10-Q 1 afsi930201310q.htm 10-Q AFSI 9.30.2013 10Q


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
(Mark One)
 
S
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended September 30, 2013
 
£
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ___________________ to ___________________
 
Commission file no. 001-33143
 
AmTrust Financial Services, Inc.
(Exact name of registrant as specified in its charter)
 
Delaware
 
04-3106389
(State or other jurisdiction of
 
(IRS Employer Identification No.)
incorporation or organization)
 
 
 
 
 
59 Maiden Lane, 43rd Floor, New York, New York
 
10038
(Address of principal executive offices)
 
(Zip Code)
 
(212) 220-7120
(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 Web site, 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       ¨
 
 
 
Non-accelerated filer         ¨
 
Smaller reporting company      ¨
(Do not check if a smaller reporting company)
 
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act).
Yes      ¨ No      x
 
As of November 1, 2013, the Registrant had one class of Common Stock ($.01 par value), of which 74,649,716 shares were issued and outstanding. 




INDEX

 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

2



PART 1 - FINANCIAL INFORMATION
Item 1. Financial Statements
AMTRUST FINANCIAL SERVICES, INC. AND SUBSIDIARIES
Condensed Consolidated Balance Sheet (In Thousands, Except Par Value)
 
September 30,
2013
 
December 31,
2012
ASSETS
(Unaudited)
 
(Audited)
Investments:
 
 
 
Fixed maturities, available-for-sale, at market value (amortized cost $3,041,141; $1,947,644)
$
3,053,959

 
$
2,065,226

Equity securities, available-for-sale, at market value (cost $29,498; $20,943)
29,704

 
20,465

Short-term investments
22,471

 
10,282

Equity investment in unconsolidated subsidiaries – related party
88,847

 
96,153

Other investments
24,511

 
11,144

Total investments
3,219,492

 
2,203,270

Cash and cash equivalents
485,801

 
414,370

Restricted cash and cash equivalents
112,137

 
78,762

Accrued interest and dividends
24,399

 
18,536

Premiums receivable, net
1,431,301

 
1,251,262

Reinsurance recoverable (related party $1,008,073; $789,519)
1,857,634

 
1,318,395

Prepaid reinsurance premium (related party $664,917; $547,128)
957,114

 
754,844

Prepaid expenses and other assets (recorded at fair value $227,164; $193,927)
663,689

 
421,163

Federal income tax receivable

 
16,609

Deferred policy acquisition costs
457,369

 
349,126

Property and equipment, net
95,270

 
75,933

Goodwill
249,154

 
229,780

Intangible assets
345,738

 
285,187

 
$
9,899,098

 
$
7,417,237

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Liabilities:
 
 
 
Loss and loss expense reserves
$
3,615,536

 
$
2,426,400

Unearned premiums
2,537,401

 
1,773,593

Ceded reinsurance premiums payable (related party $272,802; $333,962)
434,332

 
528,322

Reinsurance payable on paid losses
31,468

 
13,410

Funds held under reinsurance treaties
30,376

 
33,946

Note payable on collateral loan – related party
167,975

 
167,975

Securities sold but not yet purchased, at market

 
56,711

Securities sold under agreements to repurchase, at contract value
204,306

 
234,911

Accrued expenses and other current liabilities (recorded at fair value $11,045; $11,750)
642,361

 
406,447

Deferred income taxes
168,664

 
225,484

Debt
559,662

 
301,973

Total liabilities
8,392,081

 
6,169,172

Commitments and contingencies


 


Redeemable non-controlling interest
600

 
600

Stockholders’ equity:
 
 
 
Common stock, $.01 par value; 150,000 shares authorized, 98,116 and 91,216 issued in 2013 and 2012, respectively; 74,550 and 73,911 outstanding in 2013 and 2012, respectively
980

 
912

Preferred stock, $.01 par value; 10,000 shares authorized, 4,600 and 0 issued and outstanding in 2013 and 2012, respectively
115,000

 

Additional paid-in capital
1,029,274

 
761,105

Treasury stock at cost; 23,567 and 24,024 shares in 2013 and 2012, respectively
(286,980
)
 
(293,791
)
Accumulated other comprehensive (loss) income
(8,000
)
 
64,231

Retained earnings
538,165

 
611,664

Total AmTrust Financial Services, Inc. equity
1,388,439

 
1,144,121

Non-controlling interest
117,978

 
103,344

Total stockholders’ equity
1,506,417

 
1,247,465

 
$
9,899,098

 
$
7,417,237

See accompanying notes to unaudited condensed consolidated financial statements.

3



AmTrust Financial Services, Inc.
Condensed Consolidated Statements of Income
(Unaudited)
(In Thousands, Except Per Share Data)
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2013
 
2012
 
2013
 
2012
Revenues:
 
 

 
 

 
 

 
 

Premium income:
 
 

 
 

 
 

 
 

Net written premium
 
$
728,796

 
$
483,659

 
$
1,900,899

 
$
1,235,025

Change in unearned premium
 
(114,901
)
 
(96,212
)
 
(342,471
)
 
(199,560
)
Net earned premium
 
613,895

 
387,447

 
1,558,428

 
1,035,465

Ceding commission – primarily related party
 
68,219

 
49,860

 
199,334

 
140,684

Service and fee income (related parties – three months $11,715; $7,171 and nine months $36,636; $20,195)
 
89,981

 
44,561

 
238,596

 
118,110

Net investment income
 
23,290

 
18,429

 
64,019

 
49,291

Net realized gain on investments
 
1,112

 
2,213

 
20,463

 
3,768

Total revenues
 
796,497

 
502,510

 
2,080,840

 
1,347,318

Expenses:
 
 

 
 

 
 

 
 

Loss and loss adjustment expense
 
410,579

 
255,646

 
1,046,945

 
667,362

Acquisition costs and other underwriting expenses
 
207,819

 
143,736

 
557,198

 
397,474

Other
 
78,980

 
42,337

 
212,117

 
110,296

Total expenses
 
697,378

 
441,719

 
1,816,260

 
1,175,132

Income before other income (expense), income taxes and equity in earnings of unconsolidated subsidiaries
 
99,119

 
60,791

 
264,580

 
172,186

Other income (expense):
 
 

 
 

 
 

 
 

Interest expense
 
(9,120
)
 
(7,218
)
 
(24,089
)
 
(21,303
)
Gain on investment in life settlement contracts net of profit commission
 
76


3,251

 
80

 
5,302

Foreign currency gain (loss)
 
368


(951
)
 
2,423

 
(2,985
)
Acquisition gain on purchase
 



 
55,786



Total other income (expense)
 
(8,676
)
 
(4,918
)
 
34,200

 
(18,986
)
Income before income taxes and equity in earnings of unconsolidated subsidiaries
 
90,443

 
55,873

 
298,780

 
153,200

Provision for income taxes
 
32,681

 
13,187

 
87,808

 
36,106

Income before equity in earnings of unconsolidated subsidiaries
 
57,762

 
42,686


210,972

 
117,094

Equity in earnings of unconsolidated subsidiary – related party
 
1,927

 
3,207

 
10,537

 
8,659

Net income
 
$
59,689

 
$
45,893

 
$
221,509

 
$
125,753

Net loss (income) attributable to non-controlling interest of subsidiaries
 
597

 
(2,663
)
 
1,474

 
(3,079
)
Net income attributable to AmTrust Financial Services, Inc.
 
$
60,286

 
$
43,230

 
$
222,983

 
$
122,674

Dividends on preference stock
 
(2,048
)
 

 
(2,048
)
 

Net income attributable to AmTrust common shareholders
 
$
58,238

 
$
43,230

 
$
220,935

 
$
122,674

Earnings per common share:
 
 

 
 

 
 

 
 

Basic earnings per share
 
$
0.78

 
$
0.59

 
$
2.98

 
$
1.67

Diluted earnings per share
 
$
0.74

 
$
0.56

 
$
2.84

 
$
1.61

Dividends declared per common share
 
$
0.14

 
$
0.10

 
$
0.42

 
$
0.29

Net realized gain on investments:
 
 

 
 

 
 

 
 

Total other-than-temporary impairment loss
 
$

 
$

 
$

 
$
(1,208
)
Portion of loss recognized in other comprehensive income
 

 

 

 

Net impairment losses recognized in earnings
 

 

 

 
(1,208
)
Other net realized gain on investments
 
1,112

 
2,213

 
20,463

 
4,976

Net realized investment gain
 
$
1,112

 
$
2,213

 
$
20,463

 
$
3,768


See accompanying notes to unaudited condensed consolidated financial statements.

4



AmTrust Financial Services, Inc.
Condensed Consolidated Statements of Comprehensive Income
(Unaudited)
(In Thousands)
 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2013
 
2012
 
2013
 
2012
Net income
 
$
59,689


$
45,893

 
$
221,509


$
125,753

Other comprehensive income, net of tax:
 
 

 
 

 
 

 
 

Foreign currency translation adjustments
 
10,826

 
7,484

 
(4,739
)
 
4,624

Change in fair value of interest rate swap
 
(74
)
 
(325
)
 
862

 
(952
)
Unrealized gains (losses) on securities:
 
 

 
 

 
 

 
 

Unrealized holding gain (loss) arising during period
 
7,290

 
27,382

 
(72,193
)
 
60,499

Reclassification adjustment for gains (losses) included in net income
 
578

 
442

 
3,839

 
(4,234
)
Other comprehensive income (loss), net of tax
 
$
18,620

 
$
34,983

 
$
(72,231
)
 
$
59,937

Comprehensive income
 
78,309

 
80,876

 
149,278

 
185,690

Less: Comprehensive income (loss) attributable to non-controlling interest
 
(597
)
 
2,663

 
(1,474
)

3,079

Comprehensive income attributable to AmTrust Financial Services, Inc.
 
$
78,906

 
$
78,213

 
$
150,752

 
$
182,611

 
See accompanying notes to unaudited condensed consolidated financial statements.

5



AmTrust Financial Services, Inc.
Consolidated Statements of Cash Flows
(Unaudited)
(In Thousands)
 
Nine Months Ended September 30,
 
2013
 
2012
Cash flows from operating activities:
 

 
 

Net income
$
221,509


$
125,753

Adjustments to reconcile net income to net cash provided by operating activities:
 

 
 

Depreciation and amortization
47,315


27,848

Net amortization of bond premium or discount
14,002


3,361

Equity earnings on investment in unconsolidated subsidiaries
(10,537
)

(8,659
)
Gain on investment in life settlement contracts, net
(80
)

(5,302
)
Realized gain on marketable securities
(20,463
)

(4,976
)
Non-cash write-down of marketable securities

 
1,208

Discount on notes payable
2,226


2,225

Stock based compensation
7,920


4,954

Bad debt expense
17,286


5,697

Foreign currency (gain) loss
(2,423
)

2,985

Acquisition gain
(55,786
)
 

Dividend received from equity investment
12,203

 

Changes in assets - (increase) decrease:
 

 
 

Premiums and note receivables
(115,370
)

(111,200
)
Reinsurance recoverable
(478,253
)

(119,611
)
Deferred policy acquisition costs, net
(108,243
)

(68,656
)
Prepaid reinsurance premiums
(202,270
)

(100,074
)
Prepaid expenses and other assets
(140,039
)

(44,998
)
Changes in liabilities - increase (decrease):
 


 

Reinsurance premium payable
(97,420
)

(13,236
)
Loss and loss expense reserve
921,763


367,943

Unearned premiums
544,781


316,330

Funds held under reinsurance treaties
(3,570
)

(10,931
)
Accrued expenses and other current liabilities
87,468


23,704

Deferred tax liability
(37,226
)

8,559

Net cash provided by operating activities
604,793

 
402,924

Cash flows from investing activities:
 

 
 

Net (purchases) sales of securities with fixed maturities
(695,935
)

(240,535
)
Net sales (purchases) of equity securities
15,491


19,068

Net (purchases) sales of other investments
(3,409
)

1,938

Acquisition of and capitalized premiums for life settlement contracts
(40,165
)

(42,225
)
Receipt of life settlement contract proceeds
9,054


10,074

Acquisition of subsidiaries, net of cash obtained
(72,867
)

(19,764
)
Increase in restricted cash and cash equivalents
(33,375
)

(23,691
)
Purchase of property and equipment
(29,311
)

(19,955
)
Net cash used in investing activities
(850,517
)
 
(315,090
)
Cash flows from financing activities:
 

 
 

Preferred share issuance, net
111,130



Common share issuance
472

 

Repurchase agreements, net
(30,605
)

34,380

Senior notes proceeds
250,000

 


6



Convertible senior notes proceeds


25,000

Secured loan agreements payments
(1,037
)

(729
)
Promissory notes borrowings (payments), net


500

Financing fees
(2,740
)

(1,670
)
Non-controlling interest capital contribution to consolidated subsidiaries
16,108


16,624

Stock option exercise and other
5,429


4,176

Dividends distributed on common stock
(29,337
)

(16,866
)
Dividends distributed on preference stock
(2,048
)


Net cash provided by financing activities
317,372

 
61,415

Effect of exchange rate changes on cash
(217
)
 
1,893

Net increase (decrease) in cash and cash equivalents
71,431

 
151,142

Cash and cash equivalents, beginning of the period
414,370

 
406,847

Cash and cash equivalents, end of the period
$
485,801

 
$
557,989

Supplemental Cash Flow Information
 

 
 

Income tax payments
$
26,634

 
$
7,893

Interest payments on debt
$
13,056

 
$
12,555

 
See accompanying notes to unaudited condensed consolidated financial statements.

7



Notes to Unaudited Condensed Consolidated Financial Statements
(Unaudited)
(Dollars In Thousands, Except Per Share Data)
1.
 Basis of Reporting
  
The accompanying unaudited interim consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial statements and with the instructions to Form 10-Q and Article 10 of Regulation S-X and, therefore, do not include all of the information and footnotes required by GAAP for complete financial statements. These interim statements should be read in conjunction with the financial statements and notes thereto included in the AmTrust Financial Services, Inc. (“AmTrust” or the “Company”) Annual Report on Form 10-K for the year ended December 31, 2012, previously filed with the Securities and Exchange Commission (“SEC”) on March 1, 2013. The balance sheet at December 31, 2012 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by GAAP for complete financial statements.
 
These interim consolidated financial statements reflect all adjustments that are, in the opinion of management, necessary for a fair presentation of the results for the interim period and all such adjustments are of a normal recurring nature. The results of operations for the interim period are not necessarily indicative, if annualized, of those to be expected for the full year. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
 
A detailed description of the Company’s significant accounting policies and management judgments is located in the audited consolidated financial statements for the year ended December 31, 2012, included in the Company’s Form 10-K filed with the SEC.
 
All significant inter-company transactions and accounts have been eliminated in the consolidated financial statements.
 
To facilitate period-to-period comparisons, certain reclassifications have been made to prior period consolidated financial statement amounts to conform to current period presentation.

The Company paid a 10% stock dividend during the three months ended September 30, 2013 and 2012. As such, the weighted average number of shares used for basic and diluted earnings per share have been adjusted in prior periods.

2.
Recent Accounting Pronouncements
 
With the exception of those discussed below, there have been no recent accounting pronouncements or changes in accounting pronouncements during the nine months ended September 30, 2013, as compared to those described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012, that are of significance, or potential significance, to the Company.

In July 2013, the Financial Accounting Standards Board ("FASB"), issued Accounting Standards Update ("ASU") 2013-11, Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists, which provides guidance on the presentation of an unrecognized tax benefit when a net operating loss ("NOL") carry-forward, a similar tax loss, or a tax credit carry-forward exists. Under the ASU, an entity must present an unrecognized tax benefit, or a portion of an unrecognized tax benefit, as a reduction to a deferred tax asset for a NOL carry-forward, similar tax loss, or a tax credit carry-forward. There are two exceptions to this form of presentation as follows:

To the extent a NOL carry-forward, a similar tax loss, or a tax credit carry-forward is not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position; and
The entity does not intend to use the deferred tax asset for this purpose.

If either of these conditions exists, an entity should present an unrecognized benefit in the financial statements as a liability and should net the unrecognizable tax benefit with a deferred tax asset. The amendments in this update are effective for fiscal years, and interim periods within those years, beginning after December 31, 2013. The adoption of this guidance is not expected to have an impact on our results of operations, financial condition or liquidity.


8



In June 2013, the FASB issued Exposure Draft Insurance Contracts Topic 834. The exposure draft would impact all entities that write insurance contracts. If adopted, the guidance would supersede the requirements in ASC Topic 944, Financial Services - Insurance which currently apply to insurance entities. The guidance in the exposure draft would require a property and casualty insurer to measure its insurance contracts under the premium allocation approach, which would require an entity to record revenue over the coverage period on the basis of the expected timing of incurred claims. Comments on the exposure draft were due on October 25, 2013. If adopted, entities would be required to adopt this standard retrospectively. The Company is currently studying this exposure draft and the impact on the Company's results of operations, financial position or liquidity.

In March 2013, the FASB issued ASU 2013-05, Parent’s Accounting for the Cumulative Translation Adjustment Upon Derecognition of Certain Subsidiaries or Groups of Assets Within a Foreign Entity or of an Investment in a Foreign Entity to standardize the release of the cumulative translation adjustment into net income when a parent either sells a part or all of its investment in a foreign entity or no longer holds a controlling financial interest in a subsidiary. ASU 2013-05 will be applied prospectively and is effective for annual reporting periods beginning after December 15, 2013, and interim periods within those years. The standard is not expected to have a material impact on the Company’s results of operations, financial position or liquidity.

In February 2013, the FASB issued ASU No. 2013-02, Reporting of Amounts Reclassified out of Accumulated Other Comprehensive Income ("ASU 2013-02"). ASU 2013-02 supersedes and replaces the presentation requirements for the reclassifications out of accumulated other comprehensive income. None of the other requirements of previously issued ASUs related to comprehensive income are affected by ASU 2013-02. The Company adopted ASU 2013-02 on January 1, 2013 and the implementation of the standard did not have a material impact on the Company's results of operations, financial position or liquidity.

In January 2013, the FASB issued ASU No. 2013-01, Clarifying the Scope of Disclosure about Offsetting Assets and Liabilities ("ASU 2013-01"). ASU 2013-01 relates to derivatives, repurchase agreements and reverse repurchase agreements, and secured borrowings and lending transactions that are either offset or subject to a master netting arrangement. The amendment provides a user of financial statements with comparable information as it relates to certain reconciling differences between financial statements prepared in accordance with U.S. GAAP and those financial statements prepared in accordance with International Financial Reporting Standards ("IFRS"). The Company adopted ASU 2013-02 on January 1, 2013 and the implementation of the standard did not have a material impact on the Company's results of operations, financial position or liquidity.

In July 2012, the FASB issued ASU No. 2012-02, Intangibles - Goodwill and Other (Topic 350) Testing Indefinite Lived Intangible Assets for Impairment ("ASU 2012-02"). ASU 2012-02 updated guidance regarding the impairment test applicable to indefinite-lived intangible assets that is similar to the impairment guidance applicable to goodwill. Under the updated guidance, an entity may assess qualitative factors (such as changes in management, strategy, technology or customers) that may impact the fair value of the indefinite-lived intangible asset and lead to the determination that it is more likely than not that the fair value of the asset is less than its carrying value. If an entity determines that it is more likely than not that the fair value of the intangible asset is less than its carrying value, an impairment test must be performed. The impairment test requires an entity to calculate the estimated fair value of the indefinite-lived intangible asset. If the carrying value of the indefinite-lived intangible asset exceeds its estimated fair value, an impairment loss is recognized in an amount equal to the excess. The Company adopted this guidance on January 1, 2013 and it did not have any effect on the Company's results of operations, financial position or liquidity.


9



3.
Investments
 
(a) Available-for-Sale Securities
 
The amortized cost, estimated market value and gross unrealized appreciation and depreciation of available-for-sale securities as of September 30, 2013 and December 31, 2012, are presented in the table below:
 
(Amounts in Thousands)
As of September 30, 2013
 
Original or amortized cost
 
Gross unrealized gains
 
Gross unrealized
losses
 
 Market value
Preferred stock
 
$
3,064

 
$
87

 
$
(100
)
 
$
3,051

Common stock
 
26,434

 
2,178

 
(1,959
)
 
26,653

U.S. treasury securities
 
91,566

 
1,644

 
(288
)
 
92,922

U.S. government agencies
 
12,885

 
159

 
(3,285
)
 
9,759

Municipal bonds
 
457,901

 
7,924

 
(18,966
)
 
446,859

Foreign government
 
53,072

 
994

 
(1,004
)
 
53,062

Corporate bonds:
 
 

 
 

 
 

 
 

Finance
 
1,018,340

 
44,691

 
(18,944
)
 
1,044,087

Industrial
 
634,064

 
15,273

 
(23,809
)
 
625,528

Utilities
 
70,541

 
2,419

 
(3,096
)
 
69,864

Commercial mortgage backed securities
 
18,383

 
97

 
(263
)
 
18,217

Residential mortgage backed securities:
 
 

 
 

 
 

 
 

Agency backed
 
663,069

 
17,008

 
(7,855
)
 
672,222

Non-agency backed
 
14,259

 
128

 
(7
)
 
14,380

Asset-backed securities
 
7,061

 
5

 
(7
)
 
7,059

 
 
$
3,070,639

 
$
92,607


$
(79,583
)
 
$
3,083,663

 
Investments in foreign government securities include securities issued by national entities as well as instruments that are unconditionally guaranteed by such entities. As of September 30, 2013, the Company's foreign government securities were issued or guaranteed primarily by the European Investment Bank, Israel and the United Kingdom.

(Amounts in Thousands)
As of December 31, 2012
 
Original or amortized cost
 
Gross unrealized gains
 
Gross unrealized losses
 
 Market value
Preferred stock
 
$
5,092

 
$
112

 
$
(20
)
 
$
5,184

Common stock
 
15,851

 
596

 
(1,166
)
 
15,281

U.S. treasury securities
 
62,502

 
3,694

 
(4
)
 
66,192

U.S. government agencies
 
39,594

 
707

 

 
40,301

Municipal bonds
 
287,361

 
12,833

 
(752
)
 
299,442

Corporate bonds:
 
 
 
 
 
 
 
 
Finance
 
830,101

 
68,190

 
(4,603
)
 
893,688

Industrial
 
387,980

 
20,914

 
(1,094
)
 
407,800

Utilities
 
45,320

 
2,611

 
(5
)
 
47,926

Commercial mortgage backed securities
 
10,065

 
135

 

 
10,200

Residential mortgage backed securities:
 
 
 
 
 
 
 
 
Agency backed
 
276,895

 
16,373

 
(654
)
 
292,614

Non-agency backed
 
7,826

 

 
(763
)
 
7,063

 
 
$
1,968,587

 
$
126,165

 
$
(9,061
)
 
$
2,085,691



10



A summary of the Company’s available-for-sale fixed securities as of September 30, 2013 and December 31, 2012, by contractual maturity, is shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
 
September 30, 2013
 
December 31, 2012
(Amounts in Thousands)
 
Amortized Cost
 
Fair Value
 
Amortized Cost
 
 Fair Value
Due in one year or less
 
$
80,580

 
$
81,201

 
$
20,786

 
$
21,945

Due after one through five years
 
442,762

 
452,916

 
400,865

 
414,016

Due after five through ten years
 
1,467,462

 
1,474,498

 
966,158

 
1,044,510

Due after ten years
 
347,565

 
333,466

 
265,049

 
274,878

Mortgage and asset backed securities
 
702,772

 
711,878

 
294,786

 
309,877

Total fixed maturities
 
$
3,041,141

 
$
3,053,959

 
$
1,947,644

 
$
2,065,226

 
Proceeds from the sale of investments in available-for-sale securities during the nine months ended September 30, 2013 and 2012 were approximately $976,396 and $761,757, respectively.

(b) Investment Income
 
Net investment income for the three and nine months ended September 30, 2013 and 2012 was derived from the following sources:
 
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
(Amounts in Thousands)
 
2013
 
2012
 
2013
 
2012
Fixed maturity securities
 
$
21,766

 
$
18,185

 
$
57,354

 
$
47,908

Equity securities
 
1,086

 
325

 
5,375

 
823

Cash and short term investments
 
782

 
120

 
2,530

 
1,096

 
 
23,634

 
18,630

 
65,259

 
49,827

Less:
 
 

 
 

 
 

 
 

Investment expenses and interest expense on securities sold under agreement to repurchase
 
(344
)
 
(201
)
 
(1,240
)
 
(536
)
 
 
$
23,290

 
$
18,429

 
$
64,019

 
$
49,291

 

11




(c) Other-Than-Temporary Impairment
 
The table below summarizes the gross unrealized losses of our fixed maturity and equity securities by length of time the security has continuously been in an unrealized position as of September 30, 2013 and December 31, 2012:
 
 
 
Less Than 12 Months

12 Months or More

Total
(Amounts in Thousands)
September 30, 2013
 
Fair Market Value

Unrealized Losses

No. of Positions Held

Fair Market Value

Unrealized Losses

No. of Positions Held

Fair Market Value

Unrealized Losses
Common and preferred stock
 
$
4,628


$
(532
)

107


$
8,767


$
(1,527
)

29


$
13,395


$
(2,059
)
U.S. treasury securities
 
49,471

 
(288
)
 
19

 

 

 

 
49,471

 
(288
)
U.S. government agencies
 
4,376

 
(3,285
)
 
14

 

 

 

 
4,376

 
(3,285
)
Municipal bonds
 
258,072


(18,327
)

320


12,939


(639
)

21


271,011


(18,966
)
Foreign government
 
32,340

 
(1,000
)
 
8

 
996

 
(4
)
 
1

 
33,336

 
(1,004
)
Corporate bonds:
 
 


 


 


 


 


 


 


 

Finance
 
438,370


(14,417
)

303


57,465


(4,527
)

45


495,835


(18,944
)
Industrial
 
415,835


(23,586
)

335


2,455


(223
)

6


418,290


(23,809
)
Utilities
 
45,403

 
(3,096
)
 
32

 

 

 

 
45,403

 
(3,096
)
Commercial mortgage backed securities
 
8,630

 
(263
)
 
12

 

 

 

 
8,630

 
(263
)
Residential mortgage backed securities:
 
 


 


 


 


 


 


 


 

Agency backed
 
222,626


(7,855
)

130








222,626


(7,855
)
Non-agency backed
 
315


(6
)

7


24


(1
)

1


339


(7
)
Asset-backed securities
 
3,821

 
(7
)
 
8

 

 

 

 
3,821

 
(7
)
Total temporarily impaired securities
 
$
1,483,887


$
(72,662
)

1,295


$
82,646


$
(6,921
)

103


$
1,566,533


$
(79,583
)
  
 
 
Less Than 12 Months
 
12 Months or More
 
Total
(Amounts in Thousands)
December 31, 2012
 
Fair Market Value
 
Unrealized Losses
 
No. of Positions Held
 
Fair Market Value
 
Unrealized Losses
 
No. of Positions Held
 
Fair Market Value
 
Unrealized Losses
Common and preferred stock
 
$
7,643

 
$
(1,138
)
 
25

 
$
1,978

 
$
(48
)
 
1

 
$
9,621

 
$
(1,186
)
U.S. treasury securities
 
997

 
(4
)
 
1

 

 

 

 
997

 
(4
)
Municipal bonds
 
63,577

 
(752
)
 
19

 

 

 

 
63,577

 
(752
)
Corporate bonds:
 
 
 
 
 

 

 

 

 
 
 
 
Finance
 
52,398

 
(899
)
 
20

 
95,992

 
(3,704
)
 
13

 
148,390

 
(4,603
)
Industrial
 
82,066

 
(881
)
 
28

 
9,105

 
(213
)
 
4

 
91,171

 
(1,094
)
 Utilities
 
5,860

 
(5
)
 
3

 

 

 

 
5,860

 
(5
)
Residential mortgage backed securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency backed
 
24,554

 
(654
)
 
2

 

 

 

 
24,554

 
(654
)
Non-agency backed
 

 

 

 
7,062

 
(763
)
 
2

 
7,062

 
(763
)
Total temporarily impaired securities
 
$
237,095

 
$
(4,333
)
 
98

 
$
114,137

 
$
(4,728
)
 
20

 
$
351,232

 
$
(9,061
)

There are 1,398 and 118 securities at September 30, 2013 and December 31, 2012, respectively, that account for the gross unrealized loss, none of which is deemed by the Company to be OTTI. Significant factors influencing the Company’s determination that unrealized losses were temporary included the magnitude of the unrealized losses in relation to each security’s cost, the nature of the investment and management’s intent not to sell these securities and it being not more likely than not that the Company will be required to sell these investments before anticipated recovery of fair value to the Company’s cost basis.

12




(d) Derivatives
 
The Company from time to time invests in a limited number of derivatives and other financial instruments as part of its investment portfolio to manage interest rate changes or other exposures to a particular financial market. The Company records changes in valuation on its derivative positions not designated as a hedge as a component of net realized gains and losses.
 
The Company records changes in valuation on its hedge positions as a component of other comprehensive income. As of September 30, 2013 and December 31, 2012, the Company had two interest rate swaps designated as hedges that were recorded as a liability in the total amount of $3,310 and $4,636, respectively, and were included as a component of accrued expenses and other liabilities.
 
The following table presents the notional amounts by remaining maturity of the Company’s interest rate swaps as of September 30, 2013: 
 
 
 
Remaining Life of Notional Amount (1)
 
(Amounts in Thousands)
 
One Year
 
Two Through Five Years
 
Six Through Ten Years
 
After Ten years
 
Total
Interest rate swaps
 
$

 
$
70,000

 
$

 
$

 
$
70,000

 
(1) 
Notional amount is not representative of either market risk or credit risk and is not recorded in the consolidated balance sheet.

(e) Restricted Cash and Investments
 
The Company, in order to conduct business in certain states, is required to maintain letters of credit or assets on deposit to support state mandated regulatory requirements and certain third party agreements. The Company also utilizes trust accounts to collateralize business with its reinsurance counterparties. These assets are primarily in the form of cash and certain high grade securities. The fair values of our restricted assets as of September 30, 2013 and December 31, 2012 are as follows:
 
(Amounts in Thousands)
2013
 
2012
Restricted cash
$
112,137

 
$
78,762

Restricted investments
385,550

 
251,082

Total restricted cash and investments
$
497,687

 
$
329,844

 
(f) Other

The Company entered into repurchase agreements that are subject to a master netting arrangement, which are accounted for as collateralized borrowing transactions and are recorded at contract amounts. The Company receives cash or securities that it invests or holds in short term or fixed income securities. As of September 30, 2013, the Company had ten repurchase agreements with an outstanding principal amount of $204,306, which approximates fair value, at interest rates between .16% and .21%. The Company has nine repurchase agreements with one counter-party totaling $171,336 and one repurchase agreement with a separate counter-party totaling $32,970. Interest expense associated with these ten repurchase agreements for the nine months ended September 30, 2013 and 2012 was $688 and $676, respectively, of which $0 was accrued as of September 30, 2013. The Company has approximately $222,344 of collateral pledged in support of these agreements. Interest expense related to repurchase agreements is recorded as a component of investment income. Additionally, during 2013, the Company closed its reverse repurchase agreement and did not incur any gain or loss as a result of this agreement.

13



4.
Fair Value of Financial Instruments

The following tables present the level within the fair value hierarchy at which the Company’s financial assets and financial liabilities are measured on a recurring basis as of September 30, 2013 and December 31, 2012:
 
(Amounts in Thousands)
As of September 30, 2013
 
Total

Level 1

Level 2

Level 3
Assets:
 
 


 


 


 

U.S. treasury securities
 
$
92,922


$
92,922


$


$

U.S. government agencies
 
9,759




9,759



Municipal bonds
 
446,859




446,859



Foreign government
 
53,062

 

 
53,062

 

Corporate bonds and other bonds:
 
 


 


 


 

Finance
 
1,044,087




1,044,087



Industrial
 
625,528




625,528



Utilities
 
69,864




69,864



Commercial mortgage backed securities
 
18,217




18,217



Residential mortgage backed securities:
 
 


 


 


 

Agency backed
 
672,222




672,222



Non-agency backed
 
14,380




14,380



Asset-backed securities
 
7,059

 

 
7,059

 

Equity securities
 
29,704


29,704





Short term investments
 
22,471


22,471





Other investments
 
24,511






24,511

Life settlement contracts
 
227,164






227,164

 
 
$
3,357,809


$
145,097


$
2,961,037


$
251,675

Liabilities:
 
 


 


 


 

Securities sold under agreements to repurchase, at carrying value
 
204,306




204,306



Life settlement contract profit commission
 
11,045






11,045

Derivatives
 
3,310




3,310



 
 
$
218,661


$


$
207,616


$
11,045

 

14



(Amounts in Thousands)
As of December 31, 2012
 
Total
 
Level 1
 
Level 2
 
Level 3
Assets:
 
 
 
 
 
 
 
 
U.S. treasury securities
 
$
66,192

 
$
66,192

 
$

 
$

U.S. government agencies
 
40,301

 

 
40,301

 

Municipal bonds
 
299,442

 

 
299,442

 

Corporate bonds and other bonds:
 

 

 

 

Finance
 
893,688

 

 
893,688

 

Industrial
 
407,800

 

 
407,800

 

Utilities
 
47,926

 

 
47,926

 

Commercial mortgage backed securities
 
10,200

 

 
10,200

 

Residential mortgage backed securities:
 
 
 
 
 

 

Agency backed
 
292,614

 

 
292,614

 

Non-agency backed
 
7,063

 

 
7,063

 

Equity securities
 
20,465

 
20,465

 

 

Short term investments
 
10,282

 
10,282

 

 

Other investments
 
11,144

 

 

 
11,144

Life settlement contracts
 
193,927

 

 

 
193,927

 
 
$
2,301,044

 
$
96,939

 
$
1,999,034

 
$
205,071

Liabilities:
 
 
 
 
 
 
 
 
Equity securities sold but not yet purchased, market
 
$
11

 
$
11

 
$

 
$

Fixed maturity securities sold but not yet purchased, market
 
56,700

 
56,700

 

 

Securities sold under agreements to repurchase, at carrying value
 
234,911

 

 
234,911

 

Life settlement contract profit commission
 
11,750

 

 

 
11,750

Derivatives
 
4,636

 

 
4,636

 

 
 
$
308,008

 
$
56,711

 
$
239,547

 
$
11,750


The Company classifies its financial assets and liabilities in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement.  This classification requires judgment in assessing the market and pricing methodologies for a particular security.  The fair value hierarchy includes the following three levels:
 
Level 1 – Valuations are based on unadjusted quoted market prices in active markets for identical financial assets or liabilities.

Examples of instruments utilizing Level 1 inputs include: exchange-traded securities and U.S. Treasury bonds.
 
Level 2 – Valuations of financial assets and liabilities are based on quoted prices for similar assets or liabilities in active markets, quoted prices for identical assets or liabilities in inactive markets obtained from third party pricing services or valuations based on models where the significant inputs are observable (e.g., interest rates, yield curves, prepayment speeds, default rates, loss severities, etc.) or can be corroborated by observable market data.
 
Examples of instruments utilizing Level 2 inputs include: U.S. government-sponsored agency securities; non-U.S. government obligations; corporate and municipal bonds; mortgage-backed bonds; asset-backed securities and listed derivatives that are not actively traded.

Level 3 – Valuations are based on unobservable inputs for assets and liabilities where there is little or no market activity.  Management’s assumptions are used in internal valuation pricing models to determine the fair value of financial assets or liabilities, which may include projected cash flows, collateral performance or liquidity circumstances in the security or similar securities that may have occurred since the prior pricing period.

Examples of instruments utilizing Level 3 inputs include: hedge and credit funds with partial transparency.

15




For additional discussion regarding techniques used to value the Company’s investment portfolio, refer to Note 2. “Significant Accounting Policies” in Item 8. “Financial Statements and Supplementary Data” in its 2012 Form 10-K.
 
The following table provides a summary of changes in fair value of the Company’s Level 3 financial assets and liabilities for the three and nine months ended September 30, 2013 and 2012:

(Amounts in Thousands)

Balance as of June 30, 2013

Net income

Other comprehensive income

Purchases and issuances

Sales and settlements

Net transfers into (out of) Level 3

Balance as of September 30,
2013
Other investments

$
24,779


$
295


$


$
2,304


$
(2,867
)

$


$
24,511

Life settlement contracts

208,694


9,575




11,906


(3,011
)



227,164

Life settlement contract profit commission

(12,513
)

1,468










(11,045
)
Total

$
220,960


$
11,338


$


$
14,210


$
(5,878
)

$


$
240,630

 
(Amounts in Thousands)

Balance as of December 31,
2012

Net income

Other comprehensive income

Purchases and issuances

Sales and settlements

Net transfers into (out of) Level 3

Balance as of September 30,
2013
Other investments

$
11,144


$
973


$


$
17,185


$
(4,791
)

$


$
24,511

Life settlement contracts

193,927


30,385




11,906


(9,054
)



227,164

Life settlement contract profit commission

(11,750
)

705










(11,045
)
Total

$
193,321


$
32,063


$


$
29,091


$
(13,845
)

$


$
240,630


(Amounts in Thousands)
 
Balance as of June 30, 2012
 
Net income
 
Other comprehensive income
 
Purchases and issuances
 
Sales and settlements
 
Net transfers into (out of) Level 3
 
Balance as of
September 30,
2012
Other investments
 
$
15,103

 
$
1,491

 
$

 
$
315

 
$
(2,585
)
 
$

 
$
14,324

Life settlement contracts
 
151,092

 
10,758

 

 
9,626

 

 

 
171,476

Life settlement contract profit commission
 
(11,465
)
 
1,915

 

 

 

 

 
(9,550
)
Derivatives
 
(4,472
)
 

 
(501
)
 

 

 
4,973

 

Total
 
$
150,258

 
$
14,164

 
$
(501
)
 
$
9,941

 
$
(2,585
)
 
$
4,973

 
$
176,250


(Amounts in Thousands)
 
Balance as of December 31, 2011
 
Net income
 
Other comprehensive income
 
Purchases and issuances
 
Sales and settlements
 
Net transfers into (out of) Level 3
 
Balance as of
September 30,
2012
Other investments
 
$
14,588

 
$
(2,861
)
 
$
4,535

 
$
1,062

 
$
(3,000
)
 
$

 
$
14,324

Life settlement contracts
 
131,387

 
26,174

 

 
23,989

 
(10,074
)
 

 
171,476

Life settlement contract profit commission
 
(12,022
)
 
2,472

 

 

 

 

 
(9,550
)
Derivatives
 
(3,508
)
 

 
(1,465
)
 

 

 
4,973

 

Total
 
$
130,445

 
$
25,785

 
$
3,070

 
$
25,051

 
$
(13,074
)
 
$
4,973

 
$
176,250


 The Company had no transfers between levels during the three and nine months ended September 30, 2013. The Company transferred its derivatives from Level 3 to Level 2 during the three and nine months ended September 30, 2012.
 

16



The Company uses the following methods and assumptions in estimating its fair value disclosures for financial instruments:

Equity and Fixed Income Investments: Fair value disclosures for these investments are disclosed above in this note. The carrying values of cash, short term investments and investment income accrued approximate their fair values and are classified as Level 1 in the financial hierarchy.
Premiums Receivable: The carrying values reported in the accompanying balance sheets for these financial instruments approximate their fair values due to the short term nature of the asset and are classified as Level 1 in the financial hierarchy.
Other Investments: The Company has approximately one percent of its investment portfolio in limited partnerships or hedge funds where the fair value estimate is determined by a fund manager based on recent filings, operating results, balance sheet stability, growth and other business and market sector fundamentals. Due to the significant unobservable inputs in these valuations, the Company includes the estimate in the amount disclosed in Level 3 hierarchy.
Equity Investment in Unconsolidated Subsidiaries - Related Party: The Company has an approximate ownership percentage of 15.4% in National General Holding Corp., which completed a 144A offering during the three months ended June 30, 2013. The Company accounts for this investment under the equity method of accounting as it has the ability to exert significant influence.
Subordinated Debentures and Debt: The current fair value of the Company's convertible senior notes and subordinated debentures was $313,440 and $70,100 as of September 30, 2013, respectively. These financial liabilities are classified as Level 3 in the financial hierarchy. The fair value of the convertible senior notes was determined using a binomial lattice model. The fair value of the subordinated debentures was determined using the Black-Derman-Toy interest rate lattice model. Additionally, on August 15, 2013 the Company issued 6.125% Notes for $250,000. As of September 30, 2013, the Notes approximate their fair value.
Derivatives: The Company classifies interest rate swaps as Level 2 hierarchy.  The Company uses these interest rate swaps to hedge floating interest rates on its debt, thereby changing the variable rate exposure to a fixed rate exposure for interest on these obligations.  The estimated fair value of the interest rate swaps, which is obtained from a third party pricing service, is measured using discounted cash flow analysis that incorporates significant observable inputs, including the LIBOR forward curve and a measurement of volatility.
Repurchase Agreements: The carrying value of repurchase agreements in the accompanying balance sheets represents their fair values and are classified as Level 2 in the financial hierarchy.
 
The fair value of life settlement contracts as well as life settlement profit commission liability is based on information available to the Company at the end of the reporting period. The Company considers the following factors in its fair value estimates: cost at date of purchase, recent purchases and sales of similar investments (if available and applicable), financial standing of the issuer, changes in economic conditions affecting the issuer, maintenance cost, premiums, benefits, standard actuarially developed mortality tables and life expectancy reports prepared by nationally recognized and independent third party medical underwriters. The Company estimates the fair value of a life insurance policy by applying an investment discount rate based on the cost of funding the Company's life settlement contracts as compared to returns on investments in asset classes with comparable credit quality, which the Company has determined to be 7.5%, to the expected cash flow generated by the policies in the Company's life settlement portfolio (death benefits less premium payments), net of policy specific adjustments and reserves. In order to confirm the integrity of their calculation of fair value, the Company, quarterly, retains an independent third-party actuary to verify that the actuarial modeling used by the Company to determine fair value was performed correctly and that the valuation, as determined through the Company’s actuarial modeling, is consistent with other methodologies. The Company considers this information in its assessment of the reasonableness of the life expectancy and discount rate inputs used in the valuation of these investments.

The Company adjusts the standard mortality for each insured for the insured's life expectancy based on reviews of the insured's medical records. The Company establishes policy specific reserves for the following uncertainties: improvements in mortality, the possibility that the high net worth individuals represented in its portfolio may have access to better health care, the volatility inherent in determining the life expectancy of insureds with significant reported health impairments, the possibility that the issuer of the policy or a third party will contest the payment of the death benefit payable to the Company, and the future expenses related to the administration of the portfolio. The application of the investment discount rate to the expected cash flow generated by the portfolio, net of the policy specific reserves, yields the fair value of the portfolio. The effective discount rate reflects the relationship between the fair value and the expected cash flow gross of these reserves.

17



The following summarizes data utilized in estimating the fair value of the portfolio of life insurance policies as of September 30, 2013 and December 31, 2012 and, as described in Note 5. "Investments in Life Settlements", only includes data for policies to which the Company assigned value at those dates:
 
 
September 30,
2013
 
December 31,
2012
Average age of insured
79.9 years

 
78.8 years

Average life expectancy, months (1)
133


139

Average face amount per policy
$
6,669,000

 
$
6,770,000

Effective discount rate (2)
14.2
%
 
17.7
%



(1) 
Standard life expectancy as adjusted for specific circumstances.
(2) 
Effective Discount Rate ("EDR") is the Company's estimated internal rate of return on its life settlement contract portfolio and is determined from the gross expected cash flows and valuation of the portfolio. The valuation of the portfolio is calculated net of all reserves using a7.5% discount rate. The EDR is implicit of the reserves and the gross expected cash flows of the portfolio. The Company anticipates that the EDR's range is between 12.5% and 17.5% and reflects the uncertainty that exists surrounding the information available as of the reporting date. As the accuracy and reliability of information improves (declines), the EDR will decrease (increase). The decrease in the EDR from December 31, 2012 to September 30, 2013 resulted from routine updating of life expectancies, which reflect a higher quality of information.

The Company's assumptions are, by their nature, inherently uncertain and the effect of changes in estimates may be significant. The fair value measurements used in estimating the present value calculation are derived from valuation techniques generally used in the industry that include inputs for the asset that are not based on observable market data. The extent to which the fair value could reasonably vary in the near term has been quantified by eval