• Our reserves for unpaid losses and loss adjustment expenses are based on estimates that may prove to be inadequate to cover our losses.

• An interruption or change in current marketing and agency relationships could reduce the amount of premium we are able to write.

• If we are unable to obtain or collect on ceded reinsurance, our results of operations and financial condition may be adversely affected.

• Our geographic concentration in certain Midwestern states and New Mexico ties our performance to the business, economic, regulatory and legislative conditions in those states.

• A downgrade in the A.M. Best Company rating of our primary insurance subsidiary could reduce the amount of business we are able to write.

• Changes in interest rates could adversely impact our results of operation, cash flows and financial condition.

• Market illiquidity and volatility associated with the current financial crisis makes the fair values of our investments increasingly difficult to estimate, and may have other unforeseen consequences that we are currently unable to predict.

• The unpredictability of court decisions could have a material impact on our operations.

• Our business could be adversely affected by the loss of one or more key employees.

• The insurance industry is subject to regulatory oversight that may impact the manner in which we operate our business, our ability to obtain future premium rate increases, the type and amount of our investments, the levels of capital and surplus deemed adequate to protect policyholder interests, or the ability of our insurance subsidiaries to pay dividends to the holding company.

• Our status as an insurance holding company with no direct operations could adversely affect our ability to meet our debt obligations and fund future cash dividends and share repurchases.

• Legislative or judicial changes in the tort system may have adverse or unintended consequences that could materially and adversely affect our results of operations and financial condition.

• Applicable law and various provisions in our articles and bylaws may prevent and discourage unsolicited attempts to acquire APCapital that you may believe are in your best interests or that might result in a substantial profit to you.

Other factors not currently anticipated by management may also materially and adversely affect our financial position and results of operations. We do not undertake, and expressly disclaim, any obligation to update or alter our statements, whether as a result of new information, future events or otherwise, except as required by applicable law.
Overview of APCapital
We are an insurance holding company whose financial performance is heavily dependent upon the results of operations of our insurance subsidiaries. Our insurance subsidiaries are property and casualty insurers that write almost exclusively medical professional liability insurance for physicians and other healthcare professionals, principally in the Midwest and New Mexico. As a property and casualty insurer, our profitability is primarily driven by our underwriting results, which are measured by subtracting incurred loss and loss adjustment expenses and underwriting expenses from net premiums earned. While our underwriting gain (loss) is a key performance indicator of our operations, it is not uncommon for a property and casualty insurer to generate an underwriting loss, yet earn a profit overall, because of the availability of investment income to offset the underwriting loss.

An insurance company earns investment income on what is commonly referred to as the "float." The float is money that we hold, in the form of investments, from premiums that we have collected. While a substantial portion of the premiums we collect will ultimately be used to make claim payments and to pay for claims adjustment expenses, the period that we hold the float prior to paying losses can extend over several years, especially with a long-tailed line of business such as medical professional liability. The key factors that determine the amount of investment income we are able to generate are the rate of return, or yield, on invested assets and the length of time we are able to hold the float. We focus on the after-tax yield of our investments, as significant tax savings can be realized on bonds that pay interest that is exempt from federal income taxes.
For further information regarding the operations of our medical professional liability insurance business see "Item 1. Business - Medical Professional Liability Operations" of our most recent Annual Report on Form 10-K.
On June 23, 2009 our Board of Directors declared a four-for-three stock split of APCapital's common shares to shareholders of record as of the close of business on July 10, 2009. Shares resulting from the stock split were distributed to shareholders on July 31, 2009. Share and per share data, including dividends paid to shareholders, have been retroactively adjusted in this Quarterly Report on Form 10-Q to reflect the stock split. Description of Ratios and Other Metrics Analyzed We measure our performance using several different ratios and other key metrics. These ratios and other metrics are calculated in accordance with accounting principles generally accepted in the United States of America, which we refer to as GAAP, and include:
Underwriting Gain or Loss: This metric measures the overall profitability of our insurance underwriting operations. It is the gain or loss that remains after deducting net loss and loss adjustment expenses and underwriting expenses incurred from net premiums earned. We use this measure to evaluate the underwriting performance of our insurance operations in relation to peer companies.
Loss Ratio: This ratio compares our losses and loss adjustment expenses incurred, net of reinsurance, to our net premiums earned, and indicates how much we expect to pay policyholders for claims and related settlement expenses compared to the amount of premiums we earn. The loss ratio uses all losses and loss adjustment expenses incurred in the current calendar year (i.e., related to all accident years). The lower the loss ratio percentage is, the more profitable our insurance business is, all other factors being equal.
Underwriting Expense Ratio: This ratio compares our expenses to obtain new business and renew existing business, plus normal operating expenses, to our net premiums earned. The ratio is used to measure how efficient we are at obtaining business and managing our underwriting operations. The lower the percentage, the more efficient we are, all else being equal. Sometimes, however, a higher underwriting expense ratio can result in better business as more

rigorous risk management and underwriting procedures may result in the non-renewal of higher risk accounts, which can in turn improve our loss ratio, and overall profitability. The determination of which expenses should be classified as underwriting expenses can vary from company to company. Accordingly, comparability of underwriting expense ratios among and between various companies may be limited.
Combined Ratio: This ratio equals the sum of our loss ratio and underwriting expense ratio. The lower the percentage, the more profitable our insurance business is. This ratio excludes the effects of investment income. As the underwriting expense ratio is a component of the overall combined ratio, comparability between companies may be limited for the reasons discussed above.
Investment Yield: Investment yield represents the average return on investments as determined by dividing investment income for the period, annualized if necessary, by the average ending monthly investment balance for the period. As we use average month ending balances, the yield for certain individual asset classes that are subject to fluctuations in a given month, such as cash and cash equivalents, may be skewed slightly. However, we believe that when calculated for the cash and invested asset portfolio in its entirety, the overall investment yield is an accurate and reliable measure for evaluating investment performance. Our calculation of investment yields may differ from those employed by other companies.
Return on Equity: As a way of evaluating our capital management strategies we measure and monitor our return on equity, or ROE, in addition to our results of operations. We measure ROE as our net income for the period, annualized if necessary, divided by our total shareholders' equity as of the beginning of the year. Other companies sometimes calculate ROE by dividing annualized net income by an average of beginning and ending shareholders' equity. Accordingly, the ROE percentage we provide may not be comparable with those provided by other companies. We use a modified version of ROE as the basis for determining performance-based compensation.
Book Value per Share: We also track the net asset value per common share outstanding, which is calculated by dividing shareholders' equity as of the end of the period by the total number of common shares outstanding at that date. This is commonly referred to as "book value per share" in the property and casualty insurance industry. Evaluating the relationship between the book value per common share and the cost of a common share in the open market helps us compare our stock value with that of our peers and to determine the relative premium that the market places on our stock and the stock of our peers.
The above ratios and other financial measures, when calculated using our reported statutory results, will differ from the GAAP ratios as a result of differences in accounting between the statutory basis of accounting and GAAP. Additionally, the denominator for the underwriting expense ratio for GAAP is net premiums earned, compared to net premiums written for the statutory underwriting expense ratio.
In addition to the above financial measures of operating performance and capital management, we also use certain non-financial measures to monitor our premium writings and price level changes. We measure policy retention by comparing the number of policies that were

renewed during a given period with the number of policies that expired. This retention ratio helps us to measure our success at retaining insured accounts. We also monitor our insured physician count, which counts the number of doctor equivalents associated with all policies. For this purpose a corporation or ancillary health care provider on a policy is assigned a value of one doctor equivalent. When used in conjunction with the retention ratio, the insured physician count helps us to monitor the overall increase or decrease in insureds that comprise our premium base.
Non-GAAP Financial Measures
Accident Year Loss Ratio: In addition to the loss ratio, which uses calendar year incurred losses as described above, we also use an accident year loss ratio, which is a non-GAAP financial measure, to evaluate our loss experience. The accident year loss ratio uses only those loss and loss adjustment expenses incurred that relate to the current accident year, and therefore excludes the effect of development on prior year loss reserves. We believe the accident year loss ratio is useful in evaluating our current underwriting performance, as it focuses on the relationship between premiums earned in the current year and losses incurred related to the exposure represented by the premiums earned in the current year related to those policies. As with the calendar year loss ratio, a lower accident year loss indicates that the premiums currently being earned will result in a greater profit, all other factors being equal. Accident year loss ratios are reconciled to calendar loss ratios in the first two tables under "-Results of Operations - Three and Nine Months Ended September 30, 2009 Compared to the Three and Nine Months Ended September 30." Net of Tax Investment Yield: We measure the performance of our investment portfolio through the use of both pre-tax and net of tax investment yields. Due to the federal income tax savings associated with state, municipal and other local government issued debt securities, and the attractive yields on these securities relative to Treasury securities with comparable durations, we have increased our allocation of the overall investment portfolio in tax-exempt securities in recent years. As higher-yielding corporate, U.S. Government agency and mortgage-backed securities have matured, been called or paid down in recent years, we have reinvested a substantial share of the proceeds in tax-exempt securities, which typically have a lower pre-tax yield. The use of net of tax investment yields allows us to monitor and measure investment performance on a more comparative basis by compensating for the lower pre-tax yields on tax-exempt securities, with the benefit of the additional federal income tax savings.
With the exception of considering the federal income tax attributable to investment income, the net of tax investment yield is calculated in the same manner as the investment yield, as described above. As with the investment yield, the use of the average month-end balances as the denominator in the net of tax investment yield calculation may produce slightly skewed results for asset classes that are subject to fluctuations within the month. Our calculation of net of tax investment yields, as with traditional investment yields, may differ from those employed by other companies, and therefore the comparability of these yields with those of other companies may be limited.
The following table shows the reconciliation of pre-tax investment yields and net of tax investment yields, in accordance with calculation described above. As a property and casualty

insurance company, federal income tax law limits the tax benefit of exempt interest income we may deduct to 85% of the exempt interest income.

                                                 For the Three Months Ended               For the Nine Months Ended
                                                        September 30,                           September 30,
                                                   2009                 2008               2009                 2008
Pre-tax investment income                     $        7,375         $    8,886        $      23,593         $   28,078
Less 85% of tax-exempt investment income              (3,057 )           (3,068 )             (9,217 )           (8,056 )

Taxable investment income                              4,318              5,818               14,376             20,022

Federal statutory tax rate                                35 %               35 %                 35 %               35 %

Federal income tax expense                    $        1,511         $    2,036        $       5,032         $    7,008


Pre-tax investment income1                    $       29,500         $   35,544        $      31,457         $   37,437
Federal income tax expense1                           (6,044 )           (8,144 )             (6,709 )           (9,344 )

Net of tax investment income                  $       23,456         $   27,400        $      24,748         $   28,093


Average cash and invested assets              $      798,666         $  843,499        $     810,694         $  845,648

Pre-tax investment yield                                3.69 %             4.21 %               3.88 %             4.43 %
Reducition in yield related to federal
income tax expense                                     -0.76 %            -0.97 %              -0.83 %            -1.10 %

Net of tax investment yield                             2.93 %             3.24 %               3.05 %             3.33 %

1 These amounts represent corresponding amounts from the table immediately preceding, annualized to give effecty to a full year's income.

Critical Accounting Policies
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect amounts reported in the accompanying unaudited Condensed Consolidated Financial Statements and notes thereto. These estimates and assumptions are evaluated on an on-going basis based on historical developments, market conditions, industry trends and other information we believe to be reasonable under the circumstances. There can be no assurance that actual results will conform to our estimates and assumptions, or that reported results of operations will not be materially adversely affected by the need to make accounting adjustments to reflect changes in these estimates and assumptions from time to time. Adjustments related to changes in estimates are reflected in our results of operations in the period in which those estimates changed.
Our "critical" accounting policies are those policies that we believe to be most sensitive to estimates and judgments. These policies are more fully described in "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations, Critical Accounting Policies" of our most recent Annual Report on Form 10-K. With the exception of items noted below, there have been no material changes to these policies since the most recent year end.

Investments
The Company classifies all investment securities as either held-to-maturity or available-for-sale at the date of purchase based on the Company's ability and intent to hold individual securities until they mature. In addition, on a periodic basis, the Company reviews its fixed-income and equity security portfolio for proper classification as trading, available-for-sale or held-to-maturity. Based on such a review in 2005, we transferred a significant portion of our fixed-income security portfolio from the available-for-sale category to the held-to-maturity category. Securities were transferred at their estimated fair value. Any unrealized gains or losses, net of taxes, at the date of transfer continue to be reported as a component of accumulated other comprehensive income, and are being amortized over the remaining life of the securities through other comprehensive income.
Available-for-sale fixed-income and equity securities are reported at their estimated fair value, with any unrealized gains and losses reported net of any related tax effects, as a component of accumulated other comprehensive income. Any change in the estimated fair value of available-for-sale investment securities during the period is reported as unrealized appreciation or depreciation, net of any related tax effects, in other comprehensive income. Held-to-maturity securities, other than those transferred to the held-to-maturity category as described above, are carried at amortized cost. Investment income includes amortization of premium and accrual of discount for both held-to-maturity and available for sale securities on the yield-to-maturity method if investments are acquired at other than par value.
The fair values of all of our investment securities are determined as follows. If securities are traded in active markets, quoted prices are used to measure fair value (Level 1). If quoted prices are not available, prices are obtained from various independent pricing vendors based on pricing models that consider a variety of observable inputs (Level 2). Benchmark yields, prices for similar securities in active markets and quoted bid or ask prices are just a few of the observable inputs utilized. If the pricing vendors are unable to provide a current price for a security, a fair value is developed using alternative sources based on a variety of less objective assumptions and inputs (Level 3).
We currently have only two securities in our available-for-sale investment portfolio that have Level 1 fair values. These securities are publicly traded equity securities with a total fair value of $21.9 million at September 30, 2009. We also have two available-for sale securities with Level 3 fair values, one of which is valued by a non-preferred pricing vendor using a pricing model as discussed above. However, due to a lack of comparable values from other pricing vendors with which to validate the fair value of this security, we have elected to classify the fair value of this security as a Level 3. The fair value of this security at September 30, 2009 was $4._ million. The other security with a Level 3 fair value is valued based on the present value of expected cash flows associated with the security. The assumptions implicit in fair values based on the present value of cash flows, such as the discount rate, interest rate, and principal repayments, are deemed to be unobservable due to the structure and nature of this security. However, the resulting fair value of the security approximates its par value, which was $2._ million at September 30, 2009. There were no material changes in the assumptions we used to determine the fair value of this security during the nine months ended September 30, 2009. The

rest of our available for sale fixed-income security portfolio, $237.3 million at September 30, 2009, consists of securities deemed to be Level 2.
The means and methods we use to select and validate the prices provided by pricing vendors are described in Note 6 of the Notes to unaudited Condensed Consolidated Financial Statements. Such cross-referenced information is included herein by reference.
With the exception of our two fixed-income securities with Level 3 fair values, we have determined that the markets for our other fixed-income securities are active. Accordingly, prices obtained from pricing vendors for our Level 2 fair value fixed-income securities have not been adjusted as the prices provided by vendors appear to be based on current information that reflects orderly transactions. The market for our Level 3 fair value securities, both of which are private placement securities, is inactive due to the nature of and restrictions associated with private placement securities. The determination of whether a market is inactive is made on a security-by-security basis using factors such as the following.
• Few recent transactions;

• Price quotations that are not based on current information;

• Significant increases in implied liquidity risk premiums and yields;

• Wide bid-ask spreads or a significant increase in bid-ask spreads;

• Significant decline or absence of a market for new issuances; and

• Little publicly released information

We have made no adjustment to the fair value of our one Level 3 fair value security that is priced by a pricing vendor. Our other Level 3 fair value security is not priced by vendors, but rather is priced by us as described above.
Quarterly, we review our investment portfolio for any potential credit quality or collection issues that may be indicative of an other than temporary impairment, or OTTI. Recent changes in GAAP have required us to modify the manner in which we conduct such evaluations with respects to our fixed-income securities. We must now positively affirm for all impaired securities, i.e., a security whose fair value is less than its amortized cost, that we do not intend to sell the security and that it is more likely than not that we will not be required to sell an impaired security before its entire amortized cost is recovered. Evaluating whether a security is more likely than not to be required to be sold before its full amortized cost is recovered requires judgment in assessing the reasons that a sale may be required, such as to maintain regulatory compliance or to meet liquidity needs, and the likelihood and timing of such events occurring. If both criteria cannot be positively affirmed, the security is deemed to be OTTI and must be written down to its fair value as of the end of the reporting period through a charge to income.
In determining if the full amortized cost of an impaired security is recoverable, we must make a best estimate of the present value of the security's expected cash flows. In making our best estimate of the cash flows related to a particular security, we consider the following:
• The remaining payment terms of the security;

• Prepayment risk and speeds;

• The financial condition of the issuer;

• Expected defaults; and

• The value of any underlying collateral.

If an impaired security's full amortized cost is not expected to be recovered, then the security is deemed to be OTTI and must be written down to its fair value as of the reporting date. The security's amortized cost is written down for the portion of the OTTI due to credit losses, which is the difference between the original amortized cost of the security and the present value of its expected cash flows. This write down is charged to income and the new amortized cost basis of the security is accreted to par value as interest income. Any remaining difference between the security's fair value and the present value of the expected cash flows is deemed to be the non-credit loss . . .