Fair Value

Accounting guidance regarding fair value measurements addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under GAAP and provides a common definition of fair value to be used throughout GAAP. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly fashion between market participants at the measurement date. In addition, it establishes a three-level valuation hierarchy for the disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The level in the hierarchy within which a given fair value measurement falls is determined based on the lowest level input that is significant to the measurement (Level 1 being the highest priority and Level 3 being the lowest priority).

The levels in the hierarchy are defined as follows:


Level 1:	Inputs to the valuation methodology are observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets


Level 2:	Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument


Level 3:	Inputs to the valuation methodology are unobservable and significant to the fair value measurement

Following is a description of the valuation methodologies used for securities measured at fair value, as well as the general classification of such securities pursuant to the valuation hierarchy.

The Company determines the existence of an active market based on its judgment as to whether transactions for the financial instrument occur in such market with sufficient frequency and volume to provide reliable pricing information. The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. The Company uses quoted values and other data provided by nationally recognized independent pricing sources as inputs into its process for determining fair values of its fixed maturity investments. To validate the techniques or models used by pricing sources, the Company’s review process includes, but is not limited to: (i) quantitative analysis (e.g., comparing the quarterly return for each managed portfolio to its target benchmark, with significant differences identified and investigated); (ii) a review of the average number of prices obtained in the pricing process and the range of resulting fair values; (iii) initial and ongoing evaluation of methodologies used by outside parties to calculate fair value including a review of deep dive reports on selected securities which indicate the use of observable inputs in the pricing process; (iv) comparing the fair value estimates to its knowledge of the current market; (v) a comparison of the pricing services’ fair values to other pricing services’ fair values for the same investments; and (vi) back-testing, which includes randomly selecting purchased or sold securities and comparing the executed prices to the fair value estimates from the pricing service. For a majority of investments, the Company obtained multiple quotes. A price source hierarchy was maintained in order to determine which price source would be used (i.e., a price obtained from a pricing service with more seniority in the hierarchy will be used over a less senior one in all cases). The hierarchy prioritizes pricing services based on availability and reliability and assigns the highest priority to index providers. Based on the above review, the Company will challenge any prices for a security or portfolio which are considered not to be representative of fair value. The Company did not adjust any of the prices obtained from the pricing services at March 31, 2014.

The independent pricing sources obtain market quotations and actual transaction prices for securities that have quoted prices in active markets. Each source has its own proprietary method for determining the fair value of securities that are not actively traded. In general, these methods involve the use of “matrix pricing” in which the independent pricing source uses observable market inputs including, but not limited to, investment yields, credit risks and spreads, benchmarking of like securities, broker-dealer quotes, reported trades and sector groupings to determine a reasonable fair value. In addition, pricing vendors use model processes, such as an Option Adjusted Spread model, to develop prepayment and interest rate scenarios. The Option Adjusted Spread model is commonly used to estimate fair value for securities such as mortgage backed and asset backed securities. In certain circumstances, when fair values are unavailable from these independent pricing sources, quotes are obtained directly from broker-dealers who are active in the corresponding markets. Such quotes are subject to the validation procedures noted above. Of the $13.64 billion of financial assets and liabilities measured at fair value at March 31, 2014, approximately $544.4 million, or 4.0%, were priced using non-binding broker-dealer quotes. Of the $13.37 billion of financial assets and liabilities measured at fair value at December 31, 2013, approximately $601.9 million, or 4.5%, were priced using non-binding broker-dealer quotes.

The Company reviews its securities measured at fair value and discusses the proper classification of such investments with investment advisers and others. No transfers were made in the periods presented. A discussion of the general classification of the Company’s financial instruments follows:

Fixed maturities. The Company determined that all U.S. Treasuries would be classified as Level 1 securities due to observed levels of trading activity, the high number of strongly correlated pricing quotes received on U.S. Treasuries and other factors. Where the Company believes that quoted market prices are not available or that the market is not active, fair values are estimated by using quoted prices of securities with similar characteristics, pricing models or matrix pricing and are generally classified as Level 2 securities. The Company determined that Level 2 securities included corporate bonds, mortgage backed securities, municipal bonds, asset backed securities and non-U.S. government securities.

Equity securities. The Company determined that exchange-traded equity securities would be included in Level 1 as their fair values are based on quoted market prices in active markets. Other equity securities are included in Level 2 of the valuation hierarchy.

Other investments. The fair values for certain of the Company’s other investments are determined using net asset values (“NAV”) as advised by external fund managers. The NAV is based on the fund manager’s valuation of the underlying holdings in accordance with the fund’s governing documents. Periodically, the Company performs a number of monitoring procedures in order to assess the quality of the NAVs, including regular review and discussion of each fund’s performance, regular evaluation of fund performance against applicable benchmarks and the backtesting of the NAVs against audited and interim financial statements. Other investments with liquidity terms allowing the Company to substantially redeem its holdings in a short time frame at the applicable NAV are reflected in Level 2. Other investments with redemption restrictions that prevent the Company from redeeming in the near term are classified in Level 3 of the valuation hierarchy.

Short-term investments. The Company determined that certain of its short-term investments held in highly liquid money market-type funds would be included in Level 1 as their fair values are based on quoted market prices in active markets. Other short-term investments are classified in Level 2 of the valuation hierarchy.

In securities lending transactions, the Company receives collateral in excess of the fair value of the fixed maturities and short-term investments pledged under securities lending agreements. For purposes of the following tables, the Company has excluded the collateral received and reinvested and included the fixed maturities and short-term investments pledged under securities lending agreements, at fair value.

Contingent consideration liability. The contingent consideration liability (included in ‘other liabilities’ in the consolidated balance sheets) resulted from the acquisition of the CMG Entities and is remeasured at fair value at each balance sheet date. Changes in fair value are recognized in ‘net realized gains (losses).’ To determine the fair value of the contingent consideration liability, the Company estimates future payments using an income approach based on modeled inputs which include a weighted average cost of capital. The Company determined that the contingent consideration liability would be included in Level 3 of the valuation hierarchy.

The following table presents the Company’s financial assets and liabilities measured at fair value by level at March 31, 2014:



			Fair Value Measurement Using:
	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets measured at fair value:
Available for sale securities:
Fixed maturities and fixed maturities pledged under securities lending agreements (1):
Corporate bonds	$	2,514,129	$	—	$	2,514,129	$	—
Mortgage backed securities	1,087,840		—		1,087,840		—
Municipal bonds	1,410,043		—		1,410,043		—
Commercial mortgage backed securities	1,023,055		—		1,023,055		—
U.S. government and government agencies	1,153,120		1,153,120		—		—
Non-U.S. government securities	1,114,382		—		1,114,382		—
Asset backed securities	1,573,751		—		1,573,751		—
Total	9,876,320		1,153,120		8,723,200		—

Equity securities	548,168		548,099		69		—
Other investments	426,917		—		322,582		104,335
Short-term investments	1,484,280		1,457,349		26,931		—

Fair value option:
Investments accounted for using the fair value option:
Corporate bonds	353,644		—		353,644		—
Non-U.S. government bonds	63,538		—		63,538		—
Mortgage backed securities	39,644		—		39,644		—
Other investments	799,824		—		380,678		419,146
Total	1,256,650		—		837,504		419,146
Total assets measured at fair value	$	13,592,335	$	3,158,568	$	9,910,286	$	523,481

Liabilities measured at fair value:
Contingent consideration liability	$	43,156	$	—	$	—	$	43,156
Total liabilities measured at fair value	$	43,156	$	—	$	—	$	43,156

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(1)	In securities lending transactions, the Company receives collateral in excess of the fair value of the fixed maturities and short-term investments pledged. For purposes of this table, the Company has excluded the collateral received and reinvested and included the fixed maturities and short-term investments pledged.

The following table presents the Company’s financial assets and liabilities measured at fair value by level at December 31, 2013:



			Fair Value Measurement Using:
	Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Assets measured at fair value:
Available for sale securities:
Fixed maturities and fixed maturities pledged under securities lending agreements (1):
Corporate bonds	$	2,267,263	$	—	$	2,265,218	$	2,045
Mortgage backed securities	1,133,095		—		1,133,095		—
Municipal bonds	1,481,738		—		1,481,738		—
Commercial mortgage backed securities	1,074,497		—		1,074,497		—
U.S. government and government agencies	1,301,809		1,301,809		—		—
Non-U.S. government securities	1,085,861		—		1,085,861		—
Asset backed securities	1,332,594		—		1,332,594		—
Total	9,676,857		1,301,809		8,373,003		2,045

Equity securities	496,824		496,738		86		—
Other investments	498,310		—		327,890		170,420
Short-term investments	1,478,367		1,427,744		50,623		—

Fair value option:
Investments accounted for using the fair value option:
Corporate bonds	334,065		—		334,065		—
Non-U.S. government bonds	73,156		—		73,156		—
Mortgage backed securities	41,033		—		41,033		—
Other investments	773,280		—		395,755		377,525
Total	1,221,534		—		844,009		377,525
Total assets measured at fair value	$	13,371,892	$	3,226,291	$	9,595,611	$	549,990

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(1)	In securities lending transactions, the Company receives collateral in excess of the fair value of the fixed maturities and short-term investments pledged. For purposes of this table, the Company has excluded the collateral received and reinvested and included the fixed maturities and short-term investments pledged.

The following tables present a reconciliation of the beginning and ending balances for all financial assets and liabilities measured at fair value on a recurring basis using Level 3 inputs:



	Fair Value Measurements Using: Significant Unobservable Inputs (Level 3)
	Assets												Liabilities
s	Available-For-Sale						Fair Value Option
	Corporate Bonds			Other Investments			Other Investments			Total			Contingent Consideration Liability
Three Months Ended March 31, 2014
Balance at beginning of period	$	2,045		$	170,420		$	377,525		$	549,990		$	—
Total gains or (losses) (realized/unrealized)
Included in earnings (1)	—			2,275			6,310			8,585			(1,394		)
Included in other comprehensive income	—			(2,196		)	—			(2,196		)	—
Purchases, issuances, sales and settlements
Purchases	—			—			40,110			40,110			—
Issuances	—			—			—			—			(41,762		)
Sales	(2,045		)	(66,164		)	—			(68,209		)	—
Settlements	—			—			(4,799		)	(4,799		)	—
Transfers in and/or out of Level 3	—			—			—			—			—
Balance at end of period	$	—		$	104,335		$	419,146		$	523,481		$	(43,156	)

Three Months Ended March 31, 2013
Balance at beginning of period	$	98,404		$	184,202		$	195,350		$	477,956		$	—
Total gains or (losses) (realized/unrealized)
Included in earnings (1)	1,492			4,762			373			6,627			—
Included in other comprehensive income	(1,688		)	1,912			—			224			—
Purchases, issuances, sales and settlements
Purchases	—			5,000			41,654			46,654			—
Issuances	—			—			—			—			—
Sales	—			—			—			—			—
Settlements	(910		)	(9,942		)	(58,007		)	(68,859		)	—
Transfers in and/or out of Level 3	—			—			—			—			—
Balance at end of period	$	97,298		$	185,934		$	179,370		$	462,602		$	—

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(1)	Gains or losses on corporate bonds were included in net realized gains (losses) while gains or losses on other investments were included in net realized gains (losses) or net investment income. Gains or losses on the contingent consideration liability were included in net realized gains (losses).

The amount of total gains for the 2014 first quarter included in earnings attributable to the change in unrealized gains or losses relating to assets still held at March 31, 2014 was $3.3 million, while the amount of total gains for the 2013 first quarter included in earnings attributable to the change in unrealized gains or losses relating to assets still held at March 31, 2013 was $6.6 million.

Financial Instruments Disclosed, But Not Carried, At Fair Value

The Company uses various financial instruments in the normal course of its business. The carrying values of cash, accrued investment income, receivable for securities sold, certain other assets, payable for securities purchased and certain other liabilities approximated their fair values at March 31, 2014, due to their respective short maturities. As these financial instruments are not actively traded, their respective fair values are classified within Level 2.

At March 31, 2014, the senior notes of ACGL were carried at their cost of $300.0 million and had a fair value of $394.7 million while the senior notes of Arch-U.S. were carried at their cost of $500.0 million and had a fair value of $530.3 million. The fair values of the senior notes were obtained from a third party pricing service and are based on observable market inputs. As such, the fair value of the senior notes is classified within Level 2.