Note 7. Income Taxes

The Company is subject to the tax laws and regulations of the United States (“U.S.”) and foreign countries in which it operates. The Company files a consolidated U.S. federal tax return, which includes all domestic subsidiaries and the United Kingdom (“U.K.”) Branch. The income from the foreign operations is designated as either U.S. connected income or non-U.S. connected income. Lloyd’s is required to pay U.S. income tax on U.S. connected income written by Lloyd’s syndicates. Lloyd’s and the Internal Revenue Service (“IRS”) have entered into an agreement whereby the amount of tax due on U.S. connected income is calculated by Lloyd’s and remitted directly to the IRS. These amounts are then charged to the corporate members in proportion to their participation in the relevant syndicates. The Company’s corporate members are subject to this agreement and will receive U.K. tax credits for any U.S. income tax incurred up to the U.K. income tax charged on the U.S. connected income. The non-U.S. connected insurance income would generally constitute taxable income under the Subpart F income section of the Internal Revenue Code (“Subpart F”) since less than 50% of Syndicate 1221’s premiums are derived within the U.K. and would therefore be subject to U.S. taxation when the Lloyd’s year of account closes. Taxes are accrued at a 35% rate on the Company’s foreign source insurance income and foreign tax credits, where available, are utilized to offset U.S. tax as permitted. The Company’s effective tax rate for Syndicate 1221 taxable income could substantially exceed 35% to the extent the Company is unable to offset U.S. taxes paid under Subpart F tax regulations with U.K. tax credits on future underwriting year distributions. U.S. taxes are not accrued on the earnings of the Company’s foreign agencies as these earnings are not includable as Subpart F income in the current year. These earnings are subject to taxes under U.K. tax regulations at a 28% rate through March 31, 2011. A finance bill was enacted in the U.K. that reduces the U.K. corporate tax rate from 28% to 26% effective April 2011. The effect of such tax rate change was not material.

The components of current and deferred income tax expense (benefit) are as follows:

		September 30,		September 30,		September 30,
	Year Ended December 31,
In thousands	2011		2010		2009
Current income tax expense:
Federal and foreign	$	573	$	11,965	$	25,833
State and local		340		97		142

Subtotal		913		12,062		25,975

Deferred income tax expense (benefit):
Federal and foreign		6,224		17,189		(2,285	)
State and local		—		—		—

Subtotal		6,224		17,189		(2,285	)

Total income tax expense	$	7,137	$	29,251	$	23,690

A reconciliation of total income taxes applicable to pre-tax operating income and the amounts computed by applying the federal statutory income tax rate to the pre-tax operating income was as follows:

		September 30,		September 30,			September 30,		September 30,			September 30,		September 30,
	Year Ended December 31,
In thousands	2011					2010					2009
Computed expected tax expense	$	11,457		35.0	%	$	34,590		35.0	%	$	30,397		35.0	%
Tax-exempt interest		(4,437	)	-13.6	%		(5,992	)	-6.1	%		(8,295	)	-9.6	%
Dividends received deduction		(1,065	)	-3.3	%		(718	)	-0.7	%		(598	)	-0.7	%
Proration		825		2.5	%		1,006		1.0	%		1,334		1.5	%
Current state and local income taxes, net of federal income tax		221		0.7	%		63		0.1	%		93		0.1	%
Other		136		0.4	%		302		0.3	%		759		0.9	%

Actual tax expense and rate	$	7,137		21.8	%	$	29,251		29.6	%	$	23,690		27.3	%

The tax effects of temporary differences that give rise to federal, foreign, state and local deferred tax assets and deferred tax liabilities were as follows:

		September 30,			September 30,
	December 31,
In thousands	2011			2010
Deferred tax assets:
Loss reserve discount	$	31,687		$	30,190
Unearned premiums		19,253			14,358
Compensation related		2,695			5,149
State and local net deferred tax assets		242			2,185
Other		664			3,872

Total gross deferred tax assets		54,541			55,754
Less: Valuation allowance		(242	)		(2,185	)

Total deferred tax assets		54,299			53,569

Deferred tax liabilities:
Deferred acquisition costs		(16,939	)		(11,645	)
Net unrealized gains on securities		(32,782	)		(17,638	)
Other		(10,869	)		(9,145	)

Total deferred tax liabilities		(60,590	)		(38,428	)

Net deferred income tax asset (liability)	$	(6,291	)	$	15,141

The Company has not provided for U.S. deferred income taxes on the undistributed earnings of approximately $60.9 million of its non-U.S. subsidiaries since these earnings are intended to be permanently reinvested in the non-U.S. subsidiaries. However, in the future, if such earnings were distributed to the Company, taxes of approximately $1.2 million, assuming all foreign tax credits are realized, would be payable on such undistributed earnings and would be reflected in the tax provision for the year in which these earnings are no longer intended to be permanently reinvested in the foreign subsidiary.

In assessing the realization of deferred tax assets, management considers whether it is more likely than not that the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, tax planning strategies and anticipated future taxable income in making this assessment and believes it is more likely than not that we will realize the benefits of its deductible differences as of December 31, 2011, net of any valuation allowance.

The Company had state and local deferred tax assets amounting to potential future tax benefits of $0.2 million and $2.2 million as of December 31, 2011 and 2010, respectively. Included in the deferred tax assets are state and local net operating loss carry-forwards of $0.2 million and $1.4 million as of December 31, 2011 and 2010, respectively. A valuation allowance was established for the full amount of these potential future tax benefits due to the uncertainty associated with their realization. The Company’s state and local tax carry-forwards as of December 31, 2011 expire from 2024 to 2030.

Unrecognized tax benefits are differences between tax positions taken in the tax returns and benefits recognized in the financial statements. The Company has no unrecognized tax benefits as of December 31, 2011 and 2010. The Company did not incur any interest or penalties related to unrecognized tax benefits for the years ended December 31, 2011 and 2010. The Company is currently not under examination by any major U.S. or foreign tax authority and is generally subject to U.S. Federal, state or local, or foreign tax examinations by tax authorities for 2008 and subsequent years.