MKL 06.30.2013 10-Q
Table of Contents

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
___________________________________________
 FORM 10-Q
___________________________________________
x
Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended June 30, 2013
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: 001-15811
___________________________________________
MARKEL CORPORATION
(Exact name of registrant as specified in its charter)
___________________________________________
 
Virginia
 
54-1959284
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)

4521 Highwoods Parkway, Glen Allen, Virginia 23060-6148
(Address of principal executive offices)
(Zip Code)
(804) 747-0136
(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  x   No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes x No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer  x
 
Accelerated filer  o
 
Non-accelerated filer  o
 
Smaller reporting company  o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x
Number of shares of the registrant’s common stock outstanding at July 31, 2013: 13,998,686

Table of Contents

Markel Corporation
Form 10-Q
Index
 
 
 
 
 
 
Page Number
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

2
Table of Contents

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

MARKEL CORPORATION AND SUBSIDIARIES

Consolidated Balance Sheets
(dollars in thousands)
 
June 30,
2013
 
December 31,
2012
 
(unaudited)
 
 
ASSETS
 
 
 
Investments, available-for-sale, at estimated fair value:
 
 
 
Fixed maturities (amortized cost of $10,599,255 in 2013 and $4,562,278 in 2012)
$
10,678,463

 
$
4,979,283

Equity securities (cost of $1,451,182 in 2013 and $1,387,305 in 2012)
2,810,434

 
2,406,951

Short-term investments (estimated fair value approximates cost)
995,697

 
973,330

Total Investments
14,484,594

 
8,359,564

Cash and cash equivalents
1,702,622

 
863,766

Restricted cash and cash equivalents
396,416

 
109,415

Receivables
1,416,165

 
413,883

Reinsurance recoverable on unpaid losses
1,876,858

 
778,774

Reinsurance recoverable on paid losses
141,736

 
51,145

Deferred policy acquisition costs
225,492

 
157,465

Prepaid reinsurance premiums
426,514

 
110,332

Goodwill
1,041,900

 
674,930

Intangible assets
576,688

 
374,295

Other assets
1,210,995

 
663,019

Total Assets
$
23,499,980

 
$
12,556,588

LIABILITIES AND EQUITY
 
 
 
Unpaid losses and loss adjustment expenses
$
10,012,140

 
$
5,371,426

Life and annuity benefits
1,456,829

 
—

Unearned premiums
2,332,267

 
1,000,261

Payables to insurance and reinsurance companies
422,731

 
103,212

Senior long-term debt and other debt (estimated fair value of $2,383,000 in 2013 and $1,688,000 in 2012)
2,249,819

 
1,492,550

Other liabilities
625,487

 
613,897

Total Liabilities
17,099,273

 
8,581,346

Redeemable noncontrolling interests
74,858

 
86,225

Commitments and contingencies

 

Shareholders’ equity:
 
 
 
Common stock
3,269,355

 
908,980

Retained earnings
2,148,240

 
2,068,340

Accumulated other comprehensive income
903,309

 
911,337

Total Shareholders’ Equity
6,320,904

 
3,888,657

Noncontrolling interests
4,945

 
360

Total Equity
6,325,849

 
3,889,017

Total Liabilities and Equity
$
23,499,980

 
$
12,556,588

See accompanying notes to consolidated financial statements.

3
Table of Contents

MARKEL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Income and Comprehensive Income (Loss)
(Unaudited)
 
Quarter Ended June 30,
 
Six Months Ended June 30,
 
2013
 
2012
 
2013
 
2012
 
(dollars in thousands, except per share data)
OPERATING REVENUES
 
 
 
 
 
 
 
Earned premiums
$
784,819

 
$
513,056

 
$
1,349,406

 
$
1,042,652

Net investment income
77,979

 
63,602

 
142,596

 
143,396

Net realized investment gains:
 
 
 
 
 
 
 
Other-than-temporary impairment losses
(4,589
)
 
(992
)
 
(4,589
)
 
(992
)
Net realized investment gains, excluding other-than-temporary impairment losses
16,135

 
9,208

 
34,052

 
21,117

Net realized investment gains
11,546

 
8,216

 
29,463

 
20,125

Other revenues
157,425

 
108,373

 
330,168

 
220,209

Total Operating Revenues
1,031,769

 
693,247

 
1,851,633

 
1,426,382

OPERATING EXPENSES
 
 
 
 
 
 
 
Losses and loss adjustment expenses
442,406

 
221,094

 
730,302

 
509,615

Underwriting, acquisition and insurance expenses
363,095

 
224,784

 
591,768

 
463,481

Amortization of intangible assets
11,292

 
8,315

 
20,907

 
17,119

Other expenses
140,759

 
97,719

 
293,076

 
198,123

Total Operating Expenses
957,552

 
551,912

 
1,636,053

 
1,188,338

Operating Income
74,217

 
141,335

 
215,580

 
238,044

Interest expense
28,561

 
22,209

 
52,135

 
44,376

Income Before Income Taxes
45,656

 
119,126

 
163,445

 
193,668

Income tax expense
16,980

 
28,358

 
45,506

 
45,187

Net Income
$
28,676

 
$
90,768

 
$
117,939

 
$
148,481

Net income attributable to noncontrolling interests
920

 
1,081

 
1,281

 
1,541

Net Income to Shareholders
$
27,756

 
$
89,687

 
$
116,658

 
$
146,940

 
 
 
 
 
 
 
 
OTHER COMPREHENSIVE INCOME (LOSS)
 
 
 
 
 
 
 
Change in net unrealized gains on investments, net of taxes:
 
 
 
 
 
 
 
Net holding gains (losses) arising during the period
$
(158,690
)
 
$
(8,029
)
 
$
22,909

 
$
145,426

Change in unrealized other-than-temporary impairment losses on fixed maturities arising during the period
(70
)
 
130

 
179

 
(8
)
Reclassification adjustments for net gains included in net income
(7,957
)
 
(5,739
)
 
(20,212
)
 
(13,670
)
Change in net unrealized gains on investments, net of taxes
(166,717
)
 
(13,638
)
 
2,876

 
131,748

Change in foreign currency translation adjustments, net of taxes
(10,459
)
 
(3,162
)
 
(11,640
)
 
(339
)
Change in net actuarial pension loss, net of taxes
366

 
482

 
736

 
965

Total Other Comprehensive Income (Loss)
(176,810
)
 
(16,318
)
 
(8,028
)
 
132,374

Comprehensive Income (Loss)
$
(148,134
)
 
$
74,450

 
$
109,911

 
$
280,855

Comprehensive income attributable to noncontrolling interests
920

 
1,034

 
1,281

 
1,494

Comprehensive Income (Loss) to Shareholders
$
(149,054
)
 
$
73,416

 
$
108,630

 
$
279,361

 
 
 
 
 
 
 
 
NET INCOME PER SHARE
 
 
 
 
 
 
 
Basic
$
2.24

 
$
8.44

 
$
10.83

 
$
14.38

Diluted
$
2.24

 
$
8.42

 
$
10.79

 
$
14.35


See accompanying notes to consolidated financial statements.

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Table of Contents

MARKEL CORPORATION AND SUBSIDIARIES

Consolidated Statements of Changes in Equity
(Unaudited)
 
(dollars in thousands)
Common
Stock
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income
 
Total
Shareholders’
Equity
 
Noncontrolling
Interests
 
Total Equity
 
Redeemable
Noncontrolling
Interests
December 31, 2011
$
891,507

 
$
1,835,086

 
$
660,920

 
$
3,387,513

 
$
602

 
$
3,388,115

 
$
74,231

Net income (loss)
 
 
146,940

 
—

 
146,940

 
(477
)
 
146,463

 
2,018

Other comprehensive income (loss)
 
 
—

 
132,421

 
132,421

 
—

 
132,421

 
(47
)
Comprehensive Income (Loss)
 
 
 
 
 
 
279,361

 
(477
)
 
278,884

 
1,971

Issuance of common stock
8,413

 
—

 
—

 
8,413

 
—

 
8,413

 
—

Repurchase of common stock
—

 
(16,062
)
 
—

 
(16,062
)
 
—

 
(16,062
)
 
—

Restricted stock units expensed
3,806

 
—

 
—

 
3,806

 
—

 
3,806

 
—

Acquisitions
—

 
—

 
—

 
—

 
—

 
—

 
7,896

Adjustment of redeemable noncontrolling interests
—

 
(8,186
)
 
—

 
(8,186
)
 
—

 
(8,186
)
 
8,186

Other
321

 
—

 
—

 
321

 
—

 
321

 
(4,671
)
June 30, 2012
$
904,047

 
$
1,957,778

 
$
793,341

 
$
3,655,166

 
$
125

 
$
3,655,291

 
$
87,613

 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2012
$
908,980

 
$
2,068,340

 
$
911,337

 
$
3,888,657

 
$
360

 
$
3,889,017

 
$
86,225

Net income (loss)
 
 
116,658

 
—

 
116,658

 
(363
)
 
116,295

 
1,644

Other comprehensive loss
 
 
—

 
(8,028
)
 
(8,028
)
 
—

 
(8,028
)
 
—

Comprehensive Income (Loss)
 
 
 
 
 
 
108,630

 
(363
)
 
108,267

 
1,644

Issuance of common stock
15,935

 
—

 
—

 
15,935

 
—

 
15,935

 
—

Repurchase of common stock
—

 
(40,858
)
 
—

 
(40,858
)
 
—

 
(40,858
)
 
—

Restricted stock units expensed
14,932

 
—

 
—

 
14,932

 
—

 
14,932

 
—

Acquisition of Alterra
2,330,199

 
—

 
—

 
2,330,199

 
—

 
2,330,199

 
—

Adjustment of redeemable noncontrolling interests
—

 
3,101

 
—

 
3,101

 
—

 
3,101

 
(3,101
)
Purchase of noncontrolling interest
(283
)
 
—

 
—

 
(283
)
 
—

 
(283
)
 
(8,157
)
Other
(408
)
 
999

 
—

 
591

 
4,948

 
5,539

 
(1,753
)
June 30, 2013
$
3,269,355

 
$
2,148,240

 
$
903,309

 
$
6,320,904

 
$
4,945

 
$
6,325,849

 
$
74,858


See accompanying notes to consolidated financial statements.

5
Table of Contents

MARKEL CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows
(Unaudited)
 
Six Months Ended June 30,
 
2013
 
2012
 
(dollars in thousands)
OPERATING ACTIVITIES
 
 
 
Net income
$
117,939

 
$
148,481

Adjustments to reconcile net income to net cash provided by operating activities
122,032

 
(43,734
)
Net Cash Provided By Operating Activities
239,971

 
104,747

INVESTING ACTIVITIES
 
 
 
Proceeds from sales of fixed maturities and equity securities
124,109

 
143,429

Proceeds from maturities, calls and prepayments of fixed maturities
490,775

 
256,503

Cost of fixed maturities and equity securities purchased
(373,153
)
 
(285,988
)
Net change in short-term investments
(18,962
)
 
75,539

Proceeds from sales of equity method investments
75,370

 
—

Cost of equity method investments
(5,791
)
 
(38,250
)
Acquisitions, net of cash acquired
7,756

 
(143,620
)
Additions to property and equipment
(26,418
)
 
(22,885
)
Change in restricted cash and cash equivalents
127,496

 
(40,873
)
Other
(2,484
)
 
(1,509
)
Net Cash Provided (Used) By Investing Activities
398,698

 
(57,654
)
FINANCING ACTIVITIES
 
 
 
Additions to senior long-term debt and other debt
516,934

 
73,705

Repayments of senior long-term debt and other debt
(271,559
)
 
(71,529
)
Repurchases of common stock
(40,858
)
 
(16,062
)
Issuance of common stock
15,935

 
8,413

Distributions to noncontrolling interests
(2,779
)
 
(4,351
)
Purchase of redeemable noncontrolling interests
(8,440
)
 
(320
)
Other
(254
)
 
(14,987
)
Net Cash Provided (Used) By Financing Activities
208,979

 
(25,131
)
Effect of foreign currency rate changes on cash and cash equivalents
(8,792
)
 
(659
)
Increase in cash and cash equivalents
838,856

 
21,303

Cash and cash equivalents at beginning of period
863,766

 
703,259

CASH AND CASH EQUIVALENTS AT END OF PERIOD
$
1,702,622

 
$
724,562


See accompanying notes to consolidated financial statements.

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Table of Contents

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation

Markel Corporation is a diverse financial holding company serving a variety of niche markets. Markel Corporation’s principal business markets and underwrites specialty insurance products and programs. Markel Corporation also owns interests in various industrial and service businesses that operate outside of the specialty insurance marketplace.

On May 1, 2013 (the Acquisition Date), Markel Corporation completed the acquisition of 100% of the issued and outstanding common stock of Alterra Capital Holdings Limited (Alterra) pursuant to an agreement dated December 18, 2012 which provided for the merger of Alterra with one of Markel Corporation's subsidiaries. Total purchase consideration was $3.3 billion. Alterra was a Bermuda-headquartered global enterprise providing diversified specialty insurance and reinsurance products to corporations, public entities and other property and casualty insurers.

The consolidated balance sheet as of June 30, 2013 and the related consolidated statements of income and comprehensive income (loss), changes in equity and cash flows for the quarters and six months ended June 30, 2013 and 2012 are unaudited. In the opinion of management, all adjustments necessary for fair presentation of such consolidated financial statements have been included. Such adjustments consist only of normal, recurring items. Interim results are not necessarily indicative of results of operations for the entire year. The consolidated balance sheet as of December 31, 2012 was derived from Markel Corporation’s audited annual consolidated financial statements.

The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) and include the accounts of Markel Corporation and its subsidiaries (the Company). All significant intercompany balances and transactions have been eliminated in consolidation. The consolidated financial statements include the results of operations and cash flows of Alterra from the Acquisition Date to June 30, 2013 and not in any prior periods, except with respect to the Supplemental Pro Forma Information included in note 3. The Company consolidates the results of its non-insurance subsidiaries on a one-month lag. Certain prior year amounts have been reclassified to conform to the current presentation.

The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities. Actual results may differ materially from the estimates and assumptions used in preparing the consolidated financial statements.

The consolidated financial statements and notes are presented as permitted by Form 10-Q and do not contain certain information included in the Company’s annual consolidated financial statements and notes. Readers are urged to review the Company’s 2012 Annual Report on Form 10-K for a more complete description of the Company’s business and accounting policies.

2. Recent Accounting Pronouncements

Effective January 1, 2013, the Company adopted Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) No. 2013-02, Reporting Amounts Reclassified Out of Accumulated Other Comprehensive Income, which amends FASB Accounting Standards Codification (ASC) 220, Comprehensive Income, to improve the reporting of reclassifications out of accumulated other comprehensive income. ASU No. 2013-02 requires information about reclassifications out of accumulated other comprehensive income to be reported in one place, by component. The guidance also requires disclosure of the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under U.S. GAAP to be reclassified in its entirety to net income. For other amounts that are not required to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under U.S. GAAP that provide additional detail about those amounts. The adoption of this guidance did not have an impact on the Company's financial position, results of operations or cash flows. The Company has included the additional disclosures required by ASU No. 2013-02 in note 14.


7
Table of Contents

3. Acquisitions

Acquisition of Alterra

a)Overview. On May 1, 2013, the Company completed the acquisition of 100% of the issued and outstanding common stock of Alterra pursuant to an agreement dated December 18, 2012 (the Merger Agreement) which provided for the merger of Alterra with one of the Company's subsidiaries. Alterra was a Bermuda-headquartered global enterprise providing diversified specialty property and casualty insurance and reinsurance products to corporations, public entities and other property and casualty insurers. The acquisition of Alterra creates additional size and scale, providing additional insurance and investment opportunities for the Company. As a result of the acquisition of Alterra, the Company formed a new operating segment, the Alterra segment. Results attributable to Alterra's property and casualty insurance and reinsurance business are included in the Alterra segment. Previously, Alterra also offered life and annuity reinsurance products. In 2010, Alterra ceased writing life and annuity reinsurance contracts and placed this business into run-off. Results attributable to the run-off of Alterra's life and annuity reinsurance business, as well as other lines of business previously discontinued by Alterra, are included in the Company's Other Insurance (Discontinued Lines) segment. See note 6 for further discussion of the Company's operating segments.

Pursuant to the terms of the Merger Agreement, on the Acquisition Date, equity holders of Alterra received, in exchange for each share of Alterra common stock held (other than restricted shares that did not vest in connection with the transaction), (1) 0.04315 shares of the Company's common stock and (2) $10.00 in cash. In total, equity holders of Alterra received total consideration of $3.3 billion, consisting of cash consideration of $964.3 million and stock consideration of 4.3 million shares of the Company's common stock.

Following the acquisition, the Company's board of directors consists of all 10 members from its pre-acquisition board of directors and two additional members who were designated by Alterra and approved by the Company's Nominating/Corporate Governance Committee.


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Table of Contents

b)Purchase Price. The Company's total purchase price for Alterra as of the Acquisition Date was calculated as follows:

(in thousands, except per share amounts)
 
Shares of Alterra common stock outstanding as of the Acquisition Date
96,433

Exchange ratio per the Merger Agreement
0.04315

Markel share issuance to Alterra shareholders
4,161

 
 
Shares of Alterra restricted stock outstanding as of the Acquisition Date
2,239

Incentive award ratio per the Merger Agreement
0.06252

Markel restricted stock issuance to Alterra restricted stock holders
140

 
 
Multiplied by Markel's weighted average stock price on April 30, 2013 (1)
$
529.59

 
 
Markel share and restricted stock issuance consideration, net of taxes
$
2,267,648

 
 
Alterra common shares outstanding as of the Acquisition Date that received cash consideration
96,433

Multiplied by cash price per share component per the Merger Agreement
$
10.00

Markel cash consideration
$
964,330

 
 
Fair value of Markel warrant issuance to Alterra warrant holders as of the Acquisition Date
$
73,685

Fair value of Markel stock option issuance to Alterra stock option holders as of the Acquisition Date, net of taxes
$
12,335

Fair value of partially vested Markel restricted stock unit issuance as of the Acquisition Date, net of taxes
$
6,867

Unrecognized compensation on unvested restricted stock and restricted stock units
$
(20,572
)
Total acquisition consideration
$
3,304,293

(1) 
The fair value of the shares issued by the Company was calculated as the weighted average price of the Company's stock on April 30, 2013, the day preceding the Acquisition Date.

As part of the consideration, the Company issued replacement warrants, options and restricted stock awards to holders of Alterra warrants, options and restricted stock awards. The acquisition consideration related to the options, restricted stock awards and partially vested restricted stock units issued was net of income taxes of $1.9 million, $10.1 million and $0.7 million, respectively. See note 13 for additional information about the equity awards issued in connection with the acquisition.

c)Fair Value of Net Assets Acquired and Liabilities Assumed. The purchase price was allocated to the acquired assets and liabilities of Alterra based on estimated fair values at the Acquisition Date. The Company recognized goodwill of $371.6 million, all of which was preliminarily recorded within the Alterra segment and is primarily attributable to Alterra's assembled workforce and synergies that are expected to result upon integration of Alterra into the Company’s insurance operations and investing activities. The Company estimates that none of the goodwill that was recorded will be deductible for income tax purposes. The Company also recognized indefinite lived intangible assets of $37.5 million and other intangible assets of $150 million, which will be amortized over a weighted average period of 17 years.

The Company has not completed the process of determining the fair value of the intangible assets acquired, unpaid losses and loss adjustment expenses and deferred taxes. These valuations will be completed within the measurement period, which cannot exceed 12 months from the Acquisition Date. As a result, the fair value recorded for these items is a provisional estimate and may be subject to adjustment. Once completed, any adjustments resulting from the valuations may impact the individual amounts recorded for assets acquired and liabilities assumed, as well as the residual goodwill.


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Table of Contents

The following table summarizes the provisional fair values of the assets acquired and liabilities assumed at the Acquisition Date.
(dollars in thousands)
 
ASSETS
 
Investments
$
6,407,841

Cash and cash equivalents
1,036,274

Restricted cash and cash equivalents
414,497

Receivables
866,388

Reinsurance recoverable on unpaid losses
1,169,084

Reinsurance recoverable on paid losses
80,672

Prepaid reinsurance premiums
317,445

Other assets
801,758

LIABILITIES
 
Unpaid losses and loss adjustment expenses
4,719,461

Life and annuity benefits
1,477,482

Unearned premiums
1,075,610

Payables to insurance and reinsurance companies
342,858

Senior long-term debt
512,463

Other liabilities
220,903

Net assets
2,745,182

Goodwill
371,611

Intangible assets
187,500

Acquisition date fair value
$
3,304,293


An explanation of the significant adjustments for fair value and the related impact on amortization is as follows:
•
Investments - Investments acquired include a net increase of $223.1 million to adjust the historical carrying amount of Alterra's investments to their estimated fair value as of the Acquisition Date. The difference in the par value and estimated fair value of Alterra's fixed maturity securities investments as of the Acquisition Date, $552.4 million, will be amortized to net investment income over the term of the underlying securities, or sooner upon disposition.
•
Intangible assets - Establish the provisional estimated fair value of intangible assets related to Alterra (see below for further detail).
•
Unearned Premiums - Unearned premiums acquired include a decrease of $176.3 million to adjust the carrying value of Alterra's historical unearned premiums to fair value as of the Acquisition Date. The adjustment consists of the present value of the expected underwriting profit within the unearned premiums liability less costs to service the related policies and a risk premium. This adjustment will be amortized to underwriting, acquisition and insurance expenses over a weighted average period of approximately one year, as the contracts for business in-force as of the Acquisition Date expire.
•
Unpaid losses and loss adjustment expenses - Unpaid losses and loss adjustment expenses acquired include a provisional increase of $120.8 million to adjust the carrying value of Alterra's historical unpaid losses and loss adjustment expenses, net of related reinsurance recoverable, to fair value as of the Acquisition Date. The estimated fair value consists of the present value of the expected net loss and loss adjustment expense payments plus a risk premium. This adjustment, plus the $26.5 million unamortized fair value adjustment included in Alterra's historical unpaid losses and loss adjustment expenses, will be amortized to losses and loss adjustment expenses over a weighted average period of approximately five years, based on the estimated payout pattern of net reserves as of the Acquisition Date.
•
Life and Annuity Benefits - Life and annuity benefits acquired include an increase of $329.6 million to adjust the carrying value of Alterra's historical life and annuity benefits to fair value as of the Acquisition Date. The estimated fair value consists of the present value of the expected net life and annuity benefit payments plus a risk premium. See note 8 for detail regarding accounting for life and annuity benefits.
•
Senior long-term debt - Senior long-term debt acquired includes an increase of $71.9 million to adjust the carrying value of Alterra's senior long-term debt to its estimated fair value based on prevailing interest rates and other factors as of the Acquisition Date. This adjustment will be amortized to interest expense over the term of the notes. See note 9.

10
Table of Contents

The following table summarizes the provisional intangible assets recorded in connection with the acquisition, and as of June 30, 2013.

(dollars in thousands)
Amount
 
Economic
Useful Life
Customer relationships
$
113,000

 
18 years
Broker relationships
18,000

 
18 years
Technology
18,000

 
10 years
Trade names
1,000

 
One year
Lloyd's syndicate capacity
12,000

 
Indefinite
Insurance licenses
25,500

 
Indefinite
Intangible assets, before amortization, as of the Acquisition Date
187,500

 
 
Amortization (from the Acquisition Date through June 30, 2013)
1,699

 
 
Net intangible assets of June 30, 2013
$
185,801

 
 

Customer relationships represent policyholder relationships and the network of insurance companies through which Alterra conducts its operations. The fair value of customer relationships and broker relationships was estimated using the income approach. Critical inputs into the valuation model for customer relationships and broker relationships include estimates of expected premium and attrition rates, and discounting at a weighted average cost of capital. Technology represents the intangible asset related to Alterra's internally developed software and was valued using the income approach.

The fair value of Lloyd's syndicate capacity and insurance licenses was estimated using the market approach. Lloyd's syndicate capacity represents Alterra's authorized premium income limit to write insurance business in the Lloyd's market. Alterra's proportionate share of Syndicates 1400 and 2526, the syndicates through which it conducts its Lloyd's operations, are 100% and approximately 20%, respectively. The capacity is renewed annually at no cost to the Company but may be freely purchased or sold, subject to Lloyd's approval. The ability to write insurance business within the syndicate capacity is indefinite with the premium income limit being set annually by the Company, subject to Lloyd's approval.

d)Income Taxes. As a result of the acquisition, Alterra and its non-U.S. subsidiaries became controlled foreign corporations subject to U.S. income tax at a statutory rate of 35%. The acquisition was taxable to U.S. shareholders of Alterra, and Markel has elected to treat it as an asset acquisition under section 338(g) of the U.S. Internal Revenue Code of 1986 (IRC), as amended.

Effective May 1, 2013, the Company made an IRC section 953(d) election with respect to Alterra Bermuda Limited (Alterra Bermuda), a wholly-owned subsidiary of Alterra. As a result of the 953(d) election, Alterra Bermuda is treated as a domestic corporation for U.S. tax purposes and, accordingly, was required to record deferred taxes at the 35% statutory U.S. rate.

As part of the provisional allocation of the purchase price, the Company recorded net deferred tax assets of $255.8 million. Of this amount, $284.8 million represents deferred tax assets related to accrued losses and loss adjustment expenses and life and annuity benefits, which were partially offset by deferred tax liabilities of $67.4 million related to the estimated fair value of the intangible assets recorded. Other net deferred tax assets recorded primarily relate to differences between financial reporting and tax bases of the acquired assets and liabilities as of the Acquisition Date. At June 30, 2013, earnings of Alterra's foreign subsidiaries are considered reinvested indefinitely, consistent with the Company's other foreign subsidiaries, and no provision for deferred U.S. income tax has been recorded.


11
Table of Contents

e)Transaction and Acquisition-Related Costs. The following table summarizes transaction and acquisition-related costs incurred by the Company in connection with the acquisition, all of which were included in underwriting, acquisition and insurance expenses in the consolidated statements of income and comprehensive income (loss).
(dollars in thousands)
Quarter and Six Months Ended
June 30, 2013
Transaction costs
$
15,981

Acquisition-related costs:
 
Severance costs
28,215

Stay bonuses
6,075

Acceleration of Alterra long-term incentive compensation awards and restricted stock awards
11,538

Total transaction and acquisition-related costs
$
61,809


Transaction costs primarily consist of due diligence, legal and investment banking costs. Per the terms of the Merger Agreement, transaction costs attributable to Alterra were recorded and paid by Alterra prior to the Acquisition Date ($23.0 million) and are not included within the Company's consolidated statements of income and comprehensive income (loss).

In connection with the acquisition, Alterra instituted a retention plan for certain employees under which Alterra committed to the payment of stay bonuses to such employees one year from the Acquisition Date, provided they remain employed with the Company through that date. Payments may be accelerated for certain qualifying employment terminations.

Prior to its acquisition by the Company, Alterra granted long term incentive awards to certain employees to be paid in the form of cash on March 1, 2016, provided they remain employed with the Company on that date. Payments may be accelerated prior to March 1, 2016 for certain qualifying employment terminations. Additionally, as part of the purchase consideration, the Company issued replacement restricted stock awards to holders of Alterra restricted stock awards. As a result of separations made in connection with the acquisition, the Company recognized expense totaling $11.5 million related to the acceleration of certain of these awards during the quarter and six months ended June 30, 2013.

f)Financial Results. The following table summarizes the results of Alterra since the Acquisition Date that have been included within the Company's consolidated statements of income and comprehensive income (loss).

(dollars in thousands)
For the period from
May 1, 2013 to
June 30, 2013
Operating revenues
$
243,246

Net loss to shareholders
$
(55,743
)


12
Table of Contents

g)Supplemental Pro Forma Information. Alterra's results have been included in the Company's Consolidated Financial Statements from the Acquisition Date to June 30, 2013. The following table presents unaudited pro forma consolidated information for the quarter and six months ended June 30, 2013 and 2012 and assumes the Company's acquisition of Alterra occurred on January 1, 2012. The pro forma financial information is presented for informational purposes only and does not necessarily reflect the results that would have occurred had the acquisition taken place on January 1, 2012, nor is it necessarily indicative of future results. Significant adjustments used to determine pro forma results include amortization of intangible assets and amortization of fair value adjustments discussed in c) above, and the corresponding income tax effects. The Company also excluded certain charges from the pro forma results, including transaction costs incurred by the Company ($16.0 million) and Alterra ($23.0 million) totaling $39.0 million for both the quarter and six months ended June 30, 2013, respectively, and severance and stay bonuses attributable to the acquisition totaling $28.2 million and $6.1 million, respectively, for both the quarter and six months ended June 30, 2013. The acceleration of compensation expense during the quarter ended June 30, 2013 related to Alterra's long-term incentive compensation awards and restricted stock awards was attributable to the acquisition, however, the incremental expense recognized during the period only represents a timing difference in the recognition of expense. Therefore, it was not excluded from the pro forma underwriting results.
 
 
Pro Forma
 
Pro Forma
 
Quarter Ended June 30,
 
Six Months Ended June 30,
(in thousands, except per share amounts)
2013
 
2012
 
2013
 
2012
Earned premiums
$
888,161

 
$
862,935

 
$
1,798,009

 
$
1,730,284

Operating revenues
1,154,783

 
1,089,191

 
2,395,279

 
2,218,611

Net income to shareholders
72,090

 
118,551

 
208,060

 
205,574

 
 
 
 
 
 
 
 
U.S. GAAP combined ratio (1)
97
%
 
88
%
 
94
%
 
93
%
 
 
 
 
 
 
 
 
Basic net income per share
$
5.16

 
$
7.86

 
$
15.06

 
$
14.07

Diluted net income per share
$
5.13

 
$
7.83

 
$
15.00

 
$
14.01

 
 
 
 
 
 
 
 
Weighted average common shares outstanding:
 
 
 
 
 
 
 
Basic
14,021

 
14,035

 
14,020

 
14,030

Diluted
14,084

 
14,092

 
14,082

 
14,088

(1)
The U.S. GAAP combined ratio is a measure of underwriting performance and represents the relationship of incurred losses, loss adjustment expenses and underwriting, acquisition and insurance expenses to earned premiums.

Acquisition of Essentia

On January 1, 2013, the Company completed its acquisition of 100% of the outstanding shares of Essentia Insurance Company, a company that underwrites insurance exclusively for Hagerty Insurance Agency and Hagerty Classic Marine Insurance Agency (collectively, Hagerty) throughout the United States. Hagerty offers insurance for classic cars, vintage boats, motorcycles and related automotive collectibles. The Company recognized intangible assets of $35.4 million associated with this acquisition, which includes $25.0 million of customer relationships to be amortized over a weighted average period of six years. Results attributable to this acquisition are included in the Specialty Admitted segment.


13
Table of Contents


4. Investments

a)The following tables summarize the Company’s available-for-sale investments.

 
June 30, 2013
(dollars in thousands)
Amortized
Cost
 
Gross
Unrealized
Holding
Gains
 
Gross
Unrealized
Holding
Losses
 
Unrealized
Other-Than-
Temporary
Impairment
Losses
 
Estimated
Fair
Value
Fixed maturities:
 
 
 
 
 
 
 
 
 
U.S. Treasury securities and obligations of U.S. government agencies
$
1,310,385

 
$
11,930

 
$
(24,171
)
 
$
—

 
$
1,298,144

Obligations of states, municipalities and political subdivisions
2,754,979

 
147,526

 
(19,633
)
 
—

 
2,882,872

Foreign governments
1,389,311

 
35,242

 
(45,325
)
 
—

 
1,379,228

Commercial mortgage-backed securities
423,886

 
19

 
(10,616
)
 
—

 
413,289

Residential mortgage-backed securities
1,052,615

 
10,560

 
(16,409
)
 
(2,258
)
 
1,044,508

Asset-backed securities
288,938

 
321

 
(3,167
)
 
—

 
286,092

Corporate bonds
3,379,141

 
71,802

 
(70,024
)
 
(6,589
)
 
3,374,330

Total fixed maturities
10,599,255

 
277,400

 
(189,345
)
 
(8,847
)
 
10,678,463

Equity securities:
 
 
 
 
 
 
 
 
 
Insurance, banks and other financial institutions
411,661

 
536,871

 
(230
)
 
—

 
948,302

Industrial, consumer and all other
1,039,521

 
825,243

 
(2,632
)
 
—

 
1,862,132

Total equity securities
1,451,182

 
1,362,114

 
(2,862
)
 
—

 
2,810,434

Short-term investments
995,687

 
11

 
(1
)
 
—

 
995,697

Investments, available-for-sale
$
13,046,124

 
$
1,639,525

 
$
(192,208
)
 
$
(8,847
)
 
$
14,484,594


14
Table of Contents

 
December 31, 2012
(dollars in thousands)
Amortized
Cost
 
Gross
Unrealized
Holding
Gains
 
Gross
Unrealized
Holding
Losses
 
Unrealized
Other-Than-
Temporary
Impairment
Losses
 
Estimated
Fair
Value
Fixed maturities:
 
 
 
 
 
 
 
 
 
U.S. Treasury securities and obligations of U.S. government agencies
$
297,663

 
$
19,844

 
$
—

 
$
—

 
$
317,507

Obligations of states, municipalities and political subdivisions
2,586,867

 
245,057

 
(362
)
 
—

 
2,831,562

Foreign governments
503,844

 
52,764

 
—

 
—

 
556,608

Residential mortgage-backed securities
202,644

 
14,996

 
(5
)
 
(2,258
)
 
215,377

Asset-backed securities
13,828

 
517

 
—

 
—

 
14,345

Corporate bonds
957,432

 
93,395

 
(121
)
 
(6,822
)
 
1,043,884

Total fixed maturities
4,562,278

 
426,573

 
(488
)
 
(9,080
)
 
4,979,283

Equity securities:
 
 
 
 
 
 
 
 
 
Insurance, banks and other financial institutions
508,771

 
389,434

 
(138
)
 
—

 
898,067

Industrial, consumer and all other
878,534

 
637,783

 
(7,433
)
 
—

 
1,508,884

Total equity securities
1,387,305

 
1,027,217

 
(7,571
)
 
—

 
2,406,951

Short-term investments
973,318

 
26

 
(14
)
 
—

 
973,330

Investments, available-for-sale
$
6,922,901

 
$
1,453,816

 
$
(8,073
)
 
$
(9,080
)
 
$
8,359,564


15
Table of Contents

b)The following tables summarize gross unrealized investment losses by the length of time that securities have continuously been in an unrealized loss position.

 
June 30, 2013
 
Less than 12 months
 
12 months or longer
 
Total
(dollars in thousands)
Estimated
Fair
Value
 
Gross
Unrealized
Holding and
Other-Than-
Temporary
Impairment
Losses
 
Estimated
Fair
Value
 
Gross
Unrealized
Holding and
Other-Than-
Temporary
Impairment
Losses
 
Estimated
Fair
Value
 
Gross
Unrealized
Holding and
Other-Than-
Temporary
Impairment
Losses
Fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasury securities and obligations of U.S. government agencies
$
1,016,644

 
$
(24,171
)
 
$
—

 
$
—

 
$
1,016,644

 
$
(24,171
)
Obligations of states, municipalities and political subdivisions
290,283

 
(19,526
)
 
3,367

 
(107
)
 
293,650

 
(19,633
)
Foreign governments
882,167

 
(45,325
)
 
—

 
—

 
882,167

 
(45,325
)
Commercial mortgage-backed securities
406,372

 
(10,616
)
 
—

 
—

 
406,372

 
(10,616
)
Residential mortgage-backed securities
714,143

 
(18,665
)
 
229

 
(2
)
 
714,372

 
(18,667
)
Asset-backed securities
262,570

 
(3,167
)
 
—

 
—

 
262,570

 
(3,167
)
Corporate bonds
2,429,938

 
(76,613
)
 
—

 
—

 
2,429,938

 
(76,613
)
Total fixed maturities
6,002,117

 
(198,083
)
 
3,596

 
(109
)
 
6,005,713

 
(198,192
)
Equity securities:
 
 
 
 
 
 
 
 
 
 
 
Insurance, banks and other financial institutions
4,734

 
(230
)
 
—

 
—

 
4,734

 
(230
)
Industrial, consumer and all other
65,570

 
(2,614
)
 
118

 
(18
)
 
65,688

 
(2,632
)
Total equity securities
70,304

 
(2,844
)
 
118

 
(18
)
 
70,422

 
(2,862
)
Short-term investments
164,998

 
(1
)
 
—

 
—

 
164,998

 
(1
)
Total
$
6,237,419

 
$
(200,928
)
 
$
3,714

 
$
(127
)
 
$
6,241,133

 
$
(201,055
)

At June 30, 2013, the Company held 1,971 securities with a total estimated fair value of $6.2 billion and gross unrealized losses of $201.1 million. Of these 1,971 securities, 12 securities had been in a continuous unrealized loss position for one year or longer and had a total estimated fair value of $3.7 million and gross unrealized losses of $0.1 million. Of these securities, 10 securities were fixed maturities and two were equity securities. The Company does not intend to sell or believe it will be required to sell these fixed maturities before recovery of their amortized cost. The Company has the ability and intent to hold these equity securities for a period of time sufficient to allow for the anticipated recovery of their fair value.


16
Table of Contents

 
December 31, 2012
 
Less than 12 months
 
12 months or longer
 
Total
(dollars in thousands)
Estimated
Fair
Value
 
Gross
Unrealized
Holding and
Other-Than-
Temporary
Impairment
Losses
 
Estimated
Fair
Value
 
Gross
Unrealized
Holding and
Other-Than-
Temporary
Impairment
Losses
 
Estimated
Fair
Value
 
Gross
Unrealized
Holding and
Other-Than-
Temporary
Impairment
Losses
Fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
Obligations of states, municipalities and political subdivisions
$
2,833

 
$
(46
)
 
$
3,616

 
$
(316
)
 
$
6,449

 
$
(362
)
Residential mortgage-backed securities
364

 
(2,260
)
 
201

 
(3
)
 
565

 
(2,263
)
Corporate bonds
—

 
(6,822
)
 
3,860

 
(121
)
 
3,860

 
(6,943
)
Total fixed maturities
3,197

 
(9,128
)
 
7,677

 
(440
)
 
10,874

 
(9,568
)
Equity securities:
 
 
 
 
 
 
 
 
 
 
 
Insurance, banks and other financial institutions
2,431

 
(138
)
 
—

 
—

 
2,431

 
(138
)
Industrial, consumer and all other
82,109

 
(7,310
)
 
1,983

 
(123
)
 
84,092

 
(7,433
)
Total equity securities
84,540

 
(7,448
)
 
1,983

 
(123
)
 
86,523

 
(7,571
)
Short-term investments
228,820

 
(14
)
 
—

 
—

 
228,820

 
(14
)
Total
$
316,557

 
$
(16,590
)
 
$
9,660

 
$
(563
)
 
$
326,217

 
$
(17,153
)

At December 31, 2012, the Company held 35 securities with a total estimated fair value of $326.2 million and gross unrealized losses of $17.2 million. Of these 35 securities, 10 securities had been in a continuous unrealized loss position for one year or longer and had a total estimated fair value of $9.7 million and gross unrealized losses of $0.6 million. Of these securities, eight securities were fixed maturities and two were equity securities.

The Company completes a detailed analysis each quarter to assess whether the decline in the fair value of any investment below its cost basis is deemed other-than-temporary. All securities with unrealized losses are reviewed. The Company considers many factors in completing its quarterly review of securities with unrealized losses for other-than-temporary impairment, including the length of time and the extent to which fair value has been below cost and the financial condition and near-term prospects of the issuer. For equity securities, the ability and intent to hold the security for a period of time sufficient to allow for anticipated recovery is considered. For fixed maturities, the Company considers whether it intends to sell the security or if it is more likely than not that it will be required to sell the security before recovery, the implied yield-to-maturity, the credit quality of the issuer and the ability to recover all amounts outstanding when contractually due.

For equity securities, a decline in fair value that is considered to be other-than-temporary is recognized in net income based on the fair value of the security at the time of assessment, resulting in a new cost basis for the security. For fixed maturities where the Company intends to sell the security or it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost, a decline in fair value is considered to be other-than-temporary and is recognized in net income based on the fair value of the security at the time of assessment, resulting in a new cost basis for the security. If the decline in fair value of a fixed maturity below its amortized cost is considered to be other-than-temporary based upon other considerations, the Company compares the estimated present value of the cash flows expected to be collected to the amortized cost of the security. The extent to which the estimated present value of the cash flows expected to be collected is less than the amortized cost of the security represents the credit-related portion of the other-than-temporary impairment, which is recognized in net income, resulting in a new cost basis for the security. Any remaining decline in fair value represents the non-credit portion of the other-than-temporary impairment, which is recognized in other comprehensive income (loss). The discount rate used to calculate the estimated present value of the cash flows expected to be collected is the effective interest rate implicit for the security at the date of purchase.

When assessing whether it intends to sell a fixed maturity or if it is likely to be required to sell a fixed maturity before recovery of its amortized cost, the Company evaluates facts and circumstances including, but not limited to, decisions to reposition the investment portfolio, potential sales of investments to meet cash flow needs and potential sales of investments to capitalize on favorable pricing. Additional information on the methodology and significant inputs, by security type, that the Company used to determine the amount of credit loss recognized on fixed maturities with declines in fair value below amortized cost that were considered to be other-than-temporary is provided below.


17
Table of Contents

Residential / Commercial mortgage-backed securities. For mortgage-backed securities, credit impairment is assessed by estimating future cash flows from the underlying mortgage loans and interest payments. The cash flow estimate incorporates actual cash flows from the mortgage-backed securities through the current period and then projects the remaining cash flows using a number of assumptions, including prepayment rates, default rates, recovery rates on foreclosed properties and loss severity assumptions. Management develops specific assumptions using market data and internal estimates, as well as estimates from rating agencies and other third party sources. Default rates are estimated by considering current underlying mortgage loan performance and expectations of future performance. Estimates of future cash flows are discounted to present value. If the present value of expected cash flows is less than the amortized cost, the Company recognizes the estimated credit loss in net income.

Corporate bonds. For corporate bonds, credit impairment is assessed by evaluating the underlying issuer. As part of this assessment, the Company analyzes various factors, including the following:

•
fundamentals of the issuer, including current and projected earnings, current liquidity position and ability to raise capital;
•
fundamentals of the industry in which the issuer operates;
•
expectations of defaults and recovery rates;
•
changes in ratings by rating agencies;
•
other relevant market considerations; and
•
receipt of interest payments.

Default probabilities and recovery rates from rating agencies are key factors used in calculating the credit loss. Additional research of the industry and issuer is completed to determine if there is any current information that may affect the fixed maturity or its issuer in a negative manner and require an adjustment to the cash flow assumptions.

c)The amortized cost and estimated fair value of fixed maturities at June 30, 2013 are shown below by contractual maturity.

(dollars in thousands)
Amortized
Cost
 
Estimated
Fair Value
Due in one year or less
$
906,912

 
$
911,807

Due after one year through five years
3,216,710

 
3,279,236

Due after five years through ten years
2,359,427

 
2,412,507

Due after ten years
2,350,767

 
2,331,024

 
8,833,816

 
8,934,574

Commercial mortgage-backed securities
423,886

 
413,289

Residential mortgage-backed securities
1,052,615

 
1,044,508

Asset-backed securities
288,938

 
286,092

Total fixed maturities
$
10,599,255

 
$
10,678,463


18
Table of Contents


d)The following table presents the components of net investment income.

 
Quarter Ended June 30,
 
Six Months Ended June 30,
(dollars in thousands)
2013
 
2012
 
2013
 
2012
Interest:
 
 
 
 
 
 
 
Municipal bonds (tax-exempt)
$
20,770

 
$
22,747

 
$
41,960

 
$
45,779

Municipal bonds (taxable)
6,613

 
5,685

 
12,015

 
11,385

Other taxable bonds
33,462

 
26,979

 
55,354

 
57,595

Short-term investments, including overnight deposits
604

 
679

 
1,274

 
1,274

Dividends on equity securities
10,761

 
9,512

 
23,541

 
20,458

Change in fair value of credit default swap
3,910

 
1,140

 
7,200

 
12,201

Other
4,981

 
(1,172
)
 
7,032

 
(1,231
)
 
81,101

 
65,570

 
148,376

 
147,461

Investment expenses
(3,122
)
 
(1,968
)
 
(5,780
)
 
(4,065
)
Net investment income
$
77,979

 
$
63,602

 
$
142,596

 
$
143,396


e)Cumulative credit losses recognized in net income on fixed maturities where other-than-temporary impairment was identified and a portion of the other-than-temporary impairment was included in other comprehensive income (loss) was $21,370 for the quarter and six months ended June 30, 2013 and 2012. There were no changes in cumulative credit losses for the quarter and six months ended June 30, 2013 or 2012.
 
 
 
 
 
 
 
 

f)The following table presents net realized investment gains and the change in net unrealized gains on investments. 

 
Quarter Ended June 30,
 
Six Months Ended June 30,
(dollars in thousands)
2013
 
2012
 
2013
 
2012
Realized gains:
 
 
 
 
 
 
 
Sales of fixed maturities
$
902

 
$
3,570

 
$
1,152

 
$
5,422

Sales of equity securities
15,994

 
5,820

 
33,915

 
15,514

Other
53

 
134

 
53

 
655

Total realized gains
16,949

 
9,524

 
35,120

 
21,591

Realized losses:
 
 
 
 
 
 
 
Sales of fixed maturities
(797
)
 
(316
)
 
(898
)
 
(474
)
Sales of equity securities
(17
)
 
—

 
(170
)
 
—

Other-than-temporary impairments
(4,589
)
 
(992
)
 
(4,589
)
 
(992
)
Total realized losses
(5,403
)
 
(1,308
)
 
(5,657
)
 
(1,466
)
Net realized investment gains
$
11,546

 
$
8,216

 
$
29,463

 
$
20,125

Change in net unrealized gains on investments:
 
 
 
 
 
 
 
Fixed maturities
$
(306,449
)
 
$
27,921

 
$
(337,797
)
 
$
44,590

Equity securities
58,711

 
(47,744
)
 
339,606

 
149,250

Short-term investments
(7
)
 
(2
)
 
(2
)
 
(5
)
Net increase (decrease)
$
(247,745
)
 
$
(19,825
)
 
$
1,807

 
$
193,835


19
Table of Contents


g)The following table presents other-than-temporary impairment losses recognized in net income and included in net realized investment gains by investment type.

 
Quarter Ended June 30,
 
Six Months Ended June 30,
(dollars in thousands)
2013
 
2012
 
2013
 
2012
Fixed maturities:
 
 
 
 
 
 
 
Obligations of states, municipalities and political subdivisions
$
(1,242
)
 
$
—

 
$
(1,242
)
 
$
—

Residential mortgage-backed securities
(523
)
 
—

 
(523
)
 
—

Total fixed maturities
(1,765
)
 
—

 
(1,765
)
 
—

Equity securities:
 
 
 
 
 
 
 
Insurance, banks and other financial institutions
—

 
(826
)
 
—

 
(826
)
Industrial, consumer and all other
(2,824
)
 
(166
)
 
(2,824
)
 
(166
)
Total equity securities
(2,824
)
 
(992
)
 
(2,824
)
 
(992
)
Total
$
(4,589
)
 
$
(992
)
 
$
(4,589
)
 
$
(992
)

h)The Company had $4.9 billion and $1.3 billion of restricted assets held in trust or on deposit for the benefit of policyholders or ceding companies or to support underwriting activities at June 30, 2013 and December 31, 2012, respectively, of which $3.5 billion at June 30, 2013 is attributable to Alterra. Additionally, the Company has pledged investments and cash and cash equivalents totaling $763.2 million and $23.2 million as of June 30, 2013 and December 31, 2012, respectively, as security for letters of credit that have been issued by various banks on behalf of the Company, of which $726.4 million at June 30, 2013 is attributable to Alterra.

These restricted assets are included on the Company's consolidated balance sheets as follows.

(dollars in thousands)
June 30, 2013
 
December 31, 2012
Investments, available-for-sale
$
5,154,074

 
$
1,262,755

Other assets
148,670

 
—

Restricted cash and cash equivalents
396,416

 
109,415

Total
$
5,699,160

 
$
1,372,170


5. Fair Value Measurements

FASB ASC 820-10, Fair Value Measurements and Disclosures, establishes a three-level hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure the assets or liabilities fall within different levels of the hierarchy, the classification is based on the lowest level input that is significant to the fair value measurement of the asset or liability.

Classification of assets and liabilities within the hierarchy considers the markets in which the assets and liabilities are traded and the reliability and transparency of the assumptions used to determine fair value. The hierarchy requires the use of observable market data when available. The levels of the hierarchy are defined as follows:

Level 1 – Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities traded in active markets.

Level 2 – Inputs to the valuation methodology include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability and market-corroborated inputs.

Level 3 – Inputs to the valuation methodology are unobservable for the asset or liability and are significant to the fair value measurement.


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Table of Contents

In accordance with FASB ASC 820, the Company determines fair value based on 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. In determining fair value, the Company uses various methods, including the market, income and cost approaches. The Company uses valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. The following section describes the valuation methodologies used by the Company to measure assets and liabilities at fair value, including an indication of the level within the fair value hierarchy in which each asset or liability is generally classified.

Investments available-for-sale. Investments available-for-sale are recorded at fair value on a recurring basis and include fixed maturities, equity securities and short-term investments. Short-term investments include certificates of deposit, commercial paper, discount notes and treasury bills with original maturities of one year or less. Fair value for investments available-for-sale is determined by the Company after considering various sources of information, including information provided by a third party pricing service. The pricing service provides prices for substantially all of the Company’s fixed maturities and equity securities. In determining fair value, the Company generally does not adjust the prices obtained from the pricing service. The Company obtains an understanding of the pricing service’s valuation methodologies and related inputs, which include, but are not limited to, reported trades, benchmark yields, issuer spreads, bids, offers, duration, credit ratings, estimated cash flows and prepayment speeds. The Company validates prices provided by the pricing service by reviewing prices from other pricing sources and analyzing pricing data in certain instances.

The Company has evaluated the various types of securities in its investment portfolio to determine an appropriate fair value hierarchy level based upon trading activity and the observability of market inputs. Level 1 investments include those traded on an active exchange, such as the New York Stock Exchange. Level 2 investments include U.S. Treasury securities and obligations of U.S. government agencies, municipal bonds, foreign government bonds, residential mortgage-backed securities and corporate debt securities.

Fair value for investments available-for-sale is measured based upon quoted prices in active markets, if available. Due to variations in trading volumes and the lack of quoted market prices, fixed maturities are classified as Level 2 investments. The fair value of fixed maturities is normally derived through recent reported trades for identical or similar securities, making adjustments through the reporting date based upon available market observable data described above. If there are no recent reported trades, the fair value of fixed maturities may be derived through the use of matrix pricing or model processes, where future cash flow expectations are developed based upon collateral performance and discounted at an estimated market rate. Significant inputs used to determine the fair value of obligations of states, municipalities and political subdivisions, corporate bonds and obligations of foreign governments include reported trades, benchmark yields, issuer spreads, bids, offers, credit information and estimated cash flows. Significant inputs used to determine the fair value of residential mortgage-backed securities include the type of underlying mortgage loans, benchmark yields, prepayment speeds, collateral information, tranche type and volatility, estimated cash flows, credit information, default rates, recovery rates, issuer spreads and the year of issue.

Derivatives. Derivatives are recorded at fair value on a recurring basis and include a credit default swap. The fair value of the credit default swap is measured by the Company using an external valuation model. See note 10 for a discussion of the valuation model for the credit default swap, including the key inputs and assumptions used in the model and a description of the valuation processes used by the Company. Due to the significance of unobservable inputs required in measuring the fair value of the credit default swap, the credit default swap has been classified as Level 3 within the fair value hierarchy.

Senior long-term debt and other debt. Senior long-term debt and other debt is carried at amortized cost with the estimated fair value disclosed on the consolidated balance sheets. Senior long-term debt and other debt is classified as Level 2 within the fair value hierarchy due to variations in trading volumes and the lack of quoted market prices. Fair value for senior long-term debt and other debt is generally derived through recent reported trades for identical securities, making adjustments through the reporting date, if necessary, based upon available market observable data including U.S. Treasury securities and implied credit spreads. Significant inputs used to determine the fair value of senior long-term debt and other debt include reported trades, benchmark yields, issuer spreads, bids and offers.


21
Table of Contents

The following tables present the balances of assets and liabilities measured at fair value on a recurring basis by level within the fair value hierarchy.

 
June 30, 2013
(dollars in thousands)
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
 
 
 
 
 
 
 
Investments available-for-sale:
 
 
 
 
 
 
 
Fixed maturities:
 
 
 
 
 
 
 
U.S. Treasury securities and obligations of U.S. government agencies
$
—

 
$
1,298,144

 
$
—

 
$
1,298,144

Obligations of states, municipalities and political subdivisions
—

 
2,882,872

 
—

 
2,882,872

Foreign governments
—

 
1,379,228

 
—

 
1,379,228

Commercial mortgage-backed securities
—

 
413,289

 
—

 
413,289

Residential mortgage-backed securities
—

 
1,044,508

 
—

 
1,044,508

Asset-backed securities
—

 
286,092

 
—

 
286,092

Corporate bonds
—

 
3,374,330

 
—

 
3,374,330

Total fixed maturities
—

 
10,678,463

 
—

 
10,678,463

Equity securities:
 
 
 
 
 
 
 
Insurance, banks and other financial institutions
948,302

 
—

 
—

 
948,302

Industrial, consumer and all other
1,862,132

 
—

 
—

 
1,862,132

Total equity securities
2,810,434

 
—

 
—

 
2,810,434

Short-term investments
910,255

 
85,442

 
—

 
995,697

Total investments available-for-sale
$
3,720,689

 
$
10,763,905

 
$
—

 
$
14,484,594

Liabilities:
 
 
 
 
 
 
 
Derivative contracts
$
—

 
$
—

 
$
5,490

 
$
5,490


 
December 31, 2012
(dollars in thousands)
Level 1
 
Level 2
 
Level 3
 
Total
Assets:
 
 
 
 
 
 
 
Investments available-for-sale:
 
 
 
 
 
 
 
Fixed maturities:
 
 
 
 
 
 
 
U.S. Treasury securities and obligations of U.S. government agencies
$
—

 
$
317,507

 
$
—

 
$
317,507

Obligations of states, municipalities and political subdivisions
—

 
2,831,562

 
—

 
2,831,562

Foreign governments
—

 
556,608

 
—

 
556,608

Residential mortgage-backed securities
—

 
215,377

 
—

 
215,377

Asset-backed securities
—

 
14,345

 
—

 
14,345

Corporate bonds
—

 
1,043,884

 
—

 
1,043,884

Total fixed maturities
—

 
4,979,283

 
—

 
4,979,283

Equity securities:
 
 
 
 
 
 
 
Insurance, banks and other financial institutions
898,067

 
—

 
—

 
898,067

Industrial, consumer and all other
1,508,884

 
—

 
—

 
1,508,884

Total equity securities
2,406,951

 
—

 
—

 
2,406,951

Short-term investments
888,758

 
84,572

 
—

 
973,330

Total investments available-for-sale
$
3,295,709

 
$
5,063,855

 
$
—

 
$
8,359,564

Liabilities:
 
 
 
 
 
 
 
Derivative contracts
$
—

 
$
—

 
$
12,690

 
$
12,690



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Table of Contents

The following table summarizes changes in Level 3 liabilities measured at fair value on a recurring basis.

 
Quarter Ended June 30,
 
Six Months Ended June 30,
(dollars in thousands)
2013
 
2012
 
2013
 
2012
Derivatives, beginning of period
$
9,400

 
$
18,270

 
$
12,690

 
$
29,331

Total gains included in:
 
 
 
 
 
 
 
Net income
(3,910