Summary of ACE LTD - Yahoo! Finance

ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following is a discussion of our results of operations, financial condition, and liquidity and capital resources as of and for the three and six months ended June 30, 2009. Our results of operations and cash flows for any interim period are not necessarily indicative of our results for the full year. This discussion should be read in conjunction with our Consolidated Financial Statements and related notes and our Management's Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2008 (2008 Form 10-K) and in our quarterly report on Form 10-Q for the quarter ended March 31, 2009. In addition, readers should review "Risk Factors" set forth in Item 1A. of Part I of our 2008 Form 10-K, as well as in Item 1A. of Part II of our quarterly report on Form 10-Q for the quarter ended March 31, 2009, and in Item 1A, of Part II of this report.

Other Information

We routinely post important information for investors on our website (www.acelimited.com) under the Investor Relations section. We use this website as a means of disclosing material, non-public information and for complying with our disclosure obligations under SEC Regulation FD (Fair Disclosure). Accordingly, investors should monitor the Investor Relations portion of our website, in addition to following our press releases, SEC filings, and public conference calls and webcasts. The information contained on, or that may be accessed through, our website is not incorporated by reference into, and is not a part of, this report.

Forward-Looking Statements

The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements. Any written or oral statements made by us or on our behalf may include forward-looking statements that reflect our current views with respect to future events and financial performance. These forward-looking statements are subject to certain risks, uncertainties, and other factors that could, should potential events occur, cause actual results to differ materially from such statements. These risks, uncertainties, and other factors (which are described in more detail elsewhere herein and in other documents we file with the Securities and Exchange Commission (SEC)) include but are not limited to:

• developments in global financial markets, including changes in interest rates, stock markets, and other financial markets, increased government involvement or intervention in the financial services industry, the cost and availability of financing, and foreign currency exchange rate fluctuations, which could affect our statement of operations, investment portfolio, financial position, and financing plans;

• general economic and business conditions resulting from recent declines in the stock markets and tightening of credit and the depth and duration of the current recession;

• losses arising out of natural or man-made catastrophes such as hurricanes, typhoons, earthquakes, floods, or terrorism which could be affected by:

• the number of insureds and ceding companies affected;

• the amount and timing of losses actually incurred and reported by insureds;

• the impact of these losses on our reinsurers and the amount and timing of reinsurance recoverable actually received;

• the cost of building materials and labor to reconstruct properties following a catastrophic event; and

• complex coverage and regulatory issues such as whether losses occurred from storm surge or flooding and related lawsuits;

• infection rates and severity of pandemics and their effects on our business operations and claims activity;

• actions that rating agencies may take from time to time, such as financial strength or credit ratings downgrades or placing these ratings on credit watch negative or the equivalent;

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• global political conditions, the occurrence of any terrorist attacks, including any nuclear, radiological, biological, or chemical events, or the outbreak and effects of war, and possible business disruption or economic contraction that may result from such events;

• the ability to collect reinsurance recoverable, credit developments of reinsurers, and any delays with respect thereto and changes in the cost, quality, or availability of reinsurance;

• actual loss experience from insured or reinsured events and the timing of claim payments;

• the uncertainties of the loss-reserving and claims-settlement processes, including the difficulties associated with assessing environmental damage and asbestos-related latent injuries, the impact of aggregate-policy-coverage limits, and the impact of bankruptcy protection sought by various asbestos producers and other related businesses and the timing of loss payments;

• judicial decisions and rulings, new theories of liability, legal tactics, and settlement terms;

• the effects of public company bankruptcies and/or accounting restatements, as well as disclosures by and investigations of public companies relating to possible accounting irregularities, and other corporate governance issues, including the effects of such events on:

• the capital markets,

• the markets for directors and officers and errors and omissions insurance, and

• claims and litigation arising out of such disclosures or practices by other companies;

• uncertainties relating to governmental, legislative and regulatory policies, developments, actions, investigations and treaties, which, among other things, could subject us to insurance regulation or taxation in additional jurisdictions or affect our current operations;

• the actual amount of new and renewal business, market acceptance of our products, and risks associated with the introduction of new products and services and entering new markets, including regulatory constraints on exit strategies;

• the competitive environment in which we operate, including trends in pricing or in policy terms and conditions, which may differ from our projections and changes in market conditions that could render our business strategies ineffective or obsolete;

• acquisitions made by us performing differently than expected, our failure to realize anticipated expense-related efficiencies or growth from acquisitions, or the impact of acquisitions on our pre-existing organization;

• risks associated with our re-domestication to Switzerland, including possible reduced flexibility with respect to certain aspects of capital management and the potential for additional regulatory burdens;

• the potential impact from government-mandated insurance coverage for acts of terrorism;

• the availability of borrowings and letters of credit under our credit facilities;

• the adequacy of collateral supporting funded high deductible programs;

• changes in the distribution or placement of risks due to increased consolidation of insurance and reinsurance brokers;

• material differences between actual and expected assessments for guaranty funds and mandatory pooling arrangements;

• the effects of investigations into market practices in the property and casualty (P&C) industry;

• changing rates of inflation and other economic conditions, for example, recession;

• the amount of dividends received from subsidiaries;

• loss of the services of any of our executive officers without suitable replacements being recruited in a reasonable time frame;

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• the ability of our technology resources to perform as anticipated; and

• management's response to these factors and actual events (including, but not limited to, those described above).

The words "believe," "anticipate," "estimate," "project," "should," "plan," "expect," "intend," "hope,", "feel", "will likely result," or "will continue," and variations thereof and similar expressions, identify forward-looking statements. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their dates. We undertake no obligation to publicly update or review any forward-looking statements, whether as a result of new information, future events or otherwise.

Overview

ACE Limited is the holding company of the ACE Group of Companies. ACE opened its business office in Bermuda in 1985 and continues to maintain significant operations in Bermuda. ACE Limited, which is now domiciled in Zurich, Switzerland, and its direct and indirect subsidiaries (collectively, the ACE Group of Companies, ACE, the Company, we, us, or our) comprise a global insurance and reinsurance organization, with operating subsidiaries in more than 50 countries serving the needs of commercial and individual customers in more than 140 countries. We serve the P&C insurance needs of businesses of all sizes in a broad range of industries. We also provide specialized insurance products such as personal accident, supplemental health, and life insurance to individuals in select countries. Our reinsurance operations include both P&C and life companies. At June 30, 2009, ACE had total assets of $75.7 billion and shareholders' equity of $16.6 billion.

Our product and geographic diversification differentiates us from the vast majority of our competitors and has been a source of stability during periods of industry volatility. Our long-term business strategy focuses on sustained growth in book value achieved through a combination of underwriting and investment income. By doing so, we provide value to our clients and shareholders through the utilization of our substantial capital base in the insurance and reinsurance markets.

Redomestication to Zurich, Switzerland

In July 2008, our shareholders approved proposals submitted by our Board of Directors to transfer our domicile from the Cayman Islands to Zurich, Switzerland, our new jurisdiction of incorporation (the Continuation). As a result of the Continuation, we are deregistered in the Cayman Islands and are now subject to Swiss law. In connection with the Continuation, we changed the currency in which the par value of our Ordinary Shares was stated from U.S. dollars to Swiss francs. Upon the effectiveness of the Continuation, our Ordinary Shares became Common Shares. All Common Shares are registered shares with a current par value of CHF 32.51 each.

Notwithstanding the change of the currency in which the par value of Common Shares is stated, we continue to use U.S. dollars as our reporting currency for preparing our Consolidated Financial Statements. For the foreseeable future, we expect to pay dividends as a repayment of share capital in the form of a reduction in par value or qualified paid-in capital, which is not subject to Swiss withholding tax. Refer to "Liquidity and Capital Resources" below for more information, including changes to the process by which we make distributions in the form of par value reductions.

The Combined Insurance Acquisition

On April 1, 2008, ACE acquired all of the outstanding shares of Combined Insurance Company of America (Combined Insurance) and certain of its subsidiaries from Aon Corporation for $2.56 billion. Combined Insurance is an underwriter and distributor of specialty individual accident and supplemental health insurance products targeted to middle-income consumers and small businesses in North America, Europe, Asia Pacific, and Latin America. ACE recorded the Combined Insurance acquisition using the purchase method of accounting. Our consolidated operating results include the results of Combined Insurance from April 1, 2008.

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Investment in Assured Guaranty Ltd.

On July 1, 2009, Assured Guaranty Ltd (AGO), a Bermuda-based holding company which provides, through its operating subsidiaries, credit enhancement products to the public finance, structured finance, and mortgage markets, acquired Financial Security Assurance Holdings Ltd. from Dexia Holdings Inc., a subsidiary of Dexia S.A. According to AGO's public filings, the purchase price included approximately $546 million in cash and approximately 22.3 million AGO common shares. Also, according to AGO's public filings, AGO financed the cash portion of the purchase price partly through a June 2009 issuance of 38.5 million common shares before the exercise of any overallotment option (June 2009 issuance). Prior to the June 2009 issuance, ACE included its investment in AGO in Investments in partially-owned insurance companies using the equity method of accounting. Effective with the June 2009 issuance, in accordance with the provisions of Accounting Principles Board Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock, (APB 18), ACE was deemed to no longer exert significant influence over AGO and accounts for the investment in AGO as an available-for-sale equity security in accordance with FAS 115, Accounting for Certain Investments in Debt and Equity Securities (FAS 115). FAS 115 requires that ACE carry the AGO investment at fair value with any unrealized gains and losses reflected in other comprehensive income. EITF 08-6, Equity Method Investment Accounting Considerations requires ACE to account for AGO's June 2009 issuance, and resulting dilutive effect, as if we had sold a proportionate share of the investment. In accordance with EITF 08-6, we recognized a $67 million pre-tax loss in Net realized gains (losses) upon AGO's June 2009 issuance. As of June 30, 2009, the fair value of our investment in AGO was $237 million and $131 million of unrealized loss on this investment is reflected in other comprehensive income in accordance with FAS 115.

Market Conditions

Overall, pricing across our businesses improved modestly in the quarter ended June 30, 2009, compared with the first quarter of 2009, although premium growth was adversely impacted by a strong U.S. dollar as well as the recession and the general pricing environment. Consistent with the first quarter of 2009, we continued to experience more favorable pricing on reinsurance-related risks compared to insurance-related risks and also more favorable pricing on business sourced through the retail market compared with the wholesale market. Our reinsurance business continued to report growth in the second quarter of 2009, due to better rates, particularly on short-tail exposures, better terms on treaties, given our relative financial strength compared to competitors, and as a result of companies purchasing additional reinsurance for capital relief. With respect to our insurance business, the market continues to improve, although not in all classes. This is a general statement with many exceptions, but the overall trend that started several quarters ago slowly continues. Our renewal retentions declined due to our commitment to maintain underwriting discipline, and recession-related reductions in exposure - consumer, business, and employer-related products - impacting both P&C and A&H. In those areas of our business - generally casualty related - where more than price matters, we are experiencing relatively good growth, particularly in the U.S. Where purchasing decisions are simply based on price, our premium volume is flat or down.

Recession is impacting our revenue with the second quarter of 2009 reporting lower production than the first quarter. Client exposures are down as many buyers may have less ability to pay and are seeking more affordable alternatives such as higher deductibles and less limit. Some clients are willing to place their business with lower-rated, cheaper capacity in a quest to save premium dollars. Exposure reductions impact growth, which is especially evident in workers' compensation, marine, general liability, environmental, and A&H. With respect to A&H, we are experiencing a slow-down in growth as consumers adjust to less available credit, overall decreased travel, and employers reducing employee benefits including accident insurance. Overall, our A&H business was impacted by both lower new business writings, as well as renewal persistency, which was down modestly. We believe that the impact of recession on our A&H business is transitory and over time as economic growth begins to resume, we expect our business to benefit.

Refer also to "Overview" in our "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in our 2008 Form 10-K.

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Fair Value Measurements

We partially adopted the provisions of Financial Accounting Standard No. 157, Fair Value Measurements (FAS 157) on January 1, 2008. We fully adopted FAS 157 effective January 1, 2009. FAS 157 defines fair value as the price to sell an asset or transfer a liability in an orderly transaction between market participants and establishes a three-level valuation hierarchy in which inputs into valuation techniques used to measure fair value are classified.

The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data. Inputs in Level 1 are unadjusted quoted prices for identical assets or liabilities in active markets. Level 2 includes inputs other than quoted prices included within Level 1 that are observable for assets or liabilities either directly or indirectly. Level 2 inputs include, among other items, quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, and inputs other than quoted prices that are observable for the asset or liability such as interest rates and yield curves. Level 3 inputs are unobservable and reflect our judgments about assumptions that market participants would use in pricing an asset or liability. A financial instrument's categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

While the Company obtains values for the majority of the investment securities it holds from one or more pricing services, it is ultimately management's responsibility to determine whether the values obtained and recorded in the financial statements are representative of fair value. We periodically update our understanding of the methodologies used by our pricing services in order to validate that the prices obtained from those services are consistent with FAS 157 valuation principles. Based on our understanding of the methodologies used by our pricing services, all applicable investments have been valued in accordance with FAS 157. We do not typically adjust prices obtained from pricing services.

At June 30, 2009, our Level 3 assets represented approximately four percent of our assets that are measured at fair value and two percent of our total assets. Our Level 3 liabilities represented approximately 14 percent of our liabilities that are measured at fair value and approximately one percent of our total liabilities at June 30, 2009. During the quarter ended June 30, 2009, we transferred $17 million out of our Level 3 total assets at fair value. The following is a description of the valuation measurements used for our financial instruments (Levels 1, 2, and 3) carried or disclosed at fair value, as well as the general classification of such financial instruments pursuant to the valuation hierarchy.

• Fixed maturities with active markets are classified within Level 1 as fair values are based on quoted market prices. For fixed maturities that trade in less active markets, including most corporate and municipal securities in ACE's portfolio, fair values are based on the output of "pricing matrix models", the significant inputs into which include, but are not limited to, yield curves, credit risks and spreads, measures of volatility, and prepayment speeds. These fixed maturities are classified within Level 2. Our pricing methodologies incorporate back-testing of valuation techniques as a standard part of our process. Fixed maturities for which pricing is unobservable are classified within Level 3.

• Equity securities with active markets are classified within Level 1 as fair values are based on quoted market prices. For non-public equity securities, fair values are based on market valuations and are classified within Level
2. As previously discussed, during the quarter ended June 30, 2009, ACE's investment in AGO was reclassified from Investments in partially-owned insurance companies to equity securities. The fair value of our investment in AGO is based on a quoted market price and continues to be classified within Level 1.

• Short-term investments, which comprise securities due to mature within one year of the date of purchase, that are traded in active markets are classified within Level 1 as fair values are based on quoted market prices. Securities such as commercial paper and discount notes are classified within Level 2 because these securities are typically not actively traded due to their approaching maturity and, as such, their cost approximating par value.

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• The underlying assets included in Securities lending collateral are fixed maturities which are classified in the valuation hierarchy on the same basis as our other fixed maturities. Excluded from the valuation hierarchy is the corresponding liability related to our obligation to return the collateral plus interest.

• Fair values for other investments, principally other direct equity investments, investment funds, and limited partnerships, are based on the net asset value or financial statements and are included within Level 3. Equity securities and fixed maturities held in rabbi trusts maintained by ACE for deferred compensation plans, and included in Other investments, are classified within the valuation hierarchy on the same basis as our other equity securities and fixed maturities.

• Fair values for investments in partially-owned insurance companies based on the financial statements provided by those companies used for equity accounting are classified within Level 3.

• For actively traded investment derivative instruments, including futures, options, and exchange-traded forward contracts, we obtain quoted market prices to determine fair value. As such, these instruments are included within Level 1. Forward contracts that are not exchange-traded are priced using a pricing matrix model principally employing observable inputs and, as such, are classified within Level 2. Our position in interest rate and swaps is typically classified within Level 3.

• For guaranteed minimum income benefits (GMIB) reinsurance, we estimate fair value using an internal valuation model which includes current market information and estimates of policyholder behavior. All of our treaties contain claim limits, which are factored into the valuation model. The fair value depends on a number of inputs, including changes in interest rates, changes in equity markets, credit risk, current account value, changes in market volatility, expected annuitization rates, changes in policyholder behavior, and changes in policyholder mortality. The model and related assumptions are continuously re-evaluated by management and enhanced, as appropriate, based upon additional experience obtained related to policyholder behavior and availability of more timely information, such as market conditions and demographics of in-force annuities. Based on the quarterly reserve review, no changes were made to actuarial or behavioral assumptions during the quarter ended June 30, 2009. The most significant policyholder behavior assumptions include lapse rates and annuitization rates using the guaranteed benefit (GMIB annuitization rate). Assumptions regarding lapse rates and GMIB annuitization rates differ by treaty but the underlying methodology to determine rates applied to each treaty is comparable. The assumptions regarding lapse and GMIB annuitization rates determined for each treaty are based on a dynamic calculation that uses several underlying factors. A lapse rate is the percentage of in-force policies surrendered in a given calendar year. All else equal, as lapse rates increase, ultimate claim payments will decrease. The GMIB annuitization rate is the percentage of policies for which the policyholder will elect to annuitize using the guaranteed benefit provided under the GMIB. All else equal, as GMIB annuitization rates increase, ultimate claim payments will increase, subject to treaty claim limits. The effect of changes in key market factors on assumed lapse and annuitization rates reflect emerging trends using data available from cedants. For treaties with limited experience, rates are established in line with data received from other ceding companies adjusted as appropriate with industry estimates. We view our variable annuity reinsurance business as having a similar risk profile to that of catastrophe reinsurance, with the probability of a cumulative long-term economic net loss relatively small, at the time of pricing. However, adverse changes in market factors and policyholder behavior will have an adverse impact on our net income, which may be material. Because of the significant use of unobservable inputs including policyholder behavior, GMIB reinsurance is classified within Level 3. Refer to "Guaranteed minimum income benefits derivatives" below and "Quantitative and Qualitative Disclosures about Market Risk - Reinsurance of GMIB and GMDB guarantees" under Item 3.

• Where practical, fair values for short-term debt, long-term debt, and trust preferred securities are estimated using discounted cash flow calculations based principally on observable inputs including our incremental borrowing rates, which reflects ACE's credit rating, for similar types of borrowings with maturities consistent with those remaining for the debt being valued. As such, these instruments are classified within Level 2.

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• We maintain positions in other derivative instruments including exchange-traded futures contracts and option contracts designed to limit long-term exposure to a severe equity market decline or decrease in interest rates, which would cause an increase in expected claims and, therefore, reserves for guaranteed minimum death benefits (GMDB) and GMIB reinsurance business. The fair value of the majority of our remaining positions in other derivative instruments is based on significant observable inputs including equity security and interest rate indices. Accordingly, these are classified within Level 2.

Note 9 to our Consolidated Financial Statements presents a break-down of our
financial instruments carried or disclosed at fair value by valuation hierarchy as well as a roll-forward of Level 3 financial instruments for the three and six months ended June 30, 2009 and 2008.

Guaranteed minimum income benefits derivatives

Under reinsurance programs covering living benefit guarantees, we assume the risk of GMIBs associated with variable annuity contracts. Our GMIB reinsurance product meets the definition of a derivative for accounting purposes and is therefore carried at fair value with changes in fair value recognized in net realized gains (losses) in the period of the change pursuant to Statement of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133). We believe that the most meaningful presentation of these derivatives is to reflect cash inflows or revenue as net premiums earned, and to record estimates of the average modeled value of future cash outflows as incurred losses. Accordingly, we recognize benefit reserves . . .