Note 4 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 2018 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 gross notional amount and fair value of derivative instruments by the underlying risk exposure.



As at December 31,		2018						2017
		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	$	519	$	–	$	13	$	548	$	–	$	20
	Foreign currency swaps		91		5		–		84		1		4
Cash flow hedges	Foreign currency swaps		1,834		80		367		1,757		20		333
	Forward contracts		80		–		9		165		–		4
	Equity contracts		101		–		12		125		16		1
Net investment hedges	Foreign currency forwards		1,864		21		65		–		–		–
Total derivatives in qualifying hedge accounting relationships			4,489		106		466		2,679		37		362
Derivatives not designated in qualifying hedge accounting relationships
	Interest rate swaps		300,704		11,204		5,675		246,270		12,984		6,251
	Interest rate futures		14,297		–		–		11,551		–		–
	Interest rate options		11,736		314		–		10,093		312		–
	Foreign currency swaps		23,156		747		1,341		16,321		494		1,122
	Currency rate futures		4,052		–		–		3,157		–		–
	Forward contracts		29,248		670		158		20,341		915		65
	Equity contracts		15,492		653		163		13,597		813		22
	Credit default swaps		652		9		–		606		14		–
	Equity futures		10,908		–		–		12,158		–		–
Total derivatives not designated in qualifying hedge accounting relationships			410,245		13,597		7,337		334,094		15,532		7,460
Total derivatives		$	414,734	$	13,703	$	7,803	$	336,773	$	15,569	$	7,822

The following table presents fair values of derivative instruments by the remaining term to maturity. The fair values disclosed below do not incorporate the impact of master netting agreements. Refer to note 9.


	Remaining term to maturity
As at December 31, 2018	Less than 1 year		1 to 3 years		3 to 5 years		Over 5 years		Total
Derivative assets	$	649	$	671	$	795	$	11,588	$	13,703
Derivative liabilities		359		229		227		6,988		7,803

		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

The following table presents gross notional amount by the 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, 2018	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	$	3,495	$	22,568	$	121,817	$	147,880	$	11,750	$	(6,477	)	$	5,273		$	5,301	$	787
Cleared swap contracts		5,723		16,140		131,480		153,343		95		(96	)		(1	)		–		–
Forward contracts		10,258		14,300		648		25,206		637		(126	)		511			259		37
Futures		14,297		–		–		14,297		–		–			–			–		–
Options purchased		1,166		4,981		5,589		11,736		317		–			317			376		58
Subtotal		34,939		57,989		259,534		352,462		12,799		(6,699	)		6,100			5,936		882
Foreign exchange
Swap contracts		1,024		6,281		17,776		25,081		807		(1,736	)		(929	)		2,309		256
Forward contracts		5,926		60		–		5,986		54		(106	)		(52	)		108		13
Futures		4,052		–		–		4,052		–		–			–			–		–
Credit derivatives		143		509		–		652		10		–			10			–		–
Equity contracts
Swap contracts		2,728		142		–		2,870		29		(57	)		(28	)		303		38
Futures		10,908		–		–		10,908		–		–			–			–		–
Options purchased		6,142		6,581		–		12,723		621		(118	)		503			2,277		316
Subtotal including accrued interest		65,862		71,562		277,310		414,734		14,320		(8,716	)		5,604			10,933		1,505
Less accrued interest		–		–		–		–		617		(913	)		(296	)		–		–
Total	$	65,862	$	71,562	$	277,310	$	414,734	$	13,703	$	(7,803	)	$	5,900		$	10,933	$	1,505

	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

⁽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 $415 billion (2017 – $337 billion) includes $136 billion (2017 – $114 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.

Fair value and the fair value hierarchy of derivative instruments


As at December 31, 2018	Fair value		Level 1		Level 2		Level 3
Derivative assets
Interest rate contracts	$	12,155	$	–	$	11,537	$	618
Foreign exchange contracts		886		–		876		10
Equity contracts		653		–		621		32
Credit default swaps		9		–		9		–
Total derivative assets	$	13,703	$	–	$	13,043	$	660
Derivative liabilities
Interest rate contracts	$	5,815	$	–	$	5,318	$	497
Foreign exchange contracts		1,814		–		1,813		1
Equity contracts		174		–		118		56
Total derivative liabilities	$	7,803	$	–	$	7,249	$	554

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

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,	2018			2017
Balance at the beginning of the year	$	769		$	163
Net realized / unrealized gains (losses) included in:
Net income⁽¹⁾		(666	)		1,082
OCI⁽²⁾		(48	)		(9	)
Purchases		12			22
Settlements		18			(103	)
Transfers
Into Level 3⁽³⁾		9			–
Out of Level 3⁽³⁾		(13	)		(363	)
Currency movement		25			(23	)
Balance at the end of the year	$	106		$	769
Change in unrealized gains (losses) on instruments still held	$	(460	)	$	832

⁽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, 2018	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	$	1		$	(1	)	$	–
	Fixed rate liabilities		3			(3	)		–
Foreign currency swaps	Fixed rate assets		7			(5	)		2
Total		$	11		$	(9	)	$	2

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

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, 2018	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	$	–		$	(20	)	$	–
Foreign currency swaps	Fixed rate assets		–			(1	)		–
	Floating rate liabilities		(36	)		(62	)		–
	Fixed rate liabilities		60			62			–
Forward contracts	Forecasted expenses		(8	)		(2	)		–
Equity contracts	Stock-based compensation		(21	)		27			–
Total		$	(5	)	$	4		$	–

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		$	–

The Company anticipates that net losses of approximately $31 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 18 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, 2018	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	$	(469	)	$	–	$	–
Foreign currency forward		9			–		–
Total	$	(460	)	$	–	$	–

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		$	–	$	–

(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. Since 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.

Investment income on derivatives not designated in qualifying hedge accounting relationships



For the years ended December 31,	2018			2017
Interest rate swaps	$	(1,894	)	$	(927	)
Interest rate futures		(298	)		372
Interest rate options		(52	)		(96	)
Foreign currency swaps		(122	)		529
Currency rate futures		3			(92	)
Forward contracts		(355	)		1,231
Equity futures		742			(2,190	)
Equity contracts		(276	)		153
Credit default swaps		(6	)		(4	)
Total	$	(2,258)		$	(1,024	)

(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, 2018, reinsurance ceded guaranteed minimum income benefits had a fair value of $1,148 (2017 – $1,079) and reinsurance assumed guaranteed minimum income benefits had a fair value of $114 (2017 – $100). 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, 2018, these embedded derivatives had a fair value of $53 (2017 – $123).

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.