Note 5 Derivative and Hedging Instruments

Derivatives are financial contracts, the value of which is derived from underlying interest rates, foreign exchange rates, other financial instruments, commodity prices or indices. The Company uses derivatives including swaps, forward and futures agreements, and options to manage current and anticipated exposures to changes in interest rates, foreign exchange rates, commodity prices and equity market prices, and to replicate permissible investments.

Swaps are over-the-counter (“OTC”) contractual agreements between the Company and a third party to exchange a series of cash flows based upon rates applied to a notional amount. For interest rate swaps, counterparties generally exchange fixed or floating interest rate payments based on a notional value in a single currency. Cross currency swaps involve the exchange of principal amounts between parties as well as the exchange of interest payments in one currency for the receipt of interest payments in another currency. Total return swaps are contracts that involve the exchange of payments based on changes in the values of a reference asset, including any returns such as interest earned on these assets, in return for amounts based on reference rates specified in the contract.

Forward and futures agreements are contractual obligations to buy or sell a financial instrument, foreign currency or other underlying commodity on a predetermined future date at a specified price. Forward contracts are OTC contracts negotiated between counterparties, whereas futures agreements are contracts with standard amounts and settlement dates that are traded on regulated exchanges.

Options are contractual agreements whereby the holder has the right, but not the obligation, to buy (call option) or sell (put option) a security, exchange rate, interest rate, or other financial instrument at a predetermined price/rate within a specified time.

See variable annuity dynamic hedging strategy in the “Risk Management” section of the Company’s 2017 MD&A for an explanation of the Company’s dynamic hedging strategy for its variable annuity product guarantees.

(a) Fair value of derivatives

The pricing models used to value OTC derivatives are based on market standard valuation methodologies and the inputs to these models are consistent with what a market participant would use when pricing the instruments. Derivative valuations can be affected by changes in interest rates, currency exchange rates, financial indices, credit spreads, default risk (including the counterparties to the contract), and market volatility. The significant inputs to the pricing models for most OTC derivatives are inputs that are observable or can be corroborated by observable market data and are classified as Level 2. Inputs that are observable generally include interest rates, foreign currency exchange rates and interest rate curves. However, certain OTC derivatives may rely on inputs that are significant to the fair value that are not observable in the market or cannot be derived principally from, or corroborated by, observable market data and these derivatives are classified as Level 3. Inputs that are unobservable generally include broker quotes, volatilities and inputs that are outside of the observable portion of the interest rate curve or other relevant market measures. These unobservable inputs may involve significant management judgment or estimation. Even though unobservable, these inputs are based on assumptions deemed appropriate given the circumstances and consistent with what market participants would use when pricing such instruments. The Company’s use of unobservable inputs is limited and the impact on derivative fair values does not represent a material amount as evidenced by the limited amount of Level 3 derivatives. The credit risk of both the counterparty and the Company are considered in determining the fair value for all OTC derivatives after considering the effects of netting agreements and collateral arrangements.

The following table presents the gross notional amount and fair value of derivative contracts by the underlying risk exposure for derivatives in qualifying hedging and derivatives not designated in qualifying hedging relationships.



As at December 31,		2017						2016
		Notional amount		Fair value				Notional amount		Fair value
Type of hedge	Instrument type	Notional amount		Assets		Liabilities		Notional amount		Assets		Liabilities
Qualifying hedge accounting relationships
Fair value hedges	Interest rate swaps	$	548	$	–	$	20	$	2,158	$	–	$	477
	Foreign currency swaps		84		1		4		91		1		3
Cash flow hedges	Foreign currency swaps		1,757		20		333		1,285		–		447
	Forward contracts		165		–		4		255		–		23
	Equity contracts		125		16		1		126		21		1
Total derivatives in qualifying hedge accounting relationships			2,679		37		362		3,915		22		951
Derivatives not designated in qualifying hedge accounting relationships
	Interest rate swaps		246,270		12,984		6,251		281,188		21,900		10,878
	Interest rate futures		11,551		–		–		11,616		–		–
	Interest rate options		10,093		312		–		9,390		376		–
	Foreign currency swaps		16,321		494		1,122		12,226		347		1,645
	Currency rate futures		3,157		–		–		4,729		–		–
	Forward contracts		20,341		915		65		15,411		340		644
	Equity contracts		13,597		813		22		14,989		669		33
	Credit default swaps		606		14		–		662		18		–
	Equity futures		12,158		–		–		16,072		–		–
Total derivatives not designated in qualifying hedge accounting relationships			334,094		15,532		7,460		366,283		23,650		13,200
Total derivatives		$	336,773	$	15,569	$	7,822	$	370,198	$	23,672	$	14,151

The following table presents fair value of derivative instruments by remaining term to maturity. Fair values disclosed below do not incorporate the impact of master netting agreements. Refer to note 10.


	Remaining term to maturity
As at December 31, 2017	Less than 1 year		1 to 3 years		3 to 5 years		Over 5 years		Total
Derivative assets	$	605	$	822	$	889	$	13,253	$	15,569
Derivative liabilities		224		149		168		7,281		7,822

		Remaining term to maturity
As at December 31, 2016		Less than 1 year		1 to 3 years		3 to 5 years		Over 5 years		Total
Derivative assets	$	467	$	680	$	719	$	21,806	$	23,672
Derivative liabilities		593		595		511		12,452		14,151

The following table presents gross notional amount by remaining term to maturity, total fair value (including accrued interest), credit risk equivalent and risk-weighted amount by contract type.


	Remaining term to maturity (notional amounts)								Fair value
As at December 31, 2017	Under 1 year		1 to 5 years		Over 5 years		Total		Positive		Negative			Net			Credit risk equivalent⁽¹⁾		Risk- weighted amount⁽²⁾
Interest rate contracts
OTC swap contracts	$	7,161	$	19,141	$	112,412	$	138,714	$	13,379	$	(6,867	)	$	6,512		$	6,588	$	809
Cleared swap contracts		1,615		12,928		93,561		108,104		245		(206	)		39			–		–
Forward contracts		6,036		10,614		675		17,325		903		(38	)		865			285		35
Futures		11,551		–		–		11,551		–		–			–			–		–
Options purchased		816		3,856		5,421		10,093		312		–			312			471		61
Subtotal		27,179		46,539		212,069		285,787		14,839		(7,111	)		7,728			7,344		905
Foreign exchange
Swap contracts		999		4,481		12,682		18,162		510		(1,483	)		(973	)		1,874		200
Forward contracts		3,046		135		–		3,181		12		(31	)		(19	)		101		12
Futures		3,157		–		–		3,157		–		–			–			–		–
Credit derivatives		38		568		–		606		14		–			14			–		–
Equity contracts
Swap contracts		2,612		169		–		2,781		60		(14	)		46			337		35
Futures		12,158		–		–		12,158		–		–			–			–		–
Options purchased		4,693		6,148		100		10,941		769		(10	)		759			2,606		305
Subtotal including accrued interest		53,882		58,040		224,851		336,773		16,204		(8,649	)		7,555			12,262		1,457
Less accrued interest		–		–		–		–		635		(827	)		(192	)		–		–
Total	$	53,882	$	58,040	$	224,851	$	336,773	$	15,569	$	(7,822	)	$	7,747		$	12,262	$	1,457

	Remaining term to maturity (notional amounts)								Fair value
As at December 31, 2016	Under 1 year		1 to 5 years		Over 5 years		Total		Positive		Negative			Net			Credit risk equivalent⁽¹⁾		Risk- weighted amount⁽²⁾
Interest rate contracts
OTC swap contracts	$	13,244	$	37,395	$	164,252	$	214,891	$	19,327	$	(10,154	)	$	9,173		$	10,205	$	1,493
Cleared swap contracts		717		4,786		62,952		68,455		3,507		(2,117	)		1,390			–		–
Interest rate forwards		7,229		6,143		873		14,245		326		(629	)		(303	)		192		29
Futures		11,616		–		–		11,616		–		–			–			–		–
Options purchased		483		2,927		5,980		9,390		376		–			376			458		70
Subtotal		33,289		51,251		234,057		318,597		23,536		(12,900	)		10,636			10,855		1,592
Foreign exchange
Swap contracts		425		3,917		9,259		13,601		346		(2,120	)		(1,774	)		1,491		181
Forward contracts		1,257		165		–		1,422		13		(38	)		(25	)		62		9
Futures		4,729		–		–		4,729		–		–			–			–		–
Credit derivatives		47		615		–		662		18		–			18			–		–
Equity contracts
Swap contracts		3,107		192		–		3,299		64		(35	)		29			495		54
Futures		16,072		–		–		16,072		–		–			–			–		–
Options purchased		6,007		5,809		–		11,816		626		(2	)		624			2,735		358
Subtotal including accrued interest		64,933		61,949		243,316		370,198		24,603		(15,095	)		9,508			15,638		2,194
Less accrued interest		–		–		–		–		931		(944	)		(13	)		–		–
Total	$	64,933	$	61,949	$	243,316	$	370,198	$	23,672	$	(14,151	)	$	9,521		$	15,638	$	2,194

⁽¹⁾

Credit risk equivalent is the sum of replacement cost and the potential future credit exposure. Replacement cost represents the current cost of replacing all contracts with a positive fair value. The amounts take into consideration legal contracts that permit offsetting of positions. The potential future credit exposure is calculated based on a formula prescribed by OSFI.

⁽²⁾	Risk-weighted amount represents the credit risk equivalent, weighted according to the creditworthiness of the counterparty, as prescribed by OSFI.

The total notional amount of $337 billion (2016 – $370 billion) includes $114 billion (2016 – $177 billion) related to derivatives utilized in the Company’s variable annuity guarantee dynamic hedging and macro equity risk hedging programs. Due to the Company’s variable annuity hedging practices, a large number of trades are in offsetting positions, resulting in materially lower net fair value exposure to the Company than what the gross notional amount would suggest.

The following table presents fair value of derivative contracts and the fair value hierarchy.


As at December 31, 2017	Fair value		Level 1		Level 2		Level 3
Derivative assets
Interest rate contracts	$	14,199	$	–	$	13,181	$	1,018
Foreign exchange contracts		527		–		527		–
Equity contracts		829		–		768		61
Credit default swaps		14		–		14		–
Total derivative assets	$	15,569	$	–	$	14,490	$	1,079
Derivative liabilities
Interest rate contracts	$	6,309	$	–	$	6,012	$	297
Foreign exchange contracts		1,490		–		1,490		–
Equity contracts		23		–		10		13
Total derivative liabilities	$	7,822	$	–	$	7,512	$	310

As at December 31, 2016	Fair value		Level 1		Level 2		Level 3
Derivative assets
Interest rate contracts	$	22,602	$	–	$	22,045	$	557
Foreign exchange contracts		362		–		361		1
Equity contracts		690		–		182		508
Credit default swaps		18		–		18		–
Total derivative assets	$	23,672	$	–	$	22,606	$	1,066
Derivative liabilities
Interest rate contracts	$	11,984	$	–	$	11,114	$	870
Foreign exchange contracts		2,133		–		2,133		–
Equity contracts		34		–		1		33
Total derivative liabilities	$	14,151	$	–	$	13,248	$	903

The following table presents a roll forward for net derivative contracts measured at fair value using significant unobservable inputs (Level 3).



For the years ended December 31,	2017			2016
Balance at the beginning of the year	$	163		$	350
Net realized / unrealized gains (losses) included in:
Net income⁽¹⁾		1,082			47
OCI⁽²⁾		(9	)		40
Purchases		22			373
Settlements		(103	)		(522	)
Transfers
Into Level 3⁽³⁾		–			–
Out of Level 3⁽³⁾		(363	)		(116	)
Currency movement		(23	)		(9	)
Balance at the end of the year	$	769		$	163
Change in unrealized gains (losses) on instruments still held	$	832		$	145

⁽¹⁾	These amounts are included in investment income on the Consolidated Statements of Income.

⁽²⁾	These amounts are included in AOCI on the Consolidated Statements of Financial Position.

⁽³⁾

For derivatives transferred into and out of Level 3, the Company uses the fair value of the items at the end and beginning of the period, respectively. Transfers into Level 3 occur when the inputs used to price the assets and liabilities lack observable market data (versus the previous year). Transfers out of Level 3 occur when the inputs used to price the assets and liabilities become available from observable market data.

(b) Hedging relationships

The Company uses derivatives for economic hedging purposes. In certain circumstances, these hedges also meet the requirements of hedge accounting. Risk management strategies eligible for hedge accounting are designated as fair value hedges, cash flow hedges or net investment hedges, as described below.

Fair value hedges

The Company uses interest rate swaps to manage its exposure to changes in the fair value of fixed rate financial instruments due to changes in interest rates. The Company also uses cross currency swaps to manage its exposure to foreign exchange rate fluctuations, interest rate fluctuations, or both.

The Company recognizes gains and losses on derivatives and the related hedged items in fair value hedges in investment income. These investment gains (losses) are shown in the following table.


For the year ended December 31, 2017	Hedged items in qualifying fair value hedging relationships	Gains (losses) recognized on derivatives			Gains (losses) recognized for hedged items			Ineffectiveness recognized in investment income
Interest rate swaps	Fixed rate assets	$	2		$	(3	)	$	(1)
	Fixed rate liabilities		(17	)		17			–
Foreign currency swaps	Fixed rate assets		(2	)		4			2
Total		$	(17	)	$	18		$	1

For the year ended December 31, 2016	Hedged items in qualifying fair value hedging relationships	Gains (losses) recognized on derivatives			Gains (losses) recognized for hedged items			Ineffectiveness recognized in investment income
Interest rate swaps	Fixed rate assets	$	(52	)	$	30		$	(22)
	Fixed rate liabilities		(1	)		1			–
Foreign currency swaps	Fixed rate assets		–			2			2
Total		$	(53	)	$	33		$	(20)

Cash flow hedges

The Company uses interest rate swaps to hedge the variability in cash flows from variable rate financial instruments and forecasted transactions. The Company also uses cross currency swaps and foreign currency forward contracts to hedge the variability from foreign currency financial instruments and foreign currency expenses. Total return swaps are used to hedge the variability in cash flows associated with certain stock-based compensation awards. Inflation swaps are used to reduce inflation risk generated from inflation-indexed liabilities.

The effects of derivatives in cash flow hedging relationships on the Consolidated Statements of Income and the Consolidated Statements of Comprehensive Income are shown in the following table.


For the year ended December 31, 2017	Hedged items in qualifying cash flow hedging relationships	Gains (losses) deferred in AOCI on derivatives			Gains (losses) reclassified from AOCI into investment income			Ineffectiveness recognized in investment income
Interest rate swaps	Forecasted liabilities	$	–		$	(17	)	$	–
Foreign currency swaps	Fixed rate assets		3			(1	)		–
	Floating rate liabilities		95			50			–
	Fixed rate liabilities		35			7			–
Forward contracts	Forecasted expenses		10			(10	)		–
Equity contracts	Stock-based compensation		20			29			–
Total		$	163		$	58		$	–

For the year ended December 31, 2016	Hedged items in qualifying cash flow hedging relationships	Gains (losses) deferred in AOCI on derivatives			Gains (losses) reclassified from AOCI into investment income			Ineffectiveness recognized in investment income
Interest rate swaps	Forecasted liabilities	$	–		$	(18	)	$	–
Foreign currency swaps	Fixed rate assets		(4	)		–			–
	Floating rate liabilities		47			23			–
	Fixed rate liabilities		(15	)		(8	)		–
Forward contracts	Forecasted expenses		7			(14	)		–
Equity contracts	Stock-based compensation		39			(1	)		–
Non-derivative financial instrument	Forecasted expenses		–			3			–
Total		$	74		$	(15	)	$	–

The Company anticipates that net losses of approximately $13 will be reclassified from AOCI to net income within the next 12 months. The maximum time frame for which variable cash flows are hedged is 19 years.

Hedges of net investments in foreign operations

The Company primarily uses forward currency contracts, cross currency swaps and non-functional currency denominated debt to manage its foreign currency exposures to net investments in foreign operations.

The effects of net investment hedging relationships on the Consolidated Statements of Income and the Consolidated Statements of Other Comprehensive Income are shown in the following table.


For the year ended December 31, 2017	Gains (losses) deferred in AOCI on derivatives			Gains (losses) reclassified from AOCI into investment income		Ineffectiveness recognized in investment income
Non-functional currency denominated debt	$	355		$	–	$	–
Total	$	355		$	–	$	–

For the year ended December 31, 2016	Gains (losses) deferred in AOCI on derivatives			Gains (losses) reclassified from AOCI into investment income		Ineffectiveness recognized in investment income
Non-functional currency denominated debt	$	(25	)	$	–	$	–
Total	$	(25	)	$	–	$	–

(c) Derivatives not designated in qualifying hedge accounting relationships

Derivatives used in portfolios supporting insurance contract liabilities are generally not designated in qualifying hedge accounting relationships because the change in the value of the insurance contract liabilities economically hedged by these derivatives is also recorded through net income. Given the changes in fair value of these derivatives and related hedged risks are recognized in investment income as they occur, they generally offset the change in hedged risk to the extent the hedges are economically effective. Interest rate and cross currency swaps are used in the portfolios supporting insurance contract liabilities to manage duration and currency risks.

The effects of derivatives not designated in qualifying hedge accounting relationships on the Consolidated Statements of Income are shown in the following table.



For the years ended December 31,	2017			2016
Investment income (loss)
Interest rate swaps	$	(927	)	$	(141	)
Interest rate futures		372			(26	)
Interest rate options		(96	)		(11	)
Foreign currency swaps		529			(14	)
Currency rate futures		(92	)		263
Forward contracts		1,231			(88	)
Equity futures		(2,190	)		(2,387	)
Equity contracts		153			(171	)
Credit default swaps		(4	)		1
Total	$	(1,024)		$	(2,574	)

(d) Embedded derivatives

Certain insurance contracts contain features that are classified as embedded derivatives and are measured separately at FVTPL including reinsurance contracts related to guaranteed minimum income benefits and contracts containing certain credit and interest rate features.

Certain reinsurance contracts related to guaranteed minimum income benefits contain embedded derivatives requiring separate measurement at FVTPL as the financial component contained in the reinsurance contracts does not contain significant insurance risk. As at December 31, 2017, reinsurance ceded guaranteed minimum income benefits had a fair value of $1,079 (2016 – $1,408) and reinsurance assumed guaranteed minimum income benefits had a fair value of $100 (2016 – $119). Claims recovered under reinsurance ceded contracts offset claims expenses and claims paid on the reinsurance assumed are reported as contract benefits.

The Company’s credit and interest rate embedded derivatives promise to pay the returns on a portfolio of assets to the contract holder. These embedded derivatives contain a credit and interest rate risk that is a financial risk embedded in the underlying insurance contract. As at December 31, 2017, these embedded derivatives had a fair value of $123 (2016 – $218).

Other financial instruments classified as embedded derivatives but exempt from separate measurement at fair value include variable universal life and variable life products, minimum guaranteed credited rates, no lapse guarantees, guaranteed annuitization options, CPI indexing of benefits, and segregated fund minimum guarantees other than reinsurance ceded/assumed guaranteed minimum income benefits. These embedded derivatives are measured and reported within insurance contract liabilities and are exempt from separate fair value measurement as they contain insurance risk and/or are closely related to the insurance host contract.