Endurance Specialty Insurance Ltd. Years Ended December 31, 2012 and 2011 With Report of Independent Auditors

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1 A UDITED CONSOLIDATED FINANCIAL STATEMENTS Endurance Specialty Insurance Ltd. Years Ended December 31, 2012 and 2011 With Report of Independent Auditors Ernst & Young Ltd.

2 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Report of Independent Auditors 2 Consolidated Balance Sheets at December 31, 2012 and Consolidated Statements of Income (Loss) and Comprehensive Income (Loss) for the years ended December 31, 2012 and Consolidated Statements of Changes in Shareholder s Equity for the years ended December 31, 2012 and Consolidated Statements of Cash Flows for the years ended December 31, 2012 and Notes to the Consolidated Financial Statements for the years ended December 31, 2012 and

3 Ernst & Young Ltd. #3 Bermudiana Road Hamilton HM 11, Bermuda P.O. Box 463, Hamilton, HM BX, Bermuda Direct: Direct Fax: The Board of Directors and Shareholder Endurance Specialty Insurance Ltd. and Subsidiaries. Report of Independent Auditors We have audited the accompanying consolidated financial statements of Endurance Specialty Insurance Ltd. and subsidiaries (the Company), which comprise the consolidated balance sheets as of December 31, 2012 and 2011, and the related consolidated statements of income (loss) and comprehensive income (loss), changes in stockholders equity, and cash flows for the years then ended, and the related notes to the consolidated financial statements. Management s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these financial statements in conformity with U.S. generally accepted accounting principles; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free of material misstatement, whether due to fraud or error. Auditor s Responsibility Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor s judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the Company s preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Endurance Specialty Insurance Ltd. and subsidiaries at December 31, 2012 and 2011, and the consolidated results of their operations and their cash flows for the years then ended in conformity with U.S. generally accepted accounting principles. April 10,

4 ENDURANCE SPECIALTY INSURANCE LTD. CONSOLIDATED BALANCE SHEETS DECEMBER 31, 2012 AND 2011 (In thousands of United States dollars except share amounts) DECEMBER 31, DECEMBER 31, ASSETS Investments Fixed maturity investments, available for sale at fair value (amortized cost: $4,728,596 and $4,700,989 at December 31, 2012 and 2011, respectively) $ 4,868,150 $ 4,831,966 Short-term investments, available for sale at fair value (amortized cost: $42,224 and $67,803 at December 31, 2012 and 2011, respectively) 42,230 67,802 Equity securities, available for sale at fair value (cost: $76,997 and $56,381 at December 31, 2012 and 2011, respectively) 86,997 59,767 Other investments 517, ,658 Total investments 5,514,923 5,392,193 Cash and cash equivalents 1,102, ,273 Premiums receivable, net 601, ,017 Insurance and reinsurance balances receivable 105,663 92,710 Deferred acquisition costs 168, ,049 Prepaid reinsurance premiums 166, ,670 Losses recoverable 774, ,928 Accrued investment income 27,166 29,708 Goodwill and intangible assets 172, ,828 Deferred tax asset 43,501 25,196 Net receivable on sales of investments 9,144 77,821 Other assets 77,482 43,188 Total assets $ 8,764,080 $ 8,247,581 LIABILITIES Reserve for losses and loss expenses $ 4,240,876 $ 3,824,224 Reserve for unearned premiums 965, ,108 Deposit liabilities 22,220 26,887 Reinsurance balances payable 110, ,488 Due to affiliates 200, ,210 Net payable on purchases of investments 81,469 55,243 Other liabilities 119,138 87,242 Total liabilities 5,740,719 5,327,402 Commitments and contingent liabilities SHAREHOLDER S EQUITY Common shares Ordinary 12,000,000 issued and outstanding ( ,000,000) 12,000 12,000 Additional paid-in capital 2,076,270 2,076,270 Accumulated other comprehensive income 154, ,938 Retained earnings 780, ,971 Total shareholders equity 3,023,361 2,920,179 Total liabilities and shareholder s equity $ 8,764,080 $ 8,247,581 See accompanying notes to the consolidated financial statements 3

5 ENDURANCE SPECIALTY INSURANCE LTD. CONSOLIDATED STATEMENTS OF INCOME (LOSS) AND COMPREHENSIVE INCOME (LOSS) FOR THE YEARS ENDED DECEMBER 31, 2012 AND 2011 (In thousands of United States dollars, except share and per share amounts) Revenues Gross premiums written $ 2,549,026 $ 2,467,114 Ceded premiums written (519,531) (487,293) Net premiums written 2,029,495 1,979,821 Change in unearned premiums (15,595) (48,428) Net premiums earned 2,013,900 1,931,393 Net investment income 173, ,041 Net realized and unrealized investment gains 72,304 31,861 Total other-than-temporary impairment losses (364) (2,659) Portion of loss recognized in other comprehensive income (483) (861) Net impairment losses recognized in earnings (losses) (847) (3,520) Other underwriting loss (2,183) (3,547) Total revenues 2,256,503 2,103,228 Expenses Net losses and loss expenses 1,520,995 1,632,666 Acquisition expenses 303, ,911 General and administrative expenses 220, ,525 Amortization of intangibles 10,347 11,213 Net foreign exchange gains (15,928) (7,421) Interest expense 10,200 7,446 Total expenses 2,048,799 2,170,340 Income (loss) before income taxes 207,704 (67,112) Income tax benefit ,665 Net income (loss) 207,849 (37,447) Other comprehensive income Net unrealized holding gains on investments arising during the period (net of applicable deferred income taxes in $6,155; ($6,914)) 88,897 39,805 Portion of other-than-temporary impairment losses recognized in other comprehensive income (loss) (net of applicable deferred income taxes in $16; $69) Reclassification adjustment for net realized gains and net impairment losses included in net income (loss) (70,538) (27,627) Foreign currency translation adjustments 3,057 (1,262) Other comprehensive income 21,883 11,708 Comprehensive income (loss) $ 229,732 $ (25,739) See accompanying notes to the consolidated financial statements. 4

6 ENDURANCE SPECIALTY INSURANCE LTD. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDER S EQUITY FOR THE YEARS ENDED DECEMBER 31, 2012 AND 2011 (In thousands of United States dollars) Common shares Balance, beginning and end of year $ 12,000 $ 12,000 Additional paid-in capital Balance, beginning and end of year 2,076,270 2,076,270 Accumulated other comprehensive income Cumulative foreign currency translation adjustments: Balance, beginning of year 9,648 10,910 Foreign currency translation adjustments 3,057 (1,262) Balance, end of year 12,705 9,648 Unrealized holding gains on investments, net of deferred taxes: Balance, beginning of year 123, ,320 Net unrealized holding gains arising during the period, net of reclassification adjustment 18,359 12,178 Other-than-temporary impairment losses during the year Balance, end of year 142, ,290 Total accumulated other comprehensive income 154, ,938 Retained earnings Balance, beginning of year 698, ,518 Net income (loss) 207,849 (37,447) Dividends on common shares (126,550) (107,100) Balance, end of year 780, ,971 Total shareholder s equity $ 3,023,361 $ 2,920,179 See accompanying notes to the consolidated financial statements. 5

7 ENDURANCE SPECIALTY INSURANCE LTD. CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2012 AND 2011 (In thousands of United States dollars) Cash flows provided by operating activities: Net income (loss) $ 207,849 $ (37,447) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Amortization of net premium on investments 25,989 17,790 Amortization of other intangibles and depreciation 15,824 17,280 Net realized and unrealized investment gains (72,304) (31,861) Net impairment losses recognized in earnings (losses) 847 3,520 Deferred taxes (13,987) (6,905) Equity in (earnings) losses of other investments (49,059) 694 Premiums receivable, net (57,935) 251,710 Insurance and reinsurance balances receivable (12,953) (60,828) Deferred acquisition costs (2,203) (11,565) Prepaid reinsurance premiums (17,032) (41,693) Losses recoverable (108,014) (347,579) Accrued investment income 2,542 3,226 Other assets (9,678) (2,766) Reserve for losses and loss expenses 416, ,297 Reserve for unearned premiums 33,136 89,954 Deposit liabilities (4,667) (5,618) Reinsurance balances payable (78,645) (39,904) Due to affiliates (11,281) (97,464) Other liabilities 17,510 10,685 Net cash flows provided by operating activities 282, ,526 Cash flows provided by investing activities Proceeds from sales of available for sale investments 4,143,528 3,034,880 Proceeds from maturities and calls on available for sale investments 943,445 1,086,854 Proceeds from the redemption of other investments 79,225 14,493 Purchases of available for sale investments (4,964,345) (3,870,547) Purchases of other investments (115,054) (71,193) Net settlements of other assets (15,123) (457) Purchases of fixed assets (3,056) (5,156) Change in securities lending collateral received - 59,886 Net cash paid for subsidiary acquisition (1,519) (4,557) Net cash flows provided by investing activities 67, ,203 Cash flows used in financing activities Change in securities lending payable - (59,886) Proceeds from issuance of debt Repayments of debt (945) (817) Dividends on common shares (126,550) (107,100) Net cash flows used in financing activities (126,523) (166,956) Effect of exchange rate changes on cash and cash equivalents 911 (4,226) Net increase in cash and cash equivalents 224, ,547 Cash and cash equivalents, beginning of year 878, ,726 Cash and cash equivalents, end of year $ 1,102,353 $ 878,273 See accompanying notes to the consolidated financial statements. 6

8 ENDURANCE SPECIALTY INSURANCE LTD. 1. Organization Endurance Specialty Insurance Ltd. ( Endurance Bermuda ) was organized in Bermuda on November 30, 2001 and is a wholly-owned subsidiary of Endurance Specialty Holdings Ltd. ( Endurance Holdings ). On December 14, 2001, Endurance Bermuda completed a private offering of 12 million common shares for gross cash proceeds of $1.2 billion. Under the terms of an Exchange Offer dated July 22, 2002, the shareholders of Endurance Bermuda transferred their interest in Endurance Bermuda to Endurance Holdings in exchange for an identical shareholding in Endurance Holdings. Endurance Bermuda writes specialty lines of insurance and reinsurance on a global basis through its wholly-owned operating subsidiaries: Operating Subsidiaries Endurance Worldwide Insurance Limited ("Endurance U.K.") Endurance Reinsurance Corporation of America ("Endurance U.S. Reinsurance") Endurance American Insurance Company ("Endurance American") Endurance American Specialty Insurance Company ("Endurance American Specialty") Endurance Risk Solutions Assurance Co. ("Endurance Risk Solutions") American Agri-Business Insurance Company ("American Agri-Business"), managed by ARMtech Insurance Services, Inc. (together with American Agri-Business, "ARMtech") Domicile England Delaware Delaware Delaware Delaware Texas 2. Summary of significant accounting policies The consolidated financial statements have been prepared on the basis of accounting principles generally accepted in the United States ( U.S. GAAP ) and include the accounts of Endurance Bermuda and its wholly-owned subsidiaries, which are collectively referred to herein as the Company. All intercompany transactions and balances have been eliminated in consolidation. The following are significant accounting and reporting policies adopted by the Company: (a) Premiums and related expenses The Company s insurance premiums are earned pro rata over the terms of the applicable risk period specified in the insurance policy. The Company s insurance policies cover losses occurring or claims made during the term of the policy. Generally, the Company receives a fixed premium which is identified in the policy and is recorded on the inception date of the contract or when premiums are determinable and earned evenly over the policy term. This premium will only adjust if the underlying insured values adjust. Accordingly, the Company monitors the underlying insured values and records additional or return premiums in the period in which amounts are reasonably determinable. The Company s reinsurance premiums are earned in proportion to the amount of reinsurance protection provided over the applicable risk period established in the reinsurance contract. Reinsurance contracts written on a losses occurring basis cover losses which occur during the term of the reinsurance contract, typically 12 months. Accordingly, the Company earns the premium on a losses occurring reinsurance contract evenly over the reinsurance contract term. Reinsurance contracts written on a policies attaching basis cover losses from the underlying insurance policies incepting during the terms of the reinsurance contracts. Losses under a policies attaching reinsurance contract may occur after the end date of the reinsurance contract, so long as they are losses from policies which began during the reinsurance contract period. The Company typically earns the premiums for policies attaching reinsurance contracts over a 24-month period in proportion to the amount of reinsurance protection provided to reflect the extension of the risk period past the term of the contract and the varying levels of reinsurance protection provided during the reinsurance contract period. 7

9 ENDURANCE SPECIALTY INSURANCE LTD. 2. Summary of significant accounting policies, cont d. (a) Premiums and related expenses, cont d. In addition to the applicable risk period, the Company s estimate of its reinsurance premiums written is based on the type of reinsurance contracts underwritten. For excess of loss reinsurance contracts, the deposit premium, as defined in the contract, is generally considered to be the best estimate of the reinsurance contract s written premium at inception. The Company earns reinstatement premiums upon the occurrence of a loss under the reinsurance contract. Reinstatement premiums are calculated in accordance with the contract terms based upon the ultimate loss estimate associated with each contract. For proportional reinsurance contracts, the Company estimates premium, commissions and related expenses based on broker and ceding company estimates and also utilizes judgment in establishing proportional reinsurance contract estimates. Premiums on the Company s excess of loss and proportional reinsurance contracts are estimated at the time the business is underwritten. Accordingly, this is the amount the Company records as written premium in the period the reinsurance contract is underwritten. As actual premiums are reported by the ceding companies, management evaluates the appropriateness of the original premium estimates and any adjustments to these estimates are recorded in the period in which they become known. Acquisition expenses are costs that vary with and are directly related to the successful production of new and renewal business, and consist principally of commissions and brokerage expenses. Acquisition and general and administrative expenses are shown net of commissions, other fees and expense allowances associated with and earned on ceded business. These costs are deferred and amortized over the periods in which the related premiums are earned. Deferred acquisition costs are limited to their estimated realizable value based on the related unearned premiums. Anticipated net investment income is considered in determining the recoverability of deferred acquisition costs. (b) Reserve for losses and loss expenses The Company s reserve for losses and loss expenses includes case reserves and reserves for losses incurred but not reported (referred to as IBNR reserves ). Case reserves are established for losses that have been reported, but not yet paid. IBNR reserves represent the estimated ultimate cost of events or conditions that have not been reported to or specifically identified by the Company, but have occurred. Case reserves and IBNR reserves are established by management based on reports from reinsurance intermediaries, ceding companies and insureds, and consultations with independent legal counsel. In addition, reserves for IBNR losses and loss expenses are established by management based on reported losses and loss expenses, and actuarially determined estimates of ultimate losses and loss expenses. The Company uses a variety of actuarial methods to estimate the ultimate losses and loss expenses incurred by the Company. One actuarial method used by the Company to estimate reserves for losses and loss expenses is the expected loss ratio approach, which is based on expected results independent of current loss reporting activity. This approach is typically used for immature loss periods (i.e., the current accident year). Another actuarial method used by the Company to estimate reserves for losses and loss expenses is known as the Bornhuetter-Ferguson method. The Bornhuetter-Ferguson method uses an initial loss estimate (expected loss technique) for each accident year by business line and type of contract. Under this method, IBNR is set equal to the initial loss estimate multiplied by the expected percent of loss yet to be reported at each valuation date. In a given quarter, if reported losses are less than expected, then the difference would result in a decrease in estimated ultimate losses. If losses are greater than expected, then the difference would result in an increase in estimated ultimate losses. A third actuarial method used by the Company to estimate reserves for losses and loss expenses is known as the loss development method. The loss development method extrapolates the current value of reported losses to ultimate expected losses by using selected reporting patterns of losses over time. 8

10 ENDURANCE SPECIALTY INSURANCE LTD. 2. Summary of significant accounting policies, cont d. (b) Reserve for losses and loss expenses, cont d. The selected reporting patterns are based on historical information (organized into loss development triangles) and are adjusted to reflect the changing characteristics of the book of business written by the Company. Management uses these multiple actuarial methods, supplemented with professional judgment, to establish the best estimate of reserves for losses and loss expenses. The Company s loss and loss expense reserves are reviewed regularly, and adjustments, if any, are reflected in earnings in the period in which they become known. The establishment of new loss and loss expense reserves or the adjustment of previously recorded loss and loss expense reserves could result in significant positive or negative changes to the Company s financial condition for any particular period. While management believes the Company s estimate of loss and loss expense reserves is reasonable, the ultimate loss experience may not be reliably predicted, and it is possible losses and loss expenses may be materially different than the total reserve for losses and loss expenses recorded by the Company. (c) Reinsurance Losses recoverable represent estimates of losses and loss expenses that will be recovered from reinsurers. Amounts recoverable from reinsurers are estimated in a manner consistent with the provisions of the reinsurance agreements and consistent with the establishment of the Company s reserve for losses and loss expenses. Ceding commissions earned on ceded business are classified as an offset to acquisition and general and administrative expenses. (d) Investments The Company currently classifies its fixed maturity investments, short-term investments and equity securities as available for sale and, accordingly, they are carried at estimated fair value, with related net unrealized gains or losses excluded from earnings and included in shareholders equity as a component of accumulated other comprehensive income. The Company determines the fair value of its available-for-sale investments in accordance with current accounting guidance, which defines fair value and establishes a fair value hierarchy based on inputs to the various valuation techniques used for each fair value measurement. The use of valuation techniques for any given investment requires a significant amount of judgment and consideration of factors specific to the underlying investment. Fair value measurements determined by the Company seek to maximize observable inputs and minimize the use of unobservable inputs. Current accounting guidance establishes three levels as follows: Level 1: Unadjusted quoted prices in active markets for identical assets or liabilities. Level 2: Quoted prices for similar assets in markets that are active, quoted prices for identical or similar assets in markets that are not active or inputs that are observable either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities other than quoted prices in Level 1; quoted prices in markets that are not active; or other inputs that are observable or can be derived principally from or corroborated by observable market data for substantially the full term of the assets or liabilities. 9

11 ENDURANCE SPECIALTY INSURANCE LTD. 2. Summary of significant accounting policies, cont d. (d) Investments, cont d. Level 3: Unobservable inputs that are supported by little or no market activity and are significant to the fair value of the assets or liabilities. Unobservable inputs reflect the Company s own views about the assumptions that market participants would use in pricing the asset or liability. Level 3 assets and liabilities include financial instruments whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant judgment or estimation. The Company determines the estimated fair value of each individual security utilizing the highest level inputs available. Transfers between levels are assumed to occur at the end of each period. If the Company has the intent to sell an available for sale security or it is more likely than not that the Company will be required to sell the security, the Company deems the security to be other-than-temporarily impaired and writes down the value to fair value, thereby establishing a new cost basis. The amount of the write-down is recognized in earnings as an other-than-temporary impairment ( OTTI ) loss. For fixed maturity and short-term investments in an unrealized loss position for which a decision to sell has not been made and it is not more likely than not that the Company will be required to sell the security, the Company performs additional reviews to determine whether the investment will recover its amortized cost. If the amortized cost of the Company s fixed maturity and short-term investments is, based upon the judgment of management, unlikely to be recovered, the Company writes down the investment by the amount representing the credit related portion of the decline in value, thereby establishing a new cost basis. The amount of the writedown is recognized in earnings as an OTTI loss. The new cost basis is not changed for subsequent recoveries in fair value. To the extent the Company determines that the amortized cost of the Company s fixed maturity and short-term investments is likely to be recovered and the decline in value is related to non-credit factors (such as interest rates, market conditions, etc.) and not due to credit related factors, that remaining non-credit portion of the unrealized loss is recorded as a part of accumulated other comprehensive income in the shareholders equity section of the Company s balance sheet. For equity securities in an unrealized loss position for which a decision to sell has not been made and it is not more likely than not that the Company will be required to sell the equity security, the Company considers its ability and intent to hold the equity security in an unrealized loss position for a reasonable period of time to allow for a full recovery. When the Company determines that the decline in value of an equity security is otherthan-temporary, the Company reduces the cost of the equity security to its fair value and recognizes the loss in the Consolidated Statements of Income (Loss) and Comprehensive Income (Loss). The new cost basis is not changed for subsequent recoveries in fair value. 10

12 ENDURANCE SPECIALTY INSURANCE LTD. 2. Summary of significant accounting policies, cont d. (d) Investments, cont d. Other investments within the Company s investment portfolio, which are comprised of (i) hedge funds and private investment funds that generally invest in senior secured bank debt, high yield debt securities, distressed debt, distressed real estate, derivatives and equity long/short strategies ( alternative funds ) and (ii) high yield loan and convertible debt funds ( specialty funds ) are accounted for using the equity method of accounting whereby the initial investment is recorded at cost. The carrying values of these investments are increased or decreased to reflect the Company s share of income or loss, which is included in net investment income, and are decreased for dividends. Due to the timing of the delivery of the final valuations reported by the managers of certain of our alternative and specialty funds, our investments in those funds are estimated based on the most recently available information including period end valuation statements, period end estimates, or, in some cases, prior month or quarter valuation statements. The Company participated in a securities lending program until July Under this program fixed maturity investments were loaned by the Company to third parties, primarily major brokerage firms and commercial banks. The Company retained all economic interest in the securities it lent, retained the earnings and cash flows associated with the loaned securities and received a fee from the borrower for the temporary use of the securities. The borrowers of the Company s securities provided the Company with collateral, typically cash, which the Company separately maintained. The Company typically invested such collateral in overnight repurchase agreements. All securities on loan were issued on a term or overnight basis and were subject to daily recall at the Company s discretion. Upon the termination of the securities lending program, the Company recalled all securities on loan and refunded all collateral previously held as part of the program. (e) Cash equivalents Cash equivalents include highly liquid short-term deposits and securities with maturities of ninety days or less at the time of purchase. Cash equivalents are valued at amortized cost, which approximates fair value due to the short-term, liquid nature of these securities. (f) Intangible assets Identifiable intangible assets are amortized in accordance with their useful lives. Goodwill and intangible assets with indefinite useful lives are not amortized but are tested for impairment annually or more often if impairment indicators arise. In making an assessment of the value of its goodwill, the Company uses both market based and non-market based valuations. Assumptions underlying these valuations include forecasts of discounted future cash flows and future profits in addition to an analysis of the Company s stock price relative to both its book value and its net income (loss). (g) Foreign exchange Assets and liabilities of foreign operations whose functional currency is not the United States dollar are translated at exchange rates in effect at the balance sheet date. Revenues and expenses of such foreign operations are translated at weighted average exchange rates during the year. The effect of the translation adjustments for foreign operations is included in accumulated other comprehensive income, net of applicable deferred income taxes. Other monetary assets and liabilities denominated in foreign currencies are revalued at the exchange rates in effect at the balance sheet date with the resulting net foreign exchange gains and losses included in earnings (losses). Revenues and expenses denominated in foreign currencies are translated at the prevailing exchange rate on the transaction date. 11

13 ENDURANCE SPECIALTY INSURANCE LTD. 2. Summary of significant accounting policies, cont d. (h) Derivatives Current accounting guidance requires the recognition of all derivative financial instruments including embedded derivative instruments, as either assets or liabilities in the Consolidated Balance Sheets at fair value. The Company may use various derivative instruments such as foreign exchange forward, future and option contracts; interest rate futures, swaps, swaptions, and options; credit default swaps; commodity futures and options; weather swaps and options; and to-be-announced mortgage-backed securities to manage exposure to interest rate and currency risk, to enhance the efficiency of the investment portfolio, to economically hedge certain risks, and as part of its weather risk management business. These contracts do not qualify, and are not designated, as hedges. Thus, changes in fair value and any realized gains (losses) are recognized in net realized and unrealized investment gains, net foreign exchange gains, or other underwriting loss in the Consolidated Statements of Income (Loss) and Comprehensive Income (Loss). Margin balances required of counterparties are included in cash and cash equivalents. Where the Company has entered into master netting agreements with counterparties, or the Company has the legal and contractual right to offset positions, the derivative positions are generally netted by the counterparty and are reported accordingly in other assets and other liabilities in the Consolidated Balance Sheets. (i) Income taxes The Company accounts for income taxes for its subsidiaries operating in taxable jurisdictions. Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax assets will not be realized. The accounting guidance allows for the recognition of tax benefits of uncertain tax positions only where the position is more likely than not to be sustained assuming examination by tax authorities. A liability is established for any tax benefit claimed in a tax return in excess of this threshold. Income tax related interest and penalties are included as income tax expense (benefit). (j) Stock compensation and other stock plans The Company has a stock-based employee and non-employee director equity incentive plan ( 2007 Equity Incentive Plan ) and other stock plans which are described more fully in Note 13. The fair value of the compensation cost incurred under these plans is measured at the grant date and is expensed over the period for which the employee is required to provide services in exchange for the award. Forfeiture benefits are estimated at the time of grant and incorporated in the determination of share-based compensation costs. Awards under the 2007 Equity Incentive Plan vest over four years for employees and one year for non-employee directors. (k) Use of estimates The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported and disclosed amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. 12

14 ENDURANCE SPECIALTY INSURANCE LTD. 2. Summary of significant accounting policies, cont d. (l) Variable interest entity Entities that do not have sufficient equity at risk to allow the entity to finance its activities without additional financial support or in which the equity investors, as a group, do not have the characteristic of a controlling financial interest are referred to as variable interest entities ( VIE ). A VIE is consolidated by the variable interest holder that is determined to have the controlling financial interest (primary beneficiary) as a result of having both the power to direct the activities of a VIE that most significantly impact the VIE s economic performance and the obligation to absorb losses or right to receive benefits from the VIE that could potentially be significant to the VIE. The Company determines whether it is the primary beneficiary of an entity subject to consolidation based on a qualitative assessment of the VIE s capital structure, contractual terms, nature of the VIE s operations and purpose and the Company s relative exposure to the related risks of the VIE on the date it becomes initially involved in the VIE. The Company reassesses its VIE determination with respect to an entity on an ongoing basis. See also Note 3. (m) Reclassifications Certain comparative information has been reclassified to conform to current year presentation. (n) Recent accounting pronouncements In July 2012, the Financial Accounting Standards Board (the FASB ) issued Accounting Standards Update ( ASU ) Intangibles Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment ( ASU ). Under ASU , an entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the indefinite-lived intangible asset is impaired. If, after assessing the totality of events or circumstances, an entity determines it is not more likely than not that the fair value of the indefinite-lived intangible asset is impaired, then the entity is not required to take further action. In addition, an entity has the option to bypass the qualitative assessment for any indefinite-lived intangible asset in any period and proceed directly to performing a quantitative impairment test. ASU was effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted. The Company adopted this standard prospectively on October 1, This standard did not have a material impact on the Company s consolidated financial statements. In February 2013, the FASB issued ASU Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income ( ASU ). ASU requires entities to report, in one location, information about reclassifications out of accumulated other comprehensive income ( AOCI ). ASU also requires companies to report changes in AOCI balances. For significant items reclassified out of AOCI into net income in their entirety in the same reporting period, reporting (either on the face of the statement where net income is presented or in the notes to the financial statements) is required about the effect of the reclassifications on the respective line items in the statement where net income is presented. For items that are not reclassified into net income in their entirety in the same reporting period, a cross reference to other disclosures currently required under US GAAP is required in the notes. The above information must be presented in one place (parenthetically on the face of the financial statements by income statement line item or in a note to the financial statements). ASU will be effective for fiscal years and interim periods beginning after December 15, 2012, with early adoption permitted. 13

15 ENDURANCE SPECIALTY INSURANCE LTD. 3. Investments Composition of Net Investment Income and Invested Assets The components of net investment income for the years ended December 31, 2012 and 2011 are as follows: Available for sale investments $ 135,841 $ 160,580 Other investments 49,059 (694) Cash and cash equivalents 1, $ 186,516 $ 160,809 Investment expenses (13,187) (13,768) Net investment income $ 173,329 $ 147,041 The following table summarizes the composition of the investment portfolio by investment type at December 31, 2012 and 2011: December 31, 2012 December 31, 2011 Type of Investment Fair Value Percentage Fair Value Percentage Fixed maturity securities $ 4,868, % $ 4,831, % Cash and cash equivalents (1) 1,030, % 900, % Other investments (2) 517, % 432, % Short term investments 42, % 67, % Equity securities 86, % 59, % Total $ 6,544, % $ 6,293, % (1) Includes net receivable on sales of investments and net payable on purchases of investments. (2) Consists of investments in alternative funds and specialty funds. The following table summarizes the composition by investment rating of the fixed maturity and short-term investments at December 31, 2012 and In some cases, where bonds are unrated, the rating of the issuer has been applied. December 31, 2012 December 31, 2011 Ratings (1) Fair Value Percentage Fair Value Percentage U.S. government and agencies securities $ 737, % $ 1,269, % AAA/Aaa 993, % 941, % AA/Aa 1,821, % 1,665, % A/A 993, % 776, % BBB 219, % 130, % Below BBB 143, % 114, % Not rated 2, % 1, % Total $ 4,910, % $ 4,899, % (1) The credit rating for each asset reflected above was determined based on the rating assigned to the individual security by Standard & Poor's Financial Services LLC ("Standard & Poor's"). If a rating is not supplied by Standard & Poor's, the equivalent rating supplied by either Moody's Investors Service, Inc. ("Moody's") or Fitch Ratings is used. 14

16 3. Investments, cont d. ENDURANCE SPECIALTY INSURANCE LTD. Contractual maturities of the Company s fixed maturity and short-term investments are shown below as of December 31, 2012 and 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. December 31, 2012 December 31, 2011 Amortized Amortized Cost Fair Value Cost Fair Value Due within one year $ 136,283 $ 137,567 $ 517,156 $ 520,755 Due after one year through five years 1,725,927 1,765,662 1,732,335 1,773,553 Due after five years through ten years 410, , , ,052 Due after ten years 29,654 33,803 45,837 50,803 Residential mortgage-backed securities 1,252,468 1,280,579 1,053,078 1,079,681 Commercial mortgage-backed securities 759, , , ,290 Asset-backed securities 455, , , ,634 Total $ 4,770,820 $ 4,910,380 $ 4,768,792 $ 4,899,768 In addition to the Company s fixed maturity, short-term and equity investments, the Company invests in (i) hedge funds and private investment funds that generally invest in senior secured bank debt, high yield debt securities, distressed debt, distressed real estate, derivatives and equity long/short strategies ( alternative funds ) and (ii) high yield loan and convertible debt funds ( specialty funds ). The Company s alternative funds and specialty funds are recorded on the Company s balance sheet as other investments. At December 31, 2012 and 2011, the Company had invested, net of capital returned, a total of $394.5 million and $336.3 million, respectively, in other investments. At December 31, 2012 and 2011, the carrying value of other investments was $517.5 million and $432.7 million, respectively. The following table summarizes the composition and redemption restrictions of other investments as of December 31, 2012 and 2011: Market Value Unfunded Commitments Ineligible for Redemption in 2013 December 31, 2012 Alternative funds Hedge funds $ 337,200 $ - $ 61,161 Private investment funds 35,219 29,483 35,219 Total alternative funds 372,419 29,483 96,380 Specialty funds High yield loan funds 105, Convertible debt funds 39, Total specialty funds 145, Total other investments $ 517,546 $ 29,483 $ 96,380 15

17 3. Investments, cont d. ENDURANCE SPECIALTY INSURANCE LTD. Market Value Unfunded Commitments Ineligible for Redemption in 2012 December 31, 2011 Alternative funds Hedge funds $ 293,418 $ - $ 43,250 Private investment funds 16,408 18,061 16,408 Total alternative funds 309,826 18,061 59,658 Specialty funds High yield loan funds 97,894-23,940 Convertible debt funds 24, Total specialty funds 122,832 $ - $ 23,940 Total other investments $ 432,658 $ 18,061 $ 83,598 Hedge funds The redemption frequency of the hedge funds range from monthly to biennially with notice periods from 30 to 90 days. Over one year, it is estimated that the Company can liquidate approximately 82% of the hedge fund portfolio, with the remainder over the following two years. Private investment funds The Company generally has no right to redeem its interest in any of these private investment partnerships in advance of dissolution of the applicable partnership. Instead, the nature of these investments is that distributions are received by the Company in connection with the liquidation of the underlying assets of the applicable limited partnership. It is estimated that the majority of the underlying assets of the limited partnerships would liquidate over 5 to 10 years from inception of the limited partnership. High yield loan funds There are generally no restrictions on the Company s right to redeem its interest in high yield loan funds with the exception of certain redemption frequency and notice requirements. The redemption frequency of these funds ranges from monthly to quarterly with notice periods from 30 to 90 days. Convertible debt funds There are generally no restrictions on the Company s right to redeem its interest in convertible debt funds with the exception of certain redemption frequency and notice requirements. The redemption frequency of these funds is monthly with a required notice period of 5 days. Net Realized and Unrealized Investment Gains Realized and unrealized investment gains and losses are recognized in earnings (losses) using the first in and first out method. The analysis of net realized and unrealized investment gains for the years ended December 31, 2012 and 2011 are as follows: Gross realized gains on investment sales $ 77,565 $ 51,074 Gross realized losses on investment sales (6,090) (18,500) Change in fair value of derivative financial instruments (1) 829 (713) Net realized and unrealized investment gains $ 72,304 $ 31,861 (1) For additional information on the Company's derivative financial instruments, see Note 8. 16

18 3. Investments, cont d. ENDURANCE SPECIALTY INSURANCE LTD. Unrealized Gains and Losses and Other-than-temporary Impairments The Company classifies its investments in fixed maturity investments, short-term investments and equities as available for sale. The amortized cost, fair value and related gross unrealized gains and losses and non-credit OTTI losses on the Company s securities classified as available for sale at December 31, 2012 and 2011 are as follows: Gross Gross Amortized Unrealized Unrealized Non-Credit December 31, 2012 Cost Gains Losses Fair Value OTTI (2) U.S. government and agencies securities $ 718,992 $ 18,596 $ (53) $ 737,535 $ - U.S. state and municipal securities 37,952 1,119 (177) 38,894 - Foreign government securities 106,218 3,264 (145) 109,337 - Government guaranteed corporate securities 62,782 1,682-64,464 - Corporate securities 1,334,451 40,555 (1,335) 1,373,671 - Residential mortgage-backed securities 1,252,468 30,426 (2,315) 1,280,579 (5,884) Commercial mortgage-backed securities (1) 759,930 42,187 (1,536) 800,581 (53) Asset-backed securities 455,803 7,985 (699) 463,089 - Total fixed maturity investments $ 4,728,596 $ 145,814 $ (6,260) $ 4,868,150 $ (5,937) Short-term investments 42, ,230 - Total fixed income investments $ 4,770,820 $ 145,820 $ (6,260) $ 4,910,380 $ (5,937) Equity securities $ 76,997 $ 10,621 $ (621) $ 86,997 $ - (1) Balances include amounts related to collateralized debt obligations held with total fair values of $27.7 million. (2) Represents total OTTI recognized in accumulated other comprehensive income. It does not include the change in fair value subsequent to the impairment measurement date. At December 31, 2012, the gross unrealized loss related to fixed income investments for which a non-credit OTTI was recognized in accumulated other comprehensive income was $0.4 million. Gross Gross Amortized Unrealized Unrealized Non-Credit December 31, 2011 Cost Gains Losses Fair Value OTTI (2) U.S. government and agencies securities $ 1,218,069 $ 51,140 $ (86) $ 1,269,123 $ - U.S. state and municipal securities 52,274 1,262 (19) 53,517 - Foreign government securities 73,361 1,820 (184) 74,997 - Government guaranteed corporate securities 349,447 2,531 (153) 351,825 - Corporate securities 1,118,481 31,526 (10,108) 1,139,899 - Residential mortgage-backed securities 1,053,078 33,250 (6,647) 1,079,681 (7,932) Commercial mortgage-backed securities (1) 520,067 30,293 (3,070) 547,290 (75) Asset-backed securities 316,212 2,336 (2,914) 315,634 - Total fixed maturity investments $ 4,700,989 $ 154,158 $ (23,181) $ 4,831,966 $ (8,007) Short-term investments 67,803 4 (5) 67,802 - Total fixed income investments $ 4,768,792 $ 154,162 $ (23,186) $ 4,899,768 $ (8,007) Equity securities $ 56,381 $ 4,162 $ (776) $ 59,767 $ - (1) Balances include amounts related to collateralized debt obligations held with total fair values of $17.2 million. (2) Represents total OTTI recognized in accumulated other comprehensive income. It does not include the change in fair value subsequent to the impairment measurement date. At December 31, 2011, the gross unrealized loss related to fixed income investments for which a non-credit OTTI was recognized in accumulated other comprehensive income was $1.5 million. 17

19 3. Investments, cont d. ENDURANCE SPECIALTY INSURANCE LTD. The following tables summarize, for all available for sale securities in an unrealized loss position at December 31, 2012 and 2011, the aggregate fair value and gross unrealized loss by length of time the security has continuously been in an unrealized loss position. Less than 12 months 12 months or greater Total Unrealized Fair Unrealized Fair Unrealized Fair December 31, 2012 Losses (1) Value Losses (1) Value Losses (1) Value U.S. government and agencies securities $ (53) $ 48,570 $ - $ - $ (53) $ 48,570 U.S. state and municipal securities (177) 6, (177) 6,905 Foreign government securities (139) 23,157 (6) 4,870 (145) 28,027 Corporate securities (1,305) 245,232 (30) 1,849 (1,335) 247,081 Residential mortgage-backed securities (1,920) 327,473 (395) 7,511 (2,315) 334,984 Commercial mortgage-backed securities (474) 79,125 (1,062) 11,625 (1,536) 90,750 Asset-backed securities (94) 53,471 (605) 8,123 (699) 61,594 Total fixed maturity investments $ (4,162) $ 783,933 $ (2,098) $ 33,978 $ (6,260) $ 817,911 Short-term investments Total fixed income investments $ (4,162) $ 783,933 $ (2,098) $ 33,978 $ (6,260) $ 817,911 Equity securities $ (581) $ 9,384 $ (40) $ 387 $ (621) $ 9,771 (1) Gross unrealized losses include unrealized losses on non-otti and non-credit OTTI securities recognized in accumulated other comprehensive income at December 31, As of December 31, 2012, 403 available for sale securities were in an unrealized loss position aggregating $6.9 million. Of those, 55 securities with aggregated unrealized losses of $2.1 million at December 31, 2012 had been in a continuous unrealized loss position for twelve months or greater. 18

20 3. Investments, cont d. ENDURANCE SPECIALTY INSURANCE LTD. Less than 12 months 12 months or greater Total Unrealized Fair Unrealized Fair Unrealized Fair December 31, 2011 Losses (1) Value Losses (1) Value Losses (1) Value U.S. government and agencies securities $ (86) $ 23,488 $ - $ - $ (86) $ 23,488 U.S. state and municipal securities (19) 6, (19) 6,146 Foreign government securities (114) 12,565 (70) 4,592 (184) 17,157 Government guaranteed corporate securities (70) 25,157 (83) 8,232 (153) 33,389 Corporate securities (9,949) 233,894 (159) 5,784 (10,108) 239,678 Residential mortgage-backed securities (734) 77,079 (5,913) 93,170 (6,647) 170,249 Commercial mortgage-backed securities (2,381) 45,156 (689) 10,624 (3,070) 55,780 Asset-backed securities (2,361) 165,455 (553) 10,235 (2,914) 175,690 Total fixed maturity investments $ (15,714) $ 588,940 $ (7,467) $ 132,637 $ (23,181) $ 721,577 Short-term investments (5) 6, (5) 6,740 Total fixed income investments $ (15,719) $ 595,680 $ (7,467) $ 132,637 $ (23,186) $ 728,317 Equity securities $ (707) $ 10,993 $ (69) $ 776 $ (776) $ 11,769 (1) Gross unrealized losses include unrealized losses on non-otti and non-credit OTTI securities recognized in accumulated other comprehensive income at December 31, As of December 31, 2011, 556 available for sale securities were in an unrealized loss position aggregating $24.0 million. Of those, 94 securities with aggregated unrealized losses of $7.5 million at December 31, 2011 had been in a continuous unrealized loss position for twelve months or greater. The analysis of OTTI for the years ended December 31, 2012 and 2011 is as follows: Total other-than-temporary impairment losses $ (364) $ (2,659) Portion of loss recognized in other comprehensive income (483) (861) Net impairment losses recognized in earnings (losses) $ (847) $ (3,520) Of the $0.8 million ( $3.5 million) of OTTI losses recognized by the Company for the year ended December 31, 2012, the majority of it was related to reductions in expected recovery values on mortgage-backed securities during the period. At December 31, 2012, the Company did not have the intent to sell securities in an unrealized loss position and determined that it was unlikely that the Company would be required to sell securities in an unrealized loss position. 19