Note 4. Investments

The following tables set forth the Company’s cash and investments as of December 31, 2012 and 2011. The tables below include OTTI securities recognized within OCI.


	December 31, 2012
In thousands	Fair Value		Gross Unrealized Gains		Gross Unrealized Losses			Amortized Cost
Fixed maturities:
U.S. Treasury bonds, agency bonds and foreign government bonds	$	649,692	$	8,654	$	(36	)	$	641,074
States, municipalities and political subdivisions		322,947		18,712		(380	)		304,615
Mortgage-backed and asset-backed securities:
Agency mortgage-backed securities		384,445		13,652		(204	)		370,997
Residential mortgage obligations		38,692		1,053		(549	)		38,188
Asset-backed securities		50,382		1,133		(49	)		49,298
Commercial mortgage-backed securities		204,821		17,996		(18	)		186,843

Subtotal	$	678,340	$	33,834	$	(820	)	$	645,326
Corporate bonds		470,854		27,129		(25	)		443,750

Total fixed maturities	$	2,121,833	$	88,329	$	(1,261	)	$	2,034,765
Equity securities—common stocks		101,297		16,919		(626	)		85,004
Short-term investments		153,788		—		—			153,788
Cash		45,336		—		—			45,336

Total	$	2,422,254	$	105,248	$	(1,887	)	$	2,318,893


	December 31, 2011
In thousands	Fair Value		Gross Unrealized Gains		Gross Unrealized Losses			Amortized Cost
Fixed maturities:
U.S. Treasury bonds, agency bonds and foreign government bonds	$	336,070	$	8,979	$	(383	)	$	327,474
States, municipalities and political subdivisions		410,836		28,887		(108	)		382,057
Mortgage-backed and asset-backed securities:
Agency mortgage-backed securities		395,860		17,321		(3	)		378,542
Residential mortgage obligations		23,148		8		(2,848	)		25,988
Asset-backed securities		48,934		695		(75	)		48,314
Commercial mortgage-backed securities		216,034		10,508		(593	)		206,119

Subtotal	$	683,976	$	28,532	$	(3,519	)	$	658,963
Corporate bonds		457,187		15,743		(6,772	)		448,216

Total fixed maturities	$	1,888,069	$	82,141	$	(10,782	)	$	1,816,710
Equity securities—common stocks		95,849		23,240		(958	)		73,567
Short-term investments		122,220		—		—			122,220
Cash		127,360		—		—			127,360

Total	$	2,233,498	$	105,381	$	(11,740	)	$	2,139,857

The total non-credit OTTI on debt securities included in other comprehensive income as of December 31, 2011 was $1.7 million. As of December 31, 2012 due to appreciation in the fair value, the debt securities for which non-credit OTTI was previously recognized are now in an unrealized gain position of twenty thousand.

The fair value of the Company’s investment portfolio may fluctuate significantly in response to various factors such as changes in interest rates, investment quality ratings, equity prices, foreign exchange rates and credit spreads. The Company does not have the intent to sell nor is it more likely than not that it will have to sell debt securities in unrealized loss positions that are not other-than-temporarily impaired before recovery. For structured securities, default probability and severity assumptions differ based on property type, vintage and the stress of the collateral. We do not intend to sell any of these securities and it is more likely than not that we will not be required to sell these securities before the recovery of the amortized cost basis. For equity securities, the Company also considers its intent to hold securities as part of the process of evaluating whether a decline in fair value represents an other-than-temporary decline in value. The Company may realize investment losses to the extent its liquidity needs require the disposition of fixed maturity securities in unfavorable interest rate, liquidity or credit spread environments. Significant changes in the factors the Company considers when evaluating investments for impairment losses could result in a significant change in impairment losses reported in the consolidated financial statements.

The contractual maturity dates for fixed maturity securities categorized by the number of years until maturity as of December 31, 2012 are shown in the following table:


	December 31, 2012
In thousands	Fair Value		Amortized Cost
Due in one year or less	$	107,224	$	106,500
Due after one year through five years		801,129		780,715
Due after five years through ten years		356,251		333,257
Due after ten years		178,889		168,967
Mortgage- and asset-backed securities		678,340		645,326

Total	$	2,121,833	$	2,034,765

Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Due to the periodic repayment of principal, the mortgage-backed and asset-backed securities are estimated to have an effective maturity of approximately 4.0 years.

The following table shows the amount and percentage of the Company’s fixed maturities as of December 31, 2012 by Standard & Poor’s (“S&P”) credit rating or, if an S&P rating is not available, the equivalent Moody’s Investor Services (“Moody’s”) rating. The table includes fixed maturities at fair value, and the total rating is the weighted average quality rating.


	December 31, 2012
In thousands	Rating	Fair Value		Percent of Total
Rating description:
Extremely strong	AAA	$	316,511		15	%
Very strong	AA		1,257,209		59	%
Strong	A		369,620		17	%
Adequate	BBB		159,943		8	%
Speculative	BB & Below		14,780		1	%
Not rated	NR		3,770		0	%

Total	AA	$	2,121,833		100	%

The following table summarizes all securities in a gross unrealized loss position as of December 31, 2012 and 2011, showing the aggregate fair value and gross unrealized loss by the length of time those securities had continuously been in a gross unrealized loss position as well as the relevant number of securities.


	December 31, 2012						December 31, 2011
In thousands, except # of securities	Number of Securities		Fair Value		Gross Unrealized Loss		Number of Securities		Fair Value		Gross Unrealized Loss
Fixed maturities:

U.S. Treasury bonds, agency bonds, and foreign government bonds
0-6 months		8	$	23,760	$	22		7	$	58,587	$	98
7-12 months		3		14,118		11		—		—		—
> 12 months		1		4,652		3		2		6,883		285

Subtotal		12	$	42,530	$	36		9	$	65,470	$	383
States, municipalities and political subdivisions
0-6 months		10	$	21,299	$	325		7	$	5,894	$	72
7-12 months		—		—		—		1		216		1
> 12 months		4		2,908		55		5		2,420		35

Subtotal		14	$	24,207	$	380		13	$	8,530	$	108
Agency mortgage-backed securities
0-6 months		10	$	62,516	$	174		3	$	5,087	$	3
7-12 months		2		1,671		30		—		—		—
> 12 months		—		—		—		—		—		—

Subtotal		12	$	64,187	$	204		3	$	5,087	$	3
Residential mortgage obligations
0-6 months		6	$	1,825	$	22		6	$	6,672	$	184
7-12 months		—		—		—		7		5,250		313
> 12 months		35		7,252		527		47		10,749		2,351

Subtotal		41	$	9,077	$	549		60	$	22,671	$	2,848
Asset-backed securities
0-6 months		—	$	—	$	—		2	$	4,933	$	12
7-12 months		—		—		—		5		6,645		63
> 12 months		2		2,369		49		1		2		—

Subtotal		2	$	2,369	$	49		8	$	11,580	$	75
Commercial mortgage-backed securities
0-6 months		7	$	2,639	$	7		6	$	5,465	$	29
7-12 months		—		—		—		3		6,840		550
> 12 months		5		845		11		3		1,503		14

Subtotal		12	$	3,484	$	18		12	$	13,808	$	593
Corporate bonds
0-6 months		2	$	3,528	$	6		52	$	135,516	$	4,539
7-12 months		—		—		—		18		27,561		1,457
> 12 months		4		6,689		19		8		14,898		776

Subtotal		6	$	10,217	$	25		78	$	177,975	$	6,772

Total fixed maturities		99	$	156,071	$	1,261		183	$	305,121	$	10,782

Equity securities—common stocks
0-6 months		13	$	23,345	$	522		4	$	3,320	$	587
7-12 months		1		1,943		104		1		1,629		371
> 12 months		—		—		—		—		—		—

Total equity securities		14	$	25,288	$	626		5	$	4,949	$	958

As of December 31, 2012 and 2011, the largest single unrealized loss by a non-government backed issuer in the investment portfolio was $0.2 million and $1.4 million, respectively.

The company analyzes the unrealized losses quarterly to determine if any are other-than-temporary. The above unrealized losses have been determined to be temporary based on our policies.

For debt securities, when assessing whether the amortized cost basis of the security will be recovered, the Company compares the present value of cash flows expected to be collected in relation to the current book value. Any shortfalls of the present value of the cash flows expected to be collected to the amortized cost basis is considered the credit loss portion of OTTI losses and is recognized in earnings. All non-credit losses are recognized as changes in OTTI losses within OCI.

To determine whether the unrealized loss on structured securities is other-than-temporary, the Company analyzes the projections provided by its investment managers with respect to an expected principal loss under a range of scenarios and utilizes the most likely outcomes. The analysis relies on actual collateral performance measures such as default rate, prepayment rate and loss severity. These assumptions are applied throughout the remaining term of the deal, incorporating the transaction structure and priority of payments, to generate loss adjusted cash flows. Results of the analysis will indicate whether the security is expected ultimately to incur a loss or whether there is a material impact on yield due to either a projected loss or a change in cash flow timing. A break even default rate is also calculated. A comparison of the break even default rate to the actual default rate provides an indication of the level of cushion or coverage to the first dollar principal loss. The analysis applies the stated assumptions throughout the remaining term of the transaction to forecast cash flows, which are then applied through the transaction structure to determine whether there is a loss to the security. For securities in which a tranche loss is present, and the net present value of loss adjusted cash flows is less than book value, impairment is recognized. The output data also includes a number of additional metrics such as average life remaining, original and current credit support, over 60 day delinquency and security rating.

The significant inputs used to measure the amount of credit loss recognized in earnings were actual delinquency rates, default probability assumptions, severity assumptions and prepayment assumptions. Projected losses are a function of both loss severity and probability of default. Default probability and severity assumptions differ based on property type, vintage and the stress of the collateral. The Company does not intend to sell any of these securities and it is more likely than not that it will not be required to sell these securities before the recovery of the amortized cost basis.

For equity securities, in general, the Company focuses its attention on those securities with a fair value less than 80% of their cost for six or more consecutive months. If warranted as the result of conditions relating to a particular security, the Company will focus on a significant decline in fair value regardless of the time period involved. Factors considered in evaluating potential impairment include, but are not limited to, the current fair value as compared to cost of the security, the length of time the investment has been below cost and by how much the investment is below cost. If an equity security is deemed to be other-than-temporarily impaired, the cost is written down to fair value with the loss recognized in earnings.

For equity securities, the Company also considers its intent to hold securities as part of the process of evaluating whether a decline in fair value represents an other-than-temporary decline in value. For fixed maturity securities, the Company considers its intent to sell a security and whether it is more likely than not that the Company will be required to sell a security before the anticipated recovery as part of the process of evaluating whether a security’s unrealized loss represents an other-than-temporary decline. The Company’s ability to hold such securities is supported by sufficient cash flow from its operations and from maturities within its investment portfolio in order to meet its claims payment and other disbursement obligations arising from its underwriting operations without selling such investments. With respect to securities where the decline in value is determined to be temporary and the security’s value is not written down, a subsequent decision may be made to sell that security and realize a loss. Subsequent decisions on security sales are made within the context of overall risk monitoring, changing information and market conditions.

The following table summarizes the gross unrealized investment losses by length of time that the fair value continues to be less than 80% of amortized cost as of December 31, 2012:


	December 31, 2012
In thousands	Fixed Maturities		Equity Securities		Total
Less than three months	$	—	$	—	$	—
Longer than three months and less than six months		—		—		—
Longer than six months and less than twelve months		—		—		—
Longer than twelve months		32		—		32

Total	$	32	$	—	$	32

The table below summarizes the Company’s activity related to OTTI losses for the periods indicated:


	Year Ended December 31,
	2012				2011				2010
In thousands, except # of securities	Number of Securities		Amount		Number of Securities		Amount		Number of Securities		Amount
Total OTTI losses:
Corporate and other bonds		—	$	—		1	$	109		—	$	—
Commercial mortgage-backed securities		—		—		—		—		—		—
Residential mortgage-backed securities		1		55		19		2,616		18		1,835
Asset-backed securities		—		—		—		—		—		—
Equities		3		847		2		892		2		387

Total		4	$	902		22	$	3,617		20	$	2,222
Less: Portion of loss in accumulated other comprehensive income (loss):
Corporate and other bonds			$	—			$	—			$	—
Commercial mortgage-backed securities				—				—				—
Residential mortgage-backed securities				44				1,632				1,142
Asset-backed securities				—				—				—
Equities				—				—				—

Total			$	44			$	1,632			$	1,142
Impairment losses recognized in earnings:
Corporate and other bonds			$	—			$	109			$	—
Commercial mortgage-backed securities				—				—				—
Residential mortgage-backed securities				11				984				693
Asset-backed securities				—				—				—
Equities				847				892				387

Total			$	858			$	1,985			$	1,080

The following table summarizes the cumulative amounts related to the Company’s credit loss portion of the OTTI losses on debt securities for the years ended December 31, 2012, 2011 and 2010. The Company does not intend to sell and it is more likely than not that it will not be required to sell, the securities prior to recovery of the amortized cost basis and for which the non-credit loss portion is included in OCI.


	Year Ended December 31,
In thousands	2012		2011		2010
Beginning balance	$	3,321	$	2,228	$	2,523
Additions for credit loss impairments recognized in the current period on securities not previously impaired				109		271
Additions for credit loss impairments recognized in the current period on securities previously impaired		11		984		422
Reductions for credit loss impairments previously recognized on securities sold during the period		—		—		(988	)

Ending balance	$	3,332	$	3,321	$	2,228

The contractual maturity dates for fixed maturity securities categorized by the number of years until maturity, with a gross unrealized loss as of December 31, 2012 is presented in the following table:


	December 31, 2012
	Gross Unrealized Losses					Fair Value
In thousands	Amount		Percent of Total			Amount		Percent of Total
Due in one year or less	$	7		1	%	$	8,560		5	%
Due after one year through five years		62		5	%		33,336		21	%
Due after five years through ten years		89		7	%		6,157		4	%
Due after ten years		283		22	%		28,901		19	%
Mortgage- and asset-backed securities		820		65	%		79,117		51	%

Total	$	1,261		100	%	$	156,071		100	%

The Company’s net investment income was derived from the following sources:


	Year Ended December 31,
In thousands	2012			2011			2010
Fixed maturities	$	58,995		$	65,060		$	69,996
Equity securities		3,945			5,071			3,028
Short-term investments		1,694			964			965

Total investment income		64,634			71,095			73,989
Investment expenses		(10,386	)		(7,595	)		(2,327	)

Net investment income	$	54,248		$	63,500		$	71,662

The decrease in total investment income before investment expenses for all years presented was primarily due to lower investment yields and to a lesser extent, shorter portfolio duration. The annualized pre-tax investment yield, excluding net realized gains and losses and net OTTI losses recognized in earnings, was 2.4%, 3.0% and 3.5% for the years ended December 31, 2012, 2011 and 2010, respectively. The portfolio duration was 3.6 years for both the years ended December 31, 2012 and 2011, and was 4.4 years for the year ended December 31, 2010.

Investment expenses for the year ended December 31, 2012 and 2011 include $4.5 million and $4.7 million, respectively, for a total of $9.2 million, of interest expense related to the settlement of a dispute with Equitas over foregone interest on amounts that were due on certain reinsurance contracts. In the dispute Equitas alleged that we failed to make timely payments to them under certain reinsurance agreements in connection with subrogation recoveries received by the Company with respect to several catastrophe losses that occurred in the late 1980’s and early 1990’s. In addition, investment expenses for the year ended December 31, 2012 includes a $2.8 million investment performance fee. Excluding the impact of the aforementioned interest expense and investment performance fee, the annualized pre-tax yield for the years ended December 31, 2012 and 2011 would have been 2.7% and 3.2%, reflective of the general decline in market yield.

The change in net unrealized gains and losses, inclusive of the change in the non-credit portion of OTTI losses, consisted of:


	Year Ended December 31,
In thousands	2012			2011			2010
Fixed maturities	$	15,709		$	44,712		$	(12,039	)
Equity securities		(5,989	)		(183	)		7,231

Gross unrealized gains (losses)		9,720			44,529			(4,808	)
Deferred income tax		3,418			15,143			(1,324	)

Change in net unrealized gains (losses), net	$	6,302		$	29,386		$	(3,484	)

Realized gains and losses, excluding net OTTI losses recognized in earnings, for the periods indicated were as follows:


	Year Ended December 31,
In thousands	2012			2011			2010
Fixed maturities:
Gains	$	28,789		$	11,678		$	42,932
Losses		(1,915	)		(7,044	)		(3,239	)

Fixed maturities, net	$	26,874		$	4,634		$	39,693
Equity securities:
Gains	$	14,673		$	9,319		$	1,867
Losses		(473	)		(1,957	)		(241	)

Equity securities, net	$	14,200		$	7,362		$	1,626

Net realized gains (losses)	$	41,074		$	11,996		$	41,319

Net realized gains and losses are generated as part of the normal ongoing management of our investment portfolio. Net realized gains of $41.1 million for the year ended December 31, 2012 are primarily due to the sale of municipal bonds and equity securities in anticipation of continued market uncertainty, the proceeds of which were reinvested in U.S. Government Treasury bonds and equities. Net realized gains of $12.0 million for the year ended December 31, 2011 primarily included the sale of corporate bonds and equity mutual funds. Net realized gains of $41.3 million for the year ended December 31, 2010 included the sale of the majority of our general obligation municipal bond obligations, the proceeds of which were reinvested in corporate bonds and agency mortgage-backed securities.

The following tables present, for each of the fair value hierarchy levels as defined by the accounting guidance for fair value measurements and described below, the Company’s fixed maturities and equity securities by asset class that are measured at fair value on a recurring basis as of December 31, 2012 and 2011:


	December 31, 2012
In thousands	Level 1		Level 2		Level 3		Total
Fixed maturities:
U.S. Treasury bonds, agency bonds and foreign government bonds	$	414,502	$	235,190	$	—	$	649,692
States, municipalities and political subdivisions		—		322,947		—		322,947
Mortgage-backed and asset-backed securities:								—
Agency mortgage-backed securities		—		384,445		—		384,445
Residential mortgage obligations		—		38,692		—		38,692
Asset-backed securities		—		50,382		—		50,382
Commercial mortgage-backed securities		—		204,821		—		204,821

Subtotal	$	—	$	678,340	$	—	$	678,340
Corporate bonds		—		470,854		—		470,854

Total fixed maturities	$	414,502	$	1,707,331	$	—	$	2,121,833
Equity securities—common stocks		101,297		—		—		101,297

Total	$	515,799	$	1,707,331	$	—	$	2,223,130


	December 31, 2011
In thousands	Level 1		Level 2		Level 3		Total
Fixed maturities:
U.S. Treasury bonds, agency bonds and foreign government bonds	$	136,625	$	199,445	$	—	$	336,070
States, municipalities and political subdivisions		—		410,836		—		410,836
Mortgage-backed and asset-backed securities:								—
Agency mortgage-backed securities		—		395,860		—		395,860
Residential mortgage obligations		—		23,148		—		23,148
Asset-backed securities		—		48,934		—		48,934
Commercial mortgage-backed securities		—		216,034		—		216,034

Subtotal	$	—	$	683,976	$	—	$	683,976
Corporate bonds		—		457,187		—		457,187

Total fixed maturities	$	136,625	$	1,751,444	$	—	$	1,888,069
Equity securities—common stocks		95,849		—		—		95,849

Total	$	232,474	$	1,751,444	$	—	$	1,983,918

The fair value of financial instruments is determined based on the following fair value hierarchy:

Level 1 – Quoted prices for identical instruments in active markets. Examples are listed equity and fixed income securities traded on an exchange. U.S. Treasury securities are reported as level 1 and are valued based on unadjusted quoted prices for identical assets in active markets that the Company can access.

Level 2 – Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets. Examples are asset-backed and mortgage-backed securities that are similar to other asset-backed or mortgage-backed securities observed in the market. U.S. government agency securities are reported as level 2 and are valued using yields and spreads that are observable in active markets.

Level 3 – Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable. An example would be a private placement with minimal liquidity.

The Company did not have any significant transfers between Level 1 and 2 for the years ended December 31, 2012 and 2011.

As of December 31, 2012, the company did not have any Level 3 assets. Any pricing where the input is based solely on a broker price is deemed to be a Level 3 price.

The following tables present a reconciliation of the beginning and ending balances for all investments measured at fair value using Level 3 inputs for the years ended December 31, 2011 and 2010.


	Year Ended December 31, 2011
In thousands	Beginning Balance		Realized Gains (Losses)		Unrealized Gains (Losses)		Purchases		Sales		Settlements		Transfers into Level 3		Transfers out of Level 3			Ending Balance
Assets:
Commercial Mortgage Obligations	$	1,837	$	—	$	94	$	—	$	—	$	—	$	—	$	(1,931	)	$	—

Total assets	$	1,837	$	—	$	94	$	—	$	—	$	—	$	—	$	(1,931	)	$	—


	Year Ended December 31, 2010
In thousands	Beginning Balance		Realized Gains (Losses)		Unrealized Gains (Losses)			Purchases		Sales		Settlements		Transfers into Level 3		Transfers out of Level 3		Ending Balance
Assets:
Commercial Mortgage Obligations	$	—	$	—	$	(19	)	$	1,856	$	—	$	—	$	—	$	—	$	1,837

Total assets	$	—	$	—	$	(19	)	$	1,856	$	—	$	—	$	—	$	—	$	1,837

As of December 31, 2012 and 2011, the Company’s restricted net assets in support of the underwriting activities of the Insurance Companies and Lloyd’s Operations were $519.2 million and $462.5 million, respectively, consisting of fixed maturities, short term investments and cash. Refer to Note 14, Dividends and Statutory Financial Information, for additional information on the nature and type of restricted net assets.

As of December 31, 2012 and 2011, the Company did not have a concentration of greater than 5% of invested assets in a single non-U.S. government-backed issuer.