4. Fair value measurements

a) Fair value hierarchy

Fair value of financial assets and financial liabilities is estimated based on the framework established in the fair value accounting guidance. The guidance defines fair value as the price to sell an asset or transfer a liability in an orderly transaction between market participants and establishes a three-level valuation hierarchy in which inputs into valuation techniques used to measure fair value are classified. The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data.

The three levels of the hierarchy are as follows:

• Level 1 – Unadjusted quoted prices for identical assets or liabilities in active markets;

• Level 2 – Includes, among other items, inputs other than quoted prices that are observable for the asset or liability such as interest rates and yield curves, quoted prices for similar assets and liabilities in active markets, and quoted prices for identical or similar assets and liabilities in markets that are not active; and

• Level 3 – Inputs that are unobservable and reflect management's judgments about assumptions that market participants would use in pricing an asset or liability.

We categorize financial instruments within the valuation hierarchy at the balance sheet date based upon the lowest level of inputs that are significant to the fair value measurement. Accordingly, transfers between levels within the valuation hierarchy occur when there are significant changes to the inputs, such as increases or decreases in market activity, changes to the availability of current prices, changes to the transparency to underlying inputs, and whether there are significant variances in quoted prices. Transfers in and/or out of any level are assumed to occur at the end of the period.

We use one or more pricing services to obtain fair value measurements for the majority of the investment securities we hold. Based on management's understanding of the methodologies used, these pricing services only produce an estimate of fair value if there is observable market information that would allow them to make a fair value estimate. Based on our understanding of the market inputs used by the pricing services, all applicable investments have been valued in accordance with GAAP. We do not typically adjust prices obtained from pricing services. The following is a description of the valuation techniques and inputs used to determine fair values for financial instruments carried at fair value, as well as the general classification of such financial instruments pursuant to the valuation hierarchy.

Fixed maturities

We use pricing services to estimate fair value measurements for the majority of our fixed maturities. The pricing services use market quotations for fixed maturities that have quoted prices in active markets; such securities are classified within Level 1. For fixed maturities other than U.S. Treasury securities that generally do not trade on a daily basis, the pricing services prepare estimates of fair value measurements using their pricing applications, which include available relevant market information, benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing. Additional valuation factors that can be taken into account are nominal spreads, dollar basis, and liquidity adjustments. The pricing services evaluate each asset class based on relevant market and credit information, perceived market movements, and sector news. The market inputs used in the pricing evaluation, listed in the approximate order of priority include: benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, reference data, and industry and economic events. The extent of the use of each input is dependent on the asset class and the market conditions. Given the asset class, the priority of the use of inputs may change or some market inputs may not be relevant. Additionally, the valuation of fixed maturity investments is more subjective when markets are less liquid due to the lack of market based inputs (i.e., stale pricing), which may increase the potential that the estimated fair value of an investment is not reflective of the price at which an actual transaction would occur. The overwhelming majority of fixed maturities are classified within Level 2 because the most significant inputs used in the pricing techniques are observable. For a small number of fixed maturities, we obtain a quote from a broker (typically a market maker). Due to the disclaimers on the quotes that indicate that the price is indicative only, we include these fair value estimates in Level 3.

Equity securities

Equity securities with active markets are classified within Level 1 as fair values are based on quoted market prices. For non-public equity securities, fair values are based on market valuations and are classified within Level 2. Equity securities for which pricing is unobservable are classified within Level 3.

Short-term investments

Short-term investments, which comprise securities due to mature within one year of the date of purchase that are traded in active markets, are classified within Level 1 as fair values are based on quoted market prices. Securities such as commercial paper and discount notes are classified within Level 2 because these securities are typically not actively traded due to their approaching maturity and, as such, their cost approximates fair value.

Other investments

Fair values for the majority of Other investments including investments in partially-owned investment companies, investment funds, and limited partnerships are based on their respective net asset values or equivalent (NAV). The majority of these investments, for which NAV was used as a practical expedient to measure fair value, are classified within Level 3 because either ACE will never have the contractual option to redeem the investment or will not have the contractual option to redeem the investments in the near term. The remainder of such investments is classified within Level 2. The underlying assets within failed separate accounts, as described in Note 1 i), comprise mutual funds classified within Level 1 in the valuation hierarchy on the same basis as other equity securities traded in active markets. Equity securities and fixed maturities held in rabbi trusts maintained by ACE for deferred compensation plans, and included in Other investments, are classified within the valuation hierarchy on the same basis as other equity securities and fixed maturities.

Securities lending collateral

The underlying assets included in Securities lending collateral are fixed maturities which are classified in the valuation hierarchy on the same basis as other fixed maturities. Excluded from the valuation hierarchy is the corresponding liability related to ACE's obligation to return the collateral plus interest as it is reported at contract value and not fair value on the consolidated balance sheets.

Investment derivative instruments

Actively traded investment derivative instruments, including futures, options, and exchange-traded forward contracts, are classified within Level 1 as fair values are based on quoted market prices. Investment derivative instruments are recorded in Accounts payable, accrued expenses, and other liabilities in the consolidated balance sheets.

Other derivative instruments

We maintain positions in other derivative instruments including exchange-traded equity futures contracts and option contracts designed to limit exposure to a severe equity market decline, which would cause an increase in expected claims and, therefore, reserves for our GMDB and GLB reinsurance business. Our position in exchange-traded equity futures contracts is classified within Level 1. The fair value of the majority of the remaining positions in other derivative instruments is based on significant observable inputs including equity security and interest rate indices. Accordingly, these are classified within Level 2. Our position in credit default swaps is typically included within Level 3. Other derivative instruments are recorded in Accounts payable, accrued expenses, and other liabilities in the consolidated balance sheets.

Separate account assets

Separate account assets represent segregated funds where investment risks are borne by the customers, except to the extent of certain guarantees made by ACE. Separate account assets comprise mutual funds classified in the valuation hierarchy on the same basis as other equity securities traded in active markets and are classified within Level 1. Separate account assets also include fixed maturities classified within Level 2 because the most significant inputs used in the pricing techniques are observable. Excluded from the valuation hierarchy are the corresponding liabilities as they are reported at contract value and not fair value on the consolidated balance sheets. Separate account assets are recorded in Other assets in the consolidated balance sheets.

Guaranteed living benefits

The GLB arises from life reinsurance programs covering living benefit guarantees whereby we assume the risk of GMIB and GMAB associated with variable annuity contracts. GLB's are recorded in Accounts payable, accrued expenses, and other liabilities and Future policy benefits in the consolidated balance sheets. For GLB reinsurance, ACE estimates fair value using an internal valuation model which includes current market information and estimates of policyholder behavior. All of the treaties contain claim limits, which are factored into the valuation model. The fair value depends on a number of inputs, including changes in interest rates, changes in equity markets, credit risk, current account value, changes in market volatility, expected annuitization rates, changes in policyholder behavior, and changes in policyholder mortality.

The most significant policyholder behavior assumptions include lapse rates and the GMIB annuitization rates. Assumptions regarding lapse rates and GMIB annuitization rates differ by treaty but the underlying methodologies to determine rates applied to each treaty are comparable. The assumptions regarding lapse and GMIB annuitization rates determined for each treaty are based on a dynamic calculation that uses several underlying factors.

A lapse rate is the percentage of in-force policies surrendered in a given calendar year. All else equal, as lapse rates increase, ultimate claim payments will decrease. In general, the base lapse function assumes low lapse rates (ranging from about 1 percent to 6 percent per annum) during the surrender charge period of the GMIB contract, followed by a "spike" lapse rate (ranging from about 10 percent to 30 percent per annum) in the year immediately following the surrender charge period, and then reverting to an ultimate lapse rate (generally around 10 percent per annum), typically over a 2-year period. This base rate is adjusted downward for policies with more valuable guarantees (policies with guaranteed values far in excess of their account values) by multiplying the base lapse rate by a factor ranging from 15 percent to 75 percent. Additional lapses due to partial withdrawals and older policyholders with tax-qualified contracts (due to required minimum distributions) are also included.

The GMIB annuitization rate is the percentage of policies for which the policyholder will elect to annuitize using the guaranteed benefit provided under the GMIB. All else equal, as GMIB annuitization rates increase, ultimate claim payments will increase, subject to treaty claim limits. In general ACE assumes that GMIB annuitization rates will be higher for policies with more valuable guarantees (policies with guaranteed values far in excess of their account values). In addition, we also assume that GMIB annuitization rates are higher in the first year immediately following the waiting period (the first year the policies are eligible to annuitize using the GMIB) in comparison to all subsequent years. We do not yet have a robust set of annuitization experience because most of our clients' policyholders are not yet eligible to annuitize using the GMIB. However, for certain clients there are several years of annuitization experience. For these clients the annuitization function reflects the actual experience and has a maximum annuitization rate per annum of 8 percent (a higher maximum applies in the first year a policy is eligible to annuitize using the GMIB – it is over 13 percent). For most clients, there is no currently observable relevant annuitization behavior data and so we use a weighted-average (with a heavier weighting on the observed experience noted previously) of three different annuitization functions with maximum annuitization rates per annum of 8 percent, 12 percent, and 30 percent, respectively (with significantly higher rates in the first year a policy is eligible to annuitize using the GMIB). The GMIB reinsurance treaties include claim limits to protect ACE in the event that actual annuitization behavior is significantly higher than expected.

The effect of changes in key market factors on assumed lapse and annuitization rates reflect emerging trends using data available from cedants. For treaties with limited experience, rates are established in line with data received from other ceding companies adjusted, as appropriate, with industry estimates. The model and related assumptions are continuously re-evaluated by management and enhanced, as appropriate, based upon additional experience obtained related to policyholder behavior and availability of more information, such as market conditions, market participant assumptions, and demographics of in-force annuities. During 2011, no changes were made to actuarial or behavioral assumptions. We made minor technical refinements to the model with a favorable net income impact of approximately $14 million and $98 million for the years ended December 31, 2011 and 2010, respectively.

We view the variable annuity reinsurance business as having a similar risk profile to that of catastrophe reinsurance, with the probability of a cumulative long-term economic net loss relatively small at the time of pricing. However, adverse changes in market factors and policyholder behavior will have an adverse impact on net income, which may be material. Because of the significant use of unobservable inputs including policyholder behavior, GLB reinsurance is classified within Level 3.

The following tables present, by valuation hierarchy, the financial instruments measured at fair value on a recurring basis:

December 31, 2011

(in millions of U.S. dollars)

Level 1

Level 2

Level 3

Total

Assets:

Fixed maturities available for sale

U.S. Treasury and agency

1,691

1,264

2,960

Foreign

212

12,156

12,401

Corporate securities

14,539

134

14,693

Mortgage-backed securities

–

10,173

10,201

States, municipalities, and political subdivisions

–

1,711

1,712

1,923

39,843

201

41,967

Equity securities

632

647

Short-term investments

1,246

1,055

–

2,301

Other investments

208

229

1,877

2,314

Securities lending collateral

–

1,375

–

1,375

Investment derivative instruments

–

Other derivative instruments

(16

)

Separate account assets

607

–

660

Total assets measured at fair value

4,610

42,611

2,094

49,315

Liabilities:

GLB⁽¹⁾

–

1,319

There were no significant gross transfers between Level 1 and Level 2 during the year ended December 31, 2011.


December 31, 2010 (in millions of U.S. dollars)	Level 1			Level 2		Level 3		Total
Assets:
Fixed maturities available for sale
U.S. Treasury and agency	$	1,564		$	1,399	$	–	$	2,963
Foreign		187			10,973		26		11,186
Corporate securities		31			13,441		115		13,587
Mortgage-backed securities		–			8,477		39		8,516
States, municipalities, and political subdivisions		–			1,285		2		1,287
		1,782			35,575		182		37,539
Equity securities		676			3		13		692
Short-term investments		903			1,080		–		1,983
Other investments		39			221		1,432		1,692
Securities lending collateral		–			1,495		–		1,495
Investment derivative instruments		11			–		–		11
Other derivative instruments		(25	)		46		4		25
Separate account assets		308			–		–		308
Total assets measured at fair value	$	3,694		$	38,420	$	1,631	$	43,745
Liabilities:
GLB⁽¹⁾	$	–		$	–	$	507	$	507

There were no significant gross transfers between Level 1 and Level 2 during the year ended December 31, 2010.

Fair value of alternative investments

Included in Other investments in the fair value hierarchy at December 31, 2011 and 2010 are investment funds, limited partnerships, and partially-owned investment companies measured at fair value using NAV as a practical expedient. At December 31, 2011 and 2010, there were no probable or pending sales related to any of the investments measured at fair value using NAV.

The following table presents, by investment category, the expected liquidation period, fair value, and maximum future funding commitments of alternative investments:


			December 31 2011				December 31 2010
(in millions of U.S. dollars)	Expected Liquidation Period		Fair Value		Maximum Future Funding Commitments		Fair Value		Maximum Future Funding Commitments
Financial		5 to 9 Years	$	205	$	141	$	192	$	151
Real estate		3 to 9 Years		270		96		163		92
Distressed		6 to 9 Years		182		57		243		43
Mezzanine		6 to 9 Years		195		282		125		173
Traditional		3 to 8 Years		565		200		376		291
Vintage		1 to 3 Years		18		1		27		3
Investment funds		Not Applicable		378		–		329		–
			$	1,813	$	777	$	1,455	$	753

Included in all categories in the above table except for Investment funds are investments for which ACE will never have the contractual option to redeem but receives distributions based on the liquidation of the underlying assets. Included in the "Expected Liquidation Period" column above is the range in years over which ACE expects the majority of underlying assets in the respective categories to be liquidated. Further, for all categories except for Investment funds, ACE does not have the ability to sell or transfer the investments without the consent from the general partner of individual funds.

Financial

Financial consists of investments in private equity funds targeting financial services companies such as financial institutions and insurance services around the world.

Real estate

Real estate consists of investments in private equity funds targeting global distress opportunities, value added U.S. properties, and global mezzanine debt securities in the commercial real estate market.

Distressed

Distressed consists of investments in private equity funds targeting distressed debt/credit and equity opportunities in the U.S.

Mezzanine

Mezzanine consists of investments in private equity funds targeting private mezzanine debt of large-cap and mid-cap companies in the U.S. and worldwide.

Traditional

Traditional consists of investments in private equity funds employing traditional private equity investment strategies such as buyout and venture with different geographical focuses including Brazil, Asia, Europe, and the U.S.

Vintage

Vintage consists of investments in private equity funds made before 2002 and where the funds' commitment periods had already expired.

Investment funds

ACE's investment funds employ various investment strategies such as long/short equity and arbitrage/distressed. Included in this category are investments for which ACE has the option to redeem at agreed upon value as described in each investment fund's subscription agreement. Depending on the terms of the various subscription agreements, investment fund investments may be redeemed monthly, quarterly, semi-annually, or annually. If ACE wishes to redeem an investment fund investment, it must first determine if the investment fund is still in a lock-up period (a time when ACE cannot redeem its investment so that the investment fund manager has time to build the portfolio). If the investment fund is no longer in its lock-up period, ACE must then notify the investment fund manager of its intention to redeem by the notification date prescribed by the subscription agreement. Subsequent to notification, the investment fund can redeem ACE's investment within several months of the notification. Notice periods for redemption of the investment funds range between 5 and 120 days. ACE can redeem its investment funds without consent from the investment fund managers.

Level 3 financial instruments

The following tables present a reconciliation of the beginning and ending balances of financial instruments measured at fair value using significant unobservable inputs (Level 3):


	Assets																							Liabilities
	Available-for-Sale Debt Securities
Year Ended December 31, 2011 (in millions of U.S. dollars)	U.S. Treasury and agency		Foreign			Corporate securities			MBS			States, municipalities, and political subdivisions			Equity securities			Other investments			Other derivative instruments			GLB⁽¹⁾
Balance-Beginning of year	$	–	$	26		$	115		$	39		$	2		$	13		$	1,432		$	4		$	507
Transfers into Level 3		–		9			42			4			–			–			–			–			–
Transfers out of Level 3		–		(18	)		(4	)		(48	)		–			–			–			–			–
Change in Net Unrealized Gains (Losses) included in OCI		–		(1	)		(2	)		–			–			(1	)		93			–			–
Net Realized Gains/Losses		–		–			(3	)		–			–			4			(3	)		2			812
Purchases		5		23			32			59			–			5			602			–			–
Sales		–		(3	)		(27	)		(17	)		–			(8	)		(55	)		–			–
Settlements		–		(3	)		(19	)		(9	)		(1	)		–			(192	)		(3	)		–
Balance-End of year	$	5	$	33		$	134		$	28		$	1		$	13		$	1,877		$	3		$	1,319
Net Realized Gains/Losses Attributable to Changes in Fair Value at the Balance Sheet Date	$	–	$	–		$	–		$	–		$	–		$	–		$	(3	)	$	(1	)	$	812


	Assets																					Liabilities
	Available-for-Sale Debt Securities
Year Ended December 31, 2010 (in millions of U.S. dollars)	Foreign			Corporate securities			MBS			States, municipalities, and political subdivisions			Equity securities			Other investments			Other derivative instruments			GLB⁽¹⁾
Balance-Beginning of year	$	59		$	168		$	21		$	3		$	12		$	1,149		$	14		$	443
Transfers into (Out of) Level 3		(14	)		(25	)		(1	)		–			1			–			–			–
Change in Net Unrealized Gains (Losses) included in OCI		1			9			–			–			–			53			–			–
Net Realized Gains/Losses		1			(3	)		–			–			1			(7	)		2			64
Purchases, Sales, Issuances, and Settlements, Net		(21	)		(34	)		19			(1	)		(1	)		237			(12	)		–
Balance-End of year	$	26		$	115		$	39		$	2		$	13		$	1,432		$	4		$	507
Net Realized Gains/Losses Attributable to Changes in Fair Value at the Balance Sheet Date	$	–		$	–		$	–		$	–		$	–		$	(7	)	$	1		$	64

⁽¹⁾ Our GLB reinsurance product meets the definition of a derivative instrument for accounting purposes and is accordingly carried at fair value. Excluded from the table above is the portion of the GLB derivative liability classified as Future policy benefits in the consolidated balance sheets. The liability for GLB reinsurance was $648 million at December 31, 2010, and $559 million at December 31, 2009, which includes a fair value derivative adjustment of $507 million and $443 million, respectively.


	Assets																			Liabilities
	Available-for-Sale Debt Securities
Year Ended December 31, 2009 (in millions of U.S. dollars)	Foreign			Corporate securities		MBS			States, municipalities, and political subdivisions		Equity securities			Other investments			Other derivative instruments			GLB⁽¹⁾
Balance-Beginning of year	$	45		$	117	$	109		$	3	$	21		$	1,099		$	87		$	811
Transfers into (Out of) Level 3		4			8		(37	)		–		–			(30	)		–			–
Change in Net Unrealized Gains (Losses) included in OCI		5			17		12			–		9			191			–			–
Net Realized Gains/Losses		(1	)		1		(2	)		–		–			(149	)		(71	)		(368	)
Purchases, Sales, Issuances, and Settlements, Net		6			25		(61	)		–		(18	)		38			(2	)		–
Balance-End of year	$	59		$	168	$	21		$	3	$	12		$	1,149		$	14		$	443
Net Realized Gains/Losses Attributable to Changes in Fair Value at the Balance Sheet Date	$	2		$	1	$	–		$	–	$	–		$	(149	)	$	(71	)	$	(368	)

⁽¹⁾ Our GLB reinsurance product meets the definition of a derivative instrument for accounting purposes and is accordingly carried at fair value. Excluded from the table above is the portion of the GLB derivative liability classified as Future policy benefits in the consolidated balance sheets. The liability for GLB reinsurance was $559 million at December 31, 2009, and $910 million at December 31, 2008, which includes a fair value derivative adjustment of $443 million and $811 million, respectively.

c) Financial instruments disclosed, but not carried, at fair value

ACE uses various financial instruments in the normal course of its business. Our insurance contracts are excluded from fair value of financial instruments accounting guidance and, therefore, are not included in the amounts discussed below.

The carrying values of cash, other assets, other liabilities, and other financial instruments not included below approximated their fair values.

Investments in partially-owned insurance companies

Fair values for investments in partially-owned insurance companies are based on ACE's share of the net assets based on the financial statements provided by those companies.

Short- and long-term debt and trust preferred securities

Where practical, fair values for short-term debt, long-term debt, and trust preferred securities are estimated using discounted cash flow calculations based principally on observable inputs including incremental borrowing rates, which reflect ACE's credit rating, for similar types of borrowings with maturities consistent with those remaining for the debt being valued.

The following table presents carrying values and fair values of financial instruments not measured at fair value:


	December 31 2011				December 31 2010
(in millions of U.S. dollars)	Carrying Value		Fair Value		Carrying Value		Fair Value
Assets:
Fixed maturities held to maturity
U.S. Treasury and agency	$	1,078	$	1,126	$	1,105	$	1,127
Foreign		935		930		1,049		1,013
Corporate securities		2,338		2,337		2,361		2,313
Mortgage-backed securities		2,949		3,036		3,811		3,846
States, municipalities, and political subdivisions		1,147		1,176		1,175		1,162
Total fixed maturities held to maturity		8,447		8,605		9,501		9,461
Liabilities:
Short-term debt		1,251		1,251		1,300		1,300
Long-term debt		3,360		3,823		3,358		3,690
Trust preferred securities		309		404		309		364
Total liabilities	$	4,920	$	5,478	$	4,967	$	5,354