AFSI 6.30.2013 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 June 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 August 2, 2013, the Registrant had one class of Common Stock ($.01 par value), of which 67,673,906 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)
 
June 30,
2013
 
December 31,
2012
ASSETS
(Unaudited)
 
(Audited)
Investments:
 
 
 
Fixed maturities, available-for-sale, at market value (amortized cost $2,731,738; $1,947,644)
$
2,730,830

 
$
2,065,226

Equity securities, available-for-sale, at market value (cost $24,815; $20,943)
25,895

 
20,465

Short-term investments
15,209

 
10,282

Equity investment in unconsolidated subsidiaries – related party
87,659

 
96,153

Other investments
24,779

 
11,144

Total investments
2,884,372

 
2,203,270

Cash and cash equivalents
449,634

 
414,370

Restricted cash and cash equivalents
163,868

 
78,762

Accrued interest and dividends
21,185

 
18,536

Premiums receivable, net
1,444,848

 
1,251,262

Reinsurance recoverable (related party $942,360; $789,519)
1,560,286

 
1,318,395

Prepaid reinsurance premium (related party $657,615; $547,128)
928,613

 
754,844

Prepaid expenses and other assets (recorded at fair value $208,694; $193,927)
517,052

 
421,163

Federal income tax receivable
3,414

 
16,609

Deferred policy acquisition costs
410,522

 
349,126

Property and equipment, net
92,531

 
75,933

Goodwill
246,719

 
229,780

Intangible assets
357,294

 
285,187

 
$
9,080,338

 
$
7,417,237

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Liabilities:
 
 
 
Loss and loss expense reserves
$
3,065,792

 
$
2,426,400

Unearned premiums
2,385,190

 
1,773,593

Ceded reinsurance premiums payable (related party $409,990; $333,962)
524,000

 
528,322

Reinsurance payable on paid losses
17,207

 
13,410

Funds held under reinsurance treaties
32,717

 
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
205,161

 
234,911

Accrued expenses and other current liabilities (recorded at fair value $12,513; $11,750)
758,061

 
406,447

Deferred income taxes
188,483

 
225,484

Debt
309,150

 
301,973

Total liabilities
7,653,736

 
6,169,172

Commitments and contingencies


 


Redeemable non-controlling interest
600

 
600

Stockholders’ equity:
 
 
 
Common stock, $.01 par value; 150,000 shares authorized, 91,335 and 91,216 issued in 2013 and 2012, respectively; 67,618 and 67,192 outstanding in 2013 and 2012, respectively
912

 
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
760,474

 
761,105

Treasury stock at cost; 23,716 and 24,024 shares in 2013 and 2012, respectively
(289,305
)
 
(293,791
)
Accumulated other comprehensive (loss) income
(26,620
)
 
64,231

Retained earnings
756,916

 
611,664

Total AmTrust Financial Services, Inc. equity
1,317,377

 
1,144,121

Non-controlling interest
108,625

 
103,344

Total stockholders’ equity
1,426,002

 
1,247,465

 
$
9,080,338

 
$
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 June 30,
 
Six Months Ended June 30,
 
 
2013
 
2012
 
2013
 
2012
Revenues:
 
 

 
 

 
 

 
 

Premium income:
 
 

 
 

 
 

 
 

Net written premium
 
$
639,997

 
$
391,589

 
$
1,172,103

 
$
751,366

Change in unearned premium
 
(103,458
)
 
(57,595
)
 
(227,570
)
 
(103,348
)
Net earned premium
 
536,539

 
333,994

 
944,533

 
648,018

Ceding commission – primarily related party
 
67,157

 
44,550

 
131,115

 
90,824

Service and fee income (related parties – three months $14,414; $6,932 and six months $24,921; $13,024)
 
88,102

 
33,011

 
148,615

 
73,549

Net investment income
 
22,634

 
16,344

 
40,729

 
30,862

Net realized gain (loss) on investments
 
2,067

 
2,703

 
19,351

 
1,555

Total revenues
 
716,499

 
430,602

 
1,284,343

 
844,808

Expenses:
 
 

 
 

 
 

 
 

Loss and loss adjustment expense
 
364,110

 
211,787

 
636,366

 
411,716

Acquisition costs and other underwriting expenses
 
192,559

 
129,713

 
349,379

 
253,738

Other
 
80,985

 
32,320

 
133,137

 
67,959

Total expenses
 
637,654

 
373,820

 
1,118,882

 
733,413

Income before other income (expense), income taxes and equity in earnings of unconsolidated subsidiaries
 
78,845

 
56,782

 
165,461

 
111,395

Other income (expense):
 
 

 
 

 
 

 
 

Interest expense
 
(7,608
)
 
(6,994
)
 
(14,969
)
 
(14,085
)
Gain on investment in life settlement contracts net of profit commission
 
1,080


1,961

 
4

 
2,051

Foreign currency gain (loss)
 
783


(2,455
)
 
2,055

 
(2,034
)
Acquisition gain on purchase
 
31,956


—

 
58,023


—

Total other income (expense)
 
26,211

 
(7,488
)
 
45,113

 
(14,068
)
Income before income taxes and equity in earnings of unconsolidated subsidiaries
 
105,056

 
49,294

 
210,574

 
97,327

Provision for income taxes
 
31,993

 
11,742

 
55,910

 
22,919

Income before equity in earnings of unconsolidated subsidiaries
 
73,063

 
37,552


154,664

 
74,408

Equity in earnings of unconsolidated subsidiary – related party
 
7,059

 
3,088

 
8,610

 
5,452

Net income
 
80,122

 
40,640

 
163,274

 
79,860

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

 
(282
)
 
877

 
(416
)
Net income attributable to AmTrust Financial Services, Inc.
 
$
80,122

 
$
40,358

 
$
164,151

 
$
79,444

Earnings per common share:
 
 

 
 

 
 

 
 

Basic earnings per share
 
$
1.19

 
$
0.60

 
$
2.44

 
$
1.20

Diluted earnings per share
 
$
1.14

 
$
0.59

 
$
2.34

 
$
1.16

Dividends declared per common share
 
$
0.14

 
$
0.10

 
$
0.28

 
$
0.19

Net realized gain on investments:
 
 

 
 

 
 

 
 

Total other-than-temporary impairment loss
 
$
—

 
$
(1,208
)
 
$
—

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

 
—

 
—

 
—

Net impairment losses recognized in earnings
 
—

 
(1,208
)
 
—

 
(1,208
)
Other net realized gain (loss) on investments
 
2,067

 
3,911

 
19,351

 
2,763

Net realized investment gain
 
$
2,067

 
$
2,703

 
$
19,351

 
$
1,555


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 June 30,
 
Six Months Ended June 30,
 
 
2013
 
2012
 
2013
 
2012
Net income
 
$
80,122


$
40,640

 
$
163,274


$
79,860

Other comprehensive income, net of tax:
 
 

 
 

 
 

 
 

Foreign currency translation adjustments
 
166

 
(7,057
)
 
(15,565
)
 
(2,860
)
Change in fair value of interest rate swap
 
716

 
(570
)
 
936

 
(627
)
Unrealized gains on securities:
 
 

 
 

 
 

 
 

Unrealized holding (loss) gain arising during period
 
(64,197
)
 
2,358

 
(79,483
)
 
33,117

Reclassification adjustment for (losses) gains included in net income
 
(275
)
 
(2,232
)
 
3,261

 
(4,676
)
Other comprehensive (loss) income, net of tax
 
$
(63,590
)
 
$
(7,501
)
 
$
(90,851
)
 
$
24,954

Comprehensive income
 
16,532

 
33,139

 
72,423

 
104,814

Less: Comprehensive income (loss) attributable to non-controlling interest
 
—

 
282

 
(877
)

416

Comprehensive income attributable to AmTrust Financial Services, Inc.
 
$
16,532

 
$
32,857

 
$
73,300

 
$
104,398

 
See accompanying notes to unaudited condensed consolidated financial statements.

5


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

 
 

Net income
$
163,274


$
79,860

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

 
 

Depreciation and amortization
29,294


17,419

Equity earnings on investment in unconsolidated subsidiaries
(8,610
)

(5,452
)
Gain on investment in life settlement contracts, net
(4
)

(2,051
)
Realized gain on marketable securities
(19,351
)

(2,763
)
Non-cash write-down of marketable securities
—

 
1,208

Discount on notes payable
1,454


1,515

Stock based compensation
4,781


2,746

Bad debt expense
9,754


2,479

Foreign currency (gain) loss
(2,055
)

2,034

Acquisition gain
(58,023
)
 
—

Dividend received from equity investment
12,203

 
—

Changes in assets - (increase) decrease:
 

 
 

Premiums and note receivables
(121,384
)

(41,556
)
Reinsurance recoverable
(180,905
)

(36,866
)
Deferred policy acquisition costs, net
(61,396
)

(54,707
)
Prepaid reinsurance premiums
(173,769
)

(70,009
)
Prepaid expenses and other assets
(11,982
)

(8,147
)
Changes in liabilities - increase (decrease):
 


 

Reinsurance premium payable
(7,752
)

(13,043
)
Loss and loss expense reserve
372,019


187,280

Unearned premiums
392,570


171,004

Funds held under reinsurance treaties
(1,229
)

(10,062
)
Accrued expenses and other current liabilities
207,122


4,122

Deferred tax liability
(49,408
)

(510
)
Net cash provided by operating activities
496,603

 
224,501

Cash flows from investing activities:
 

 
 

Net (purchases) sales of securities with fixed maturities
(363,514
)

(296,352
)
Net (purchases) sales of equity securities
21,904


12,199

Net (purchases) sales of other investments
(3,289
)

(332
)
Acquisition of and capitalized premiums for life settlement contracts
(18,546
)

(23,719
)
Receipt of life settlement contract proceeds
6,047


10,074

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

(3,822
)
Increase in restricted cash and cash equivalents
(85,106
)

(22,229
)
Purchase of property and equipment
(23,355
)

(14,701
)
Net cash used in investing activities
(538,726
)
 
(338,882
)
Cash flows from financing activities:
 

 
 

Preferred share issuance, net of fees
111,130


—

Common share issuance
472

 
—

Repurchase agreements, net
(29,750
)

40,201

Convertible senior notes proceeds
—


25,000

Secured loan agreements payments
(777
)

(482
)

6


Promissory notes payments
—


(2,500
)
Financing fees
—


(750
)
Capital contribution to subsidiaries
6,158


9,831

Stock option exercise and other
2,472


4,102

Dividends distributed on common stock
(9,463
)

(10,824
)
Net cash provided by financing activities
80,242

 
64,578

Effect of exchange rate changes on cash
(2,855
)
 
716

Net increase (decrease) in cash and cash equivalents
35,264

 
(49,087
)
Cash and cash equivalents, beginning of the period
414,370

 
406,847

Cash and cash equivalents, end of the period
$
449,634

 
$
357,760

Supplemental Cash Flow Information
 

 
 

Income tax payments
$
4,836

 
$
7,769

Interest payments on debt
10,602

 
10,706

 
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.

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 six months ended June 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 June 2013, the Financial Accounting Standards Board ("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 are 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 Accounting Standards Update ("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.


8


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 June 30, 2013 and December 31, 2012, are presented in the table below:
 
(Amounts in Thousands)
As of June 30, 2013
 
Original or amortized cost
 
Gross unrealized gains
 
Gross unrealized
losses
 
 Market value
Preferred stock
 
$
3,303

 
$
90

 
$
(118
)
 
$
3,275

Common stock
 
21,512

 
1,670

 
(562
)
 
22,620

U.S. treasury securities
 
91,578

 
2,211

 
(106
)
 
93,683

U.S. government agencies
 
8,594

 
206

 
(19
)
 
8,781

Municipal bonds
 
447,303

 
7,188

 
(15,272
)
 
439,219

Foreign government
 
75,486

 
548

 
(1,680
)
 
74,354

Corporate bonds:
 
 

 
 

 
 

 
 

Finance
 
916,406

 
34,182

 
(15,199
)
 
935,389

Industrial
 
570,658

 
12,429

 
(26,071
)
 
557,016

Utilities
 
71,213

 
1,279

 
(1,738
)
 
70,754

Commercial mortgage backed securities
 
24,836

 
28

 
(296
)
 
24,568

Residential mortgage backed securities:
 
 

 
 

 
 

 
 

Agency backed
 
511,293

 
10,114

 
(8,506
)
 
512,901

Non-agency backed
 
7,422

 
—

 
(194
)
 
7,228

Asset-backed securities
 
6,949

 
—

 
(12
)
 
6,937

 
 
$
2,756,553

 
$
69,945


$
(69,773
)
 
$
2,756,725

 
Investments in foreign government securities include securities issued by national entities as well as instruments that are unconditionally guaranteed by such entities. As of June 30, 2013, the Company's foreign government securities were issued or guaranteed primarily by France, 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 June 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.
 
 
June 30, 2013
 
December 31, 2012
(Amounts in Thousands)
 
Amortized Cost
 
Fair Value
 
Amortized Cost
 
 Fair Value
Due in one year or less
 
$
77,110

 
$
77,711

 
$
20,786

 
$
21,945

Due after one through five years
 
449,566

 
455,158

 
400,865

 
414,016

Due after five through ten years
 
1,310,304

 
1,310,966

 
966,158

 
1,044,510

Due after ten years
 
344,258

 
335,361

 
265,049

 
274,878

Mortgage and asset backed securities
 
550,500

 
551,634

 
294,786

 
309,877

Total fixed maturities
 
$
2,731,738

 
$
2,730,830

 
$
1,947,644

 
$
2,065,226

 
Proceeds from the sale of investments in available-for-sale securities during the six months ended June 30, 2013 and 2012 were approximately $1,198,185 and $380,614, respectively.

(b) Investment Income
 
Net investment income for the three months ended June 30, 2013 and 2012 was derived from the following sources:
 
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(Amounts in Thousands)
 
2013
 
2012
 
2013
 
2012
Fixed maturity securities
 
$
18,316

 
$
16,059

 
$
35,588

 
$
29,723

Equity securities
 
3,887

 
100

 
4,289

 
498

Cash and short term investments
 
704

 
385

 
1,748

 
976

 
 
22,907

 
16,544

 
41,625

 
31,197

Less:
 
 

 
 

 
 

 
 

Investment expenses and interest expense on securities sold under agreement to repurchase
 
(273
)
 
(200
)
 
(896
)
 
(335
)
 
 
$
22,634

 
$
16,344

 
$
40,729

 
$
30,862

 

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 June 30, 2013 and December 31, 2012:
 
 
 
Less Than 12 Months

12 Months or More

Total
(Amounts in Thousands)
June 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
 
$
9,712


$
(680
)

101


$
—


$
—


—


$
9,712


$
(680
)
U.S. treasury securities
 
8,261

 
(106
)
 
23

 
—

 
—

 
—

 
8,261

 
(106
)
U.S. government agencies
 
4,143

 
(19
)
 
9

 
—

 
—

 
—

 
4,143

 
(19
)
Municipal bonds
 
271,039


(15,229
)

322


2,013


(43
)

1


273,052


(15,272
)
Foreign government
 
63,677

 
(1,675
)
 
10

 
994

 
(5
)
 
1

 
64,671

 
(1,680
)
Corporate bonds:
 
 


 


 


 


 


 


 


 

Finance
 
418,558


(13,805
)

288


56,957


(1,394
)

8


475,515


(15,199
)
Industrial
 
475,247


(26,071
)

300


—


—


—


475,247


(26,071
)
Utilities
 
48,414

 
(1,738
)
 
34

 
—

 
—

 
—

 
48,414

 
(1,738
)
Commercial mortgage backed securities
 
9,999

 
(296
)
 
14

 
—

 
—

 
—

 
9,999

 
(296
)
Residential mortgage backed securities:
 
 


 


 


 


 


 


 


 

Agency backed
 
279,975


(8,506
)

143


—


—


—


279,975


(8,506
)
Non-agency backed
 
340


(5
)

7


6,887


(189
)

2


7,227


(194
)
Asset-backed securities
 
6,937

 
(12
)
 
13

 
—

 
—

 
—

 
6,937

 
(12
)
Total temporarily impaired securities
 
$
1,596,302


$
(68,142
)

1,264


$
66,851


$
(1,631
)

12


$
1,663,153


$
(69,773
)
  
 
 
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 1,276 and 118 securities at June 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 June 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 $3,195 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 June 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 June 30, 2013 and December 31, 2012 are as follows:
 
(Amounts in Thousands)
2013
 
2012
Restricted cash
$
163,868

 
$
78,762

Restricted investments
329,634

 
251,082

Total restricted cash and investments
$
493,502

 
$
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 June 30, 2013, the Company had sixteen repurchase agreements with a market value of $205,161 principal amount outstanding at interest rates between .00% and .53%. The sixteen agreements are with one counter-party. Interest expense associated with these repurchase agreements for the three months ended June 30, 2013 and 2012 was $214 and $200, respectively, of which $0 was accrued as of June 30, 2013. The Company has approximately $266,399 of collateral pledged in support of these agreements. Interest expense related to repurchase agreements is recorded as a component of investment income. Additionally, during the three months ended June 30, 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 June 30, 2013 and December 31, 2012:
 
(Amounts in Thousands)
As of June 30, 2013
 
Total

Level 1

Level 2

Level 3
Assets:
 
 


 


 


 

U.S. treasury securities
 
$
93,683


$
93,683


$
—


$
—

U.S. government agencies
 
8,781


—


8,781


—

Municipal bonds
 
439,219


—


439,219


—

Foreign government
 
74,354

 
—

 
74,354

 
—

Corporate bonds and other bonds:
 
 


 


 


 

Finance
 
935,389


—


935,389


—

Industrial
 
557,016


—


557,016


—

Utilities
 
70,754


—


70,754


—

Commercial mortgage backed securities
 
24,568


—


24,568


—

Residential mortgage backed securities:
 
 


 


 


 

Agency backed
 
512,901


—


512,901


—

Non-agency backed
 
7,228


—


7,228


—

Asset-backed securities
 
6,937

 
—

 
6,937

 
—

Equity securities
 
25,895


25,895


—


—

Short term investments
 
15,209


15,209


—


—

Other investments
 
24,779


—


—


24,779

Life settlement contracts
 
208,694


—


—


208,694

 
 
$
3,005,407


$
134,787


$
2,637,147


$
233,473

Liabilities:
 
 


 


 


 

Securities sold under agreements to repurchase, at carrying value
 
205,161


—


205,161


—

Life settlement contract profit commission
 
12,513


—


—


12,513

Derivatives
 
3,195


—


3,195


—

 
 
$
220,869


$
—


$
208,356


$
12,513

 

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 six months ended June 30, 2013 and 2012:

(Amounts in Thousands)

Balance as of March 31, 2013

Net income

Other comprehensive income

Purchases and issuances

Sales and settlements

Net transfers into (out of) Level 3

Balance as of June 30,
2013
Other investments

$
16,052


$
(17
)

$
—


$
9,770


$
(1,026
)

$
—


$
24,779

Life settlement contracts

199,824


10,889


—


—


(2,019
)

—


208,694

Life settlement contract profit commission

(12,237
)

(276
)

—


—


—


—


(12,513
)
Total

$
203,639


$
10,596


$
—


$
9,770


$
(3,045
)

$
—


$
220,960

 
(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 June 30,
2013
Other investments

$
11,144


$
677


$
—


$
14,881


$
(1,923
)

$
—


$
24,779

Life settlement contracts

193,927


20,815


—


—


(6,048
)

—


208,694

Life settlement contract profit commission

(11,750
)

(763
)

—


—


—


—


(12,513
)
Total

$
193,321


$
20,729


$
—


$
14,881


$
(7,971
)

$
—


$
220,960


(Amounts in Thousands)
 
Balance as of March 31, 2012
 
Net income
 
Other comprehensive income
 
Purchases and issuances
 
Sales and settlements
 
Net transfers into (out of) Level 3
 
Balance as of
June 30,
2012
Other investments
 
$
14,865

 
$
(403
)
 
$
—

 
$
677

 
$
(36
)
 
$
—

 
$
15,103

Life settlement contracts
 
142,575

 
7,456

 
—

 
11,135

 
(10,074
)
 
—

 
151,092

Life settlement contract profit commission
 
(12,050
)
 
585

 
—

 
—

 
—

 
—

 
(11,465
)
Derivatives
 
(3,595
)
 
—

 
(877
)
 
—

 
—

 
—

 
(4,472
)
Total
 
$
141,795

 
$
7,638

 
$
(877
)
 
$
11,812

 
$
(10,110
)
 
$
—

 
$
150,258


(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
June 30,
2012
Other investments
 
$
14,588

 
$
(4,352
)
 
$
4,535

 
$
747

 
$
(415
)
 
$
—

 
$
15,103

Life settlement contracts
 
131,387

 
15,416

 
—

 
14,363

 
(10,074
)
 
—

 
151,092

Life settlement contract profit commission
 
(12,022
)
 
557

 
—

 
—

 
—

 
—

 
(11,465
)
Derivatives
 
(3,508
)
 
—

 
(964
)
 
—

 
—

 
—

 
(4,472
)
Total
 
$
130,445

 
$
11,621

 
$
3,571

 
$
15,110

 
$
(10,489
)
 
$
—

 
$
150,258


 The Company had no transfers between levels during the three and six months ended June 30, 2013 and 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 less than 1% 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. The fair value of the equity investment was approximately $129,900 as of June 30, 2013. The Company includes the estimate in the amount disclosed in Level 2 hierarchy.
—
Subordinated Debentures and Debt: The current fair value of the Company's convertible senior notes and subordinated debentures was $279,800 and $69,816 as of June 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.
—
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 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, financial standing of the issuer, and changes in economic conditions affecting the issuer, maintenance cost, premiums, benefits, standard actuarially developed mortality tables and industry life expectancy reports. The fair value of a life insurance policy is estimated 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. 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. The following summarizes data utilized in estimating the fair value of the portfolio of life insurance policies as of June 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:
 
 
June 30,
2013
 
December 31,
2012
Average age of insured
79.3 years

 
78.8 years

Average life expectancy, months (1)
135


139

Average face amount per policy
$
6,748,000

 
$
6,770,000

Effective discount rate
17.3
%
 
17.7
%



(1) 
Standard life expectancy as adjusted for specific circumstances.

17




These 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 evaluating the effect of changes in significant underlying assumptions used to estimate the fair value amount. If the life expectancies were increased or decreased by 4 months and the discount factors were increased or decreased by 1% while all other variables were held constant, the carrying value of the investment in life insurance policies would increase or (decrease) by the unaudited amounts summarized below as of June 30, 2013 and December 31, 2012:
 
 
Change in life expectancy
(Amounts in Thousands)
Plus 4 Months
 
Minus 4 Months
Investment in life policies:
 

 
 

June 30, 2013
$
(27,995
)
 
$
30,488

December 31, 2012
$
(27,160
)
 
$
29,285

 
Change in discount rate
(Amounts in Thousands)
Plus 1%
 
Minus 1%
Investment in life policies:
 

 
 

June 30, 2013
$
(17,835
)
 
$
20,168

December 31, 2012
$
(17,591
)
 
$
19,926

  
5.
Investment in Life Settlements
 
A life settlement contract is a contract between the owner of a life insurance policy and a third-party who obtains the ownership and beneficiary rights of the underlying life insurance policy. During 2010, the Company formed Tiger Capital LLC (“Tiger”) with a subsidiary of National General Holdings Corp. ("NGHC"), which changed its name from American Capital Acquisition Corporation, or ACAC, in April 2013, for the purposes of acquiring life settlement contracts. In 2011, the Company formed AMT Capital Alpha, LLC (“AMT Alpha”) with a subsidiary of NGHC and AMT Capital Holdings, S.A. (“AMTCH”) with ACP Re, Ltd., an entity controlled by the Michael Karfunkel 2005