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.

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, U.S. government-sponsored enterprises, municipal bonds, foreign government bonds, commercial mortgage-backed securities, residential mortgage-backed securities, asset-backed securities and corporate debt securities. Level 3 investments include the Company's investments in insurance-linked securities funds (the ILS Funds), as further described in note 12, which are not traded on an active exchange and are valued using unobservable inputs.

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 commercial mortgage-backed securities, residential mortgage-backed securities and asset-backed securities include the type of underlying assets, 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.

Due to the significance of unobservable inputs required in measuring the fair value of the Company's investments in the ILS Funds, these investments are classified as Level 3 within the fair value hierarchy. Changes in fair value of the ILS Funds are included in net realized gains in net income. The fair value of the securities are derived using their reported net asset value (NAV) as the primary input, as well as other observable and unobservable inputs as deemed necessary by management. Management has obtained an understanding of the inputs, assumptions, process, and controls used to determine NAV, which is calculated by an independent third party. Unobservable inputs to the NAV calculations include assumptions around premium earnings patterns and loss reserve estimates for the underlying securitized reinsurance contracts in which the ILS Funds invest. Significant unobservable inputs used in the valuation of these investments include an adjustment to include the fair value of the equity that was issued by one of the ILS Funds in exchange for notes receivable, rather than cash, which is excluded from NAV. The Company's investments in the ILS Funds are redeemable annually as of January 1^st of each calendar year.

The Company's valuation policies and procedures for Level 3 investments are determined by management. Fair value measurements are analyzed quarterly to ensure the change in fair value from prior periods is reasonable relative to management's understanding of the underlying investments, recent market trends and external market data, which includes the price of a comparable security and an insurance-linked security index.

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.

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



	June 30, 2017
(dollars in thousands)	Level 1		Level 2		Level 3		Total
Assets:
Investments available-for-sale:
Fixed maturities:
U.S. Treasury securities	$	—	$	137,641	$	—	$	137,641
U.S. government-sponsored enterprises	—		381,879		—		381,879
Obligations of states, municipalities and political subdivisions	—		4,653,366		—		4,653,366
Foreign governments	—		1,451,717		—		1,451,717
Commercial mortgage-backed securities	—		1,183,399		—		1,183,399
Residential mortgage-backed securities	—		848,775		—		848,775
Asset-backed securities	—		37,797		—		37,797
Corporate bonds	—		1,358,918		—		1,358,918
Total fixed maturities	—		10,053,492		—		10,053,492
Equity securities:
Insurance, banks and other financial institutions	1,680,416		—		183,913		1,864,329
Industrial, consumer and all other	3,476,498		—		—		3,476,498
Total equity securities	5,156,914		—		183,913		5,340,827
Short-term investments	1,614,064		90,352		—		1,704,416
Total investments available-for-sale	$	6,770,978	$	10,143,844	$	183,913	$	17,098,735



	December 31, 2016
(dollars in thousands)	Level 1		Level 2		Level 3		Total
Assets:
Investments available-for-sale:
Fixed maturities:
U.S. Treasury securities	$	—	$	258,584	$	—	$	258,584
U.S. government-sponsored enterprises	—		423,212		—		423,212
Obligations of states, municipalities and political subdivisions	—		4,428,205		—		4,428,205
Foreign governments	—		1,463,462		—		1,463,462
Commercial mortgage-backed securities	—		1,040,356		—		1,040,356
Residential mortgage-backed securities	—		790,946		—		790,946
Asset-backed securities	—		27,338		—		27,338
Corporate bonds	—		1,459,407		—		1,459,407
Total fixed maturities	—		9,891,510		—		9,891,510
Equity securities:
Insurance, banks and other financial institutions	1,506,607		—		191,203		1,697,810
Industrial, consumer and all other	3,048,031		—		—		3,048,031
Total equity securities	4,554,638		—		191,203		4,745,841
Short-term investments	2,255,898		80,253		—		2,336,151
Total investments available-for-sale	$	6,810,536	$	9,971,763	$	191,203	$	16,973,502

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



	Quarter Ended June 30,						Six Months Ended June 30,
(dollars in thousands)	2017			2016			2017			2016
Equity securities, beginning of period	$	178,043		$	176,942		$	191,203		$	—
Purchases	1,250			25,000			7,250			195,250
Sales	(1,303		)	(25,000		)	(26,674		)	(25,000		)
Total gains included in:
Net income	5,923			6,581			12,134			13,273
Other comprehensive income	—			—			—			—
Transfers into Level 3	—			—			—			—
Transfers out of Level 3	—			—			—			—
Equity securities, end of period	$	183,913		$	183,523		$	183,913		$	183,523
Net unrealized gains included in net income relating to assets held at June 30, 2017 and 2016⁽¹⁾	$	5,923		$	6,581		$	12,134		$	13,273

⁽¹⁾ Included in net realized investment gains in the consolidated statements of income and comprehensive income.

There were no transfers into or out of Level 1 and Level 2 during the quarter and six months ended June 30, 2017 and 2016.

Except as disclosed in note 3, the Company did not have any assets or liabilities measured at fair value on a non-recurring basis during the six months ended June 30, 2017 and 2016.