 
Six Months Ended June 30, 2015
Shares issued at beginning of period
100,775,256

Shares canceled
(5,252,026
)
Total shares issued at end of period
95,523,230

Treasury shares issued at beginning of period
4,579,774

Shares repurchased
6,047,437

Shares issued out of treasury
(648,315
)
Shares canceled
(5,252,026
)
Total treasury shares at end of period
4,726,870

Total shares outstanding at end of period
90,796,360


During the six months ended June 30, 2015, 5,252,026 shares repurchased and designated for cancellation were constructively retired and canceled.

b) Dividends

The Company paid the following dividends during the six months ended June 30, 2015:
Dividend Paid
 
Dividend
Per
Share
 
Total
Amount
Paid
January 2, 2015
 
$
0.225

 
$
21,669

April 2, 2015
 
$
0.225

 
$
21,528

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

On April 30, 2015, the shareholders approved the Company's proposal to pay cash dividends in the form of a distribution out of general legal reserve from capital contributions. The distribution amount will be paid to shareholders in quarterly installments of $0.26 per share. The first installment of the dividend was distributed on July 2, 2015. The Company expects to distribute the remaining installments of the dividend in October 2015, January 2016 and April 2016.

c) Share Repurchases

On May 1, 2014, the shareholders approved a share repurchase program (the "2014 share repurchase program") in order for the Company to repurchase up to $500,000 of its common shares. Repurchases may be effected from time to time through open market purchases, privately negotiated transactions, tender offers or otherwise. The timing, form and amount of the share repurchases under the program will depend on a variety of factors, including market conditions, the Company’s capital position, legal requirements and other factors. Under the terms of the 2014 share repurchase program, the first three million of common shares repurchased will remain in treasury and will be used by the Company to satisfy share delivery obligations under its equity-based compensation plans. Any additional common shares repurchased will be designated for cancellation at acquisition and will be canceled upon shareholder approval. Shares repurchased and designated for cancellation are constructively retired and recorded as a share cancellation.


21
Table of Contents
ALLIED WORLD ASSURANCE COMPANY HOLDINGS, AG
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in thousands, except share, per share, percentage and ratio information)


The Company’s share repurchases were as follows:
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
2015
 
2014
 
2015
 
2014
Common shares repurchased
4,776,224

 
1,949,496

 
6,047,437

 
3,961,692

Total cost of shares repurchased
$
194,352

 
$
70,874

 
$
245,301

 
$
139,532

Average price per share
$
40.69

 
$
36.36

 
$
40.56

 
$
35.22


On May 6, 2015, the Company repurchased 4,053,537 shares from Exor S.A. at a repurchase price of $40.546 per share, for an aggregate purchase price of $164,355. The repurchase was executed under the 2014 share repurchase program.

11. EARNINGS PER SHARE

The following table sets forth the comparison of basic and diluted earnings per share:
 
Three Months Ended 
 June 30,
 
Six Months Ended 
 June 30,
 
2015
 
2014
 
2015
 
2014
Basic earnings per share:
 
 
 
 
 
 
 
Net income
$
9,458

 
$
151,863