<PAGE>
                                                                   Exhibit 10.42

                      ALLIED WORLD ASSURANCE HOLDINGS, LTD

                            LONG-TERM INCENTIVE PLAN

          1.   PURPOSE.

          The purpose of the Plan is to attract, retain and motivate Key
Employees in order to promote the long-term growth and profitability of the
Company. The Plan provides long-term incentives, contingent upon meeting
Performance Goals, to Key Employees who make substantial contributions to the
Company Group.

          2.   DEFINITIONS.

          (a) "Board" shall mean the Board of Directors of the Company.

          (b) "Committee" shall mean the Compensation Committee of the Board;
provided, however, if at any time during the term of the Plan the Compensation
Committee is not comprised of any members, the full Board shall be deemed to be
the Committee hereunder until such time that the Compensation Committee of the
Board has at least one member.

          (c) "Common Shares" shall mean the common shares of the Company, and
such other securities as may be substituted for Common Shares pursuant to
Section 6 hereof.

          (d) "Company" shall mean Allied World Assurance Holdings, Ltd, a
Bermuda corporation.

          (e) "Company Group" shall mean the Company, together with its
subsidiaries.

          (f) "Disability" shall mean, in the absence of any employment
agreement between a Key Employee and the Company otherwise defining Disability,
any physical or mental disability or infirmity that prevents the performance of
a Key Employee's employment duties for a period of (i) ninety (90) consecutive
days or (ii) one hundred twenty (120) non-consecutive days during any twelve
(12) month period. Any question as to the existence, extent or potentiality of a
Key Employee's Disability upon which the Key Employee and the Company cannot
agree shall be determined by a qualified, independent physician selected by the
Company and approved by the Key Employee (which approval shall not be
unreasonably withheld). In the event there is an employment agreement between a
Key Employee and the Company defining Disability, "Disability" shall have the
meaning provided in such agreement.

          (g) "Fair Market Value" means, with respect to a Common Share on any
day, the fair market value as determined in accordance with a valuation
methodology approved by the Committee, or if there is a public market for the
shares on such date, the average of the high and low closing bid prices of the
Common Shares on such stock exchange on which the shares are principally trading
on the date in question, or, if there were no sales on such date, on the closest
preceding date on which there were sales of shares.

          (h) "Key Employee" shall mean any employee of the Company Group
selected by the Committee for participation in the Plan.

<PAGE>

          (i) "LTIP Award" shall mean, with respect to any Key Employee and as
to any Performance Period, the number of Common Shares equal to such Key
Employee's Target LTIP Award multiplied by the Performance Period Percentage for
such Performance Period.

          (j) "Performance Criteria" shall mean one or more of the following
performance metrics: (i) consolidated earnings before or after taxes (including
earnings before interest, taxes, depreciation and amortization); (ii) net
income; (iii) operating income; (iv) earnings per share; (v) book value per
share; (vi) return on shareholders' equity; (vii) return on investment; (viii)
stock price; (ix) improvements in capital structure; (x) revenue or sales; and
(xi) total return to shareholders.

          (k) "Performance Goals" shall mean, with respect to a Performance
Period, the attainment of the Selected Performance Criteria over such
Performance Period.

          (l) "Performance Period" shall mean, with respect to an LTIP Award,
the three (3) consecutive fiscal year period to which the LTIP Award relates, or
such other period as determined by the Committee in its sole discretion.

          (m) "Performance Period Percentage" shall mean, unless otherwise
determined by the Committee, for any Performance Period, a percentage determined
as a function of percentage achievement of the Performance Goals applicable to
such Performance Period, as follows:

<TABLE>
<CAPTION>
PERCENTAGE ACHIEVEMENT   PERFORMANCE PERIOD
 OF PERFORMANCE GOALS        PERCENTAGE
----------------------   ------------------
<S>                      <C>
Less than 80%                     0%
80%                              50%
100%                            100%
120% or greater                 150%
</TABLE>

To the extent the percentage achievement of Performance Goals falls between any
level set forth on the table above, the Performance Period Percentage shall be
the Performance Period Percentage for the percentage achievement level
immediately below that actually obtained plus 2.50% for each whole percentage
achievement in excess of such stated level (e.g., at 90% achievement of
Performance Goals, the Performance Period Percentage will equal 50% plus 25%, or
75%).

          (n) "Plan" shall mean the Company's Long-Term Incentive Plan.

          (o) "Securities Act" means the Securities Act of 1933, as amended from
time to time, including rules thereunder and successor provisions and rules
thereto.

          (p) "Selected Performance Criteria" shall mean, with respect to a
Performance Period, the Performance Criteria that is selected to measure the
performance of the Company over such Performance Period.


                                       -2-

<PAGE>

          (q) "Target LTIP Award" shall mean, as to a Key Employee, the number
of Common Shares, as determined by the Committee in its sole discretion, which
would be issuable to such Key Employee upon 100% achievement of applicable
Performance Goals.

          3.   COMMON SHARES AVAILABLE UNDER THE PLAN.

          (a) Number of Common Shares Available for Delivery. Subject to
adjustment as provided in Section 6 hereof, the total number of Common Shares
reserved and available for delivery in connection with LTIP Awards under the
Plan shall be 6,000,000. Common Shares delivered under the Plan shall consist of
authorized and unissued shares or previously issued Common Shares reacquired by
the Company on the open market or by private purchase.

          (b) Share Counting Rules. The Committee may adopt reasonable counting
procedures to ensure appropriate counting. To the extent that an LTIP Award
expires or is canceled, forfeited, or otherwise terminated or concluded without
a delivery to the Key Employee of the full number of shares to which the LTIP
Award related, the undelivered shares will again be available for grant. Common
Shares withheld in payment of taxes relating to an LTIP Award and shares equal
to the number surrendered in payment of any taxes relating to an LTIP Award
shall be deemed to constitute shares not delivered to the Key Employee and shall
be deemed to again be available for LTIP Awards under the Plan.

          4.   LTIP AWARDS.

          (a) Grant of Awards. With respect to each Performance Period, the
Committee shall communicate to each Key Employee the Target LTIP Award
applicable to such Performance Period.

          (b) Determination of Performance Percentage. As soon as practicable
following the end of a Performance Period, the Committee shall determine the
Performance Period Percentage applicable to such Performance Period. The
determination of the Committee of the Performance Period Percentage shall be
final, binding and conclusive for all purposes under the Plan and on all Key
Employees.

          (c) Time and Form of Payment. LTIP Awards in respect of any
Performance Period shall be settled in Common Shares as soon as practicable
following the Committee's determination of the Performance Period Percentage as
described in subsection (b) above. Except as provided for in subsection (d)
below, or unless otherwise determined by the Committee, no Key Employee shall
receive an LTIP Award unless employed by the Company Group on the settlement
date of such LTIP Award.

          (d) Termination of Employment due to Death or Disability. In the event
that a Key Employee's employment is terminated due to his death or Disability at
any time prior to the end of a Performance Period, the Key Employee or his
estate or his beneficiaries, as the case may be, shall be entitled to (i) 25% of
the Target LTIP Award, if such termination occurs during the first (1st) fiscal
year of the Performance Period, (ii) 50% of the Target LTIP Award, if such
termination occurs during the second (2nd) fiscal year of the Performance
Period, or (iii) 75% of the Target LTIP Award, if such termination occurs during
the third (3rd) fiscal year of the


                                       -3-

<PAGE>

Performance Period. The Target LTIP Award payable under this subsection (d)
shall be settled in Common Shares as soon as practicable following the Key
Employee's termination of employment due to death or Disability, as the case may
be.

          (e) Transferability of LTIP Awards. An LTIP Award shall not be
transferable except by will or by the laws of descent and distribution.

          5.   ADMINISTRATION.

          (a) The Plan shall be administered by the Committee. The Committee
shall have the authority in its sole discretion, subject to and not inconsistent
with the express provisions of the Plan, to administer the Plan and to exercise
all the powers and authorities either specifically granted to it under the Plan
or necessary or advisable in the administration of the Plan, including, without
limitation, the authority to grant LTIP Awards; to determine the persons to whom
and the time or times at which LTIP Awards shall be granted; to determine the
terms, conditions, restrictions and performance criteria relating to any LTIP
Awards; to make adjustments in the Performance Goals in response to changes in
applicable laws, regulations, accounting principles, or for any other reason
which the Committee determines, in its sole discretion and acting in good faith,
otherwise warrants equitable adjustment; to construe and interpret the Plan; to
prescribe, amend and rescind rules and regulations relating to the Plan; and to
make all other determinations deemed necessary or advisable for the
administration of the Plan.

          (b) All decisions, determinations and interpretations of the Committee
shall be final and binding on all persons, including the Company, the Key
Employee (or any person claiming any rights under the Plan from or through any
Key Employee) and any shareholder.

          (c) No member of the Committee shall be liable for any action taken or
determination made in good faith with respect to the Plan or any LTIP Award
granted hereunder.

          6.   ADJUSTMENT FOR RECAPITALIZATION.

          The aggregate number of Common Shares which may be granted or
purchased pursuant to LTIP Awards granted hereunder, the number of Common Shares
covered by each outstanding LTIP Award, and the price per share thereof in each
such LTIP Award shall be equitably and proportionally adjusted or substituted,
as determined by the Committee in good faith and in its sole discretion, as to
the number, price or kind of a Common Share or other consideration subject to
such LTIP Awards or as otherwise determined by the Committee in good faith to be
fair and equitable (i) in the event of changes in the outstanding Common Shares
or in the capital structure of the Company by reason of share dividends, share
splits, reverse share splits, recapitalizations, reorganizations, mergers,
consolidations, combinations, exchanges, or other relevant changes in
capitalization occurring after the date of grant of any such LTIP Award; (ii) in
the event of any change in applicable laws or any change in circumstances which
results in or would result in any substantial dilution or enlargement of the
rights granted to, or available for, Key Employees participating in the Plan; or
(iii) for any other reason which the Committee determines, in its sole
discretion and acting in good faith, to otherwise warrant equitable adjustment.


                                       -4-

<PAGE>

          7.   GENERAL PROVISIONS.

          (a) Compliance with Legal Requirements. The Plan, the granting of LTIP
Awards and the other obligations of the Company under the Plan shall be subject
to all applicable federal and state laws, rules and regulations, and to such
approvals by any regulatory or governmental agency as may be required.

          (b) Compliance with Laws. The obligation of the Company to settle LTIP
Awards in Common Shares shall be subject to all applicable laws, rules and
regulations, and to such approvals by governmental agencies as may be required.
Notwithstanding any terms or conditions of any LTIP Award to the contrary, the
Company shall be under no obligation to offer to sell or to sell and shall be
prohibited from offering to sell or selling any Common Shares pursuant to an
LTIP Award unless such shares have been properly registered for sale pursuant to
the Securities Act with the Securities and Exchange Commission or unless the
Company has received an opinion of counsel, satisfactory to the Company, that
such shares may be offered or sold without such registration pursuant to an
available exemption therefrom and the terms and conditions of such exemption
have been fully complied with. The Company shall be under no obligation to
register for sale or resale under the Securities Act any of the Common Shares to
be offered or sold under the Plan or any Common Shares issued upon exercise or
settlement of LTIP Awards. If the Common Shares offered for sale or sold under
the Plan are offered or sold pursuant to an exemption from registration under
the Securities Act, the Company may restrict the transfer of such shares and may
legend the stock certificates representing such shares in such manner as it
deems advisable to ensure the availability of any such exemption.

          (c) No Right to Continued Employment. Nothing in the Plan shall confer
upon any Key Employee the right to continue in the employ of the Company Group
or to be entitled to any remuneration or benefits not set forth in the Plan or
to interfere with or limit in any way the right of any member of the Company
Group to terminate such Key Employee's employment.

          (d) Rights and Privileges as a Shareholder. Except as otherwise
specifically provided in the Plan, no person shall be entitled to the rights and
privileges of Common Share ownership in respect of Common Shares which are
subject to LTIP Awards hereunder until such shares have been issued to that
person.

          (e) Withholding Obligations. The settlement of any LTIP Award shall be
subject to withholding for all federal, state and local income and other taxes
of any kind required or permitted to be withheld in connection with such
settlement. The Committee, in its discretion, may permit Common Shares to be
used to satisfy tax withholding requirements and such shares shall be valued at
their Fair Market Value as of the settlement date of the LTIP Award; provided,
however, that the aggregate Fair Market Value of the number of Common Shares
that may be used to satisfy tax withholding requirements may not exceed the
minimum statutory required withholding amount with respect to such LTIP Award.

          (f) Amendment and Termination of the Plan. Subject to Section 7(a)
hereof, the Board may at any time and from time to time alter, amend, suspend or
terminate the Plan in


                                       -5-

<PAGE>

whole or in part. No LTIP Awards may be granted under the Plan while the Plan is
suspended or after it is terminated.

          (g) Key Employee Rights. Nothing in the Plan shall give any Key
Employee any claim to be granted any LTIP Award under the Plan, and there is no
obligation for uniformity of treatment among Key Employees.

          (h) Funding. No provision of the Plan shall require the Company, for
the purpose of satisfying any obligations under the Plan, to purchase assets or
place any assets in a trust or other entity to which contributions are made or
otherwise to segregate any assets, nor shall the Company maintain separate bank
accounts, books, records or other evidence of the existence of a segregated or
separately maintained or administered fund for such purposes. Key Employees
shall have no rights under the Plan other than as unsecured general creditors of
the Company, except that insofar as they may have become entitled to payment of
additional compensation by performance of services, they shall have the same
rights as other employees under general law.

          (i) Titles and Headings. The titles and headings of the sections in
the Plan are for convenience of reference only, and in the event of any
conflict, the text of the Plan, rather than such titles or headings, shall
control.

          (j) Governing Law. The Plan and the rights of all persons claiming
hereunder shall be construed and determined in accordance with the laws of the
State of New York without giving effect to the choice of law principles thereof.

          (k) Effective Date. The Plan shall first be effective with respect to
the 2006 fiscal year.


                                       -6-