| Fair Value of Financial Instruments |
Fair Value of Financial Instruments
The following table presents 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, 2012: | | | | | | | | | | | | | | | | | (Amounts in Thousands) | Total | | Level 1 | | Level 2 | | Level 3 | Assets: | |
| | |
| | |
| | |
| U.S. treasury securities | $ | 48,341 |
| | $ | 48,341 |
| | $ | — |
| | $ | — |
| U.S. government agencies | 46,305 |
| | — |
| | 46,305 |
| | — |
| Municipal bonds | 265,011 |
| | — |
| | 265,011 |
| | — |
| Corporate bonds and other bonds: | |
| | |
| | |
| | |
| Finance | 773,474 |
| | — |
| | 773,474 |
| | — |
| Industrial | 330,269 |
| | — |
| | 330,269 |
| | — |
| Utilities | 35,228 |
| | — |
| | 35,228 |
| | — |
| Commercial mortgage backed securities | 10,209 |
| | — |
| | 10,209 |
| | — |
| Residential mortgage backed securities: | |
| | |
| | |
| | |
| Agency backed | 332,027 |
| | — |
| | 332,027 |
| | — |
| Non-agency backed | 6,759 |
| | — |
| | 6,759 |
| | — |
| Equity securities | 18,318 |
| | 18,318 |
| | — |
| | — |
| Short term investments | 485 |
| | 485 |
| | — |
| | — |
| Other investments | 14,324 |
| | — |
| | — |
| | 14,324 |
| Life settlement contracts | 171,476 |
| | — |
| | — |
| | 171,476 |
| | $ | 2,052,226 |
| | $ | 67,144 |
| | $ | 1,799,282 |
| | $ | 185,800 |
| Liabilities: | |
| | |
| | |
| | |
| Equity securities sold but not yet purchased, market | $ | 43 |
| | $ | 43 |
| | $ | — |
| | $ | — |
| Fixed maturity securities sold but not yet purchased, market | 57,155 |
| | 57,155 |
| | — |
| | — |
| Securities sold under agreements to repurchase, at contract value | 226,098 |
| | — |
| | 226,098 |
| | — |
| Life settlement contract profit commission | 9,550 |
| | — |
| | — |
| | 9,550 |
| Derivatives | 4,973 |
| | — |
| | 4,973 |
| | — |
| | $ | 297,819 |
| | $ | 57,198 |
| | $ | 231,071 |
| | $ | 9,550 |
|
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.
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 2011 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, 2012 and 2011: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | (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 |
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | (Amounts in Thousands) | | Balance as of June 30,
2011 | | Net income | | Other comprehensive income | | Purchases and issuances | | Sales and settlements | | Net transfers into (out of) Level 3 | | Balance as of September 30,
2011 | Other investments | | $ | 22,008 |
| | $ | — |
| | $ | (1,348 | ) | | $ | 5,672 |
| | $ | (5,128 | ) | | $ | — |
| | $ | 21,204 |
| Life settlement contracts | | 108,710 |
| | 17,188 |
| | — |
| | 6,298 |
| | (10,530 | ) | | — |
| | 121,666 |
| Life settlement contract profit commission | | (9,267 | ) | | (3,369 | ) | | — |
| | — |
| | — |
| | — |
| | (12,636 | ) | Total | | $ | 121,451 |
| | $ | 13,819 |
| | $ | (1,348 | ) | | $ | 11,970 |
| | $ | (15,658 | ) | | $ | — |
| | $ | 130,234 |
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | (Amounts in Thousands) | | Balance as of December 31,
2010 | | Net income | | Other comprehensive income | | Purchases and issuances | | Sales and settlements | | Net transfers into (out of) Level 3 | | Balance as of September 30,
2011 | Other investments | | $ | 21,514 |
| | $ | 661 |
| | $ | (1,725 | ) | | $ | 6,538 |
| | $ | (5,784 | ) | | $ | — |
| | $ | 21,204 |
| Life settlement contracts | | 22,155 |
| | 75,209 |
| | — |
| | 34,832 |
| | (10,530 | ) | | — |
| | 121,666 |
| Life settlement contract profit commission | | (4,711 | ) | | (7,925 | ) | | — |
| | — |
| | — |
| | — |
| | (12,636 | ) | Total | | $ | 38,958 |
| | $ | 67,945 |
| | $ | (1,725 | ) | | $ | 41,370 |
| | $ | (16,314 | ) | | $ | — |
| | $ | 130,234 |
|
The Company transferred its derivatives from Level 3 to Level 2 during the three and nine months ended September 30, 2012. The Company had no transfers between levels during 2011. 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. | — | 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. | — | Subordinated Debentures and Debt: The current fair value of the Company's convertible senior notes and subordinated debentures was $230,000 and $55,600 as of September 30, 2012, respectively. The remaining carrying values reported in the accompanying balance sheets for these financial instruments approximate fair value. Fair value was estimated using projected cash flows, discounted at rates currently being offered for similar notes. | — | Other investments: The Company has less than 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. The Company has determined that its investments in these securities are not material to its financial position or results of operations. | — | 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. |
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 using present value calculations based on the data specific to each individual life insurance policy. The following summarizes data utilized in estimating the fair value of the portfolio of life insurance policies as of September 30, 2012 and December 31, 2011 and, as described in Note 5, only includes data for policies to which the Company assigned value at those dates: | | | | | | | | | | September 30,
2012 | | December 31,
2011 | Average age of insured | 79 years |
| | 77 years |
| Average life expectancy, months (1) | 143 months |
| | 155 months |
| Average face amount per policy (Amounts in Thousands) | $ | 6,818 |
| | $ | 6,703 |
| Fair value discount rate | 7.5 | % | | 7.5 | % | Internal rate of return (2) | 15.9 | % | | 14.1 | % |
| | (1) | Standard life expectancy as adjusted for insured’s specific circumstances. |
| | (2) | Internal rate of return includes a risk premium which represents risk adjustments applied to the estimated present value of cash flows based on the following factors: (i) the volatility in life expectancy of insureds and the associated level of future premium payments and (ii) the projected risk of non-payment, including the financial health of the insurance carrier, the possibility of legal challenges from the insurance carrier or others and the possibility of regulatory changes that may affect payment. |
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 reasonable 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 are held constant, the carrying value of the investment in life insurance policies would increase or (decrease) by the unaudited amounts summarized below as of September 30, 2012 and December 31, 2011: | | | | | | | | | | Change in life expectancy | (Amounts in Thousands) | Plus 4 Months | | Minus 4 Months | Investment in life policies: | |
| | |
| September 30, 2012 | $ | (25,386 | ) | | $ | 28,250 |
| December 31, 2011 | $ | (18,778 | ) | | $ | 20,785 |
|
| | | | | | | | | | Change in discount rate | (Amounts in Thousands) | Plus 1% | | Minus 1% | Investment in life policies: | |
| | |
| September 30, 2012 | $ | (17,167 | ) | | $ | 20,030 |
| December 31, 2011 | $ | (13,802 | ) | | $ | 15,804 |
|
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