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Derivative Instruments
 9 Months Ended
Sep. 30, 2012
Derivative Instruments [Abstract]  
Derivative Instruments

5. Derivative Instruments

The following table presents the notional amounts and fair value of derivative instruments as of September 30, 2012 and December 31, 2011 (dollars in thousands):

     September 30, 2012  December 31, 2011
      Notional Carrying Value/Fair Value   Notional Carrying Value/Fair Value
      Amount  Assets  Liabilities   Amount  Assets  Liabilities
Derivatives not designated as                  
 hedging instruments:                  
 Interest rate swaps(1)$ 2,236,718 $ 306,774 $ 174,741  $ 2,748,317 $ 184,842 $ 18,702
 Financial futures(1)  204,424   --   --    277,814   --   --
 Foreign currency forwards(1)  44,400   4,052   36    24,400   4,560   --
 Consumer price index swaps(1)  102,742   817   --    101,069   766   --
 Credit default swaps(1)  640,500   1,308   3,770    649,500   1,313   10,949
 Equity options(1)  696,776   73,659   --    510,073   90,106   --
 Synthetic guaranteed investment contracts                  
  ("GICs")(1)  1,913,202   --   --    --   --   --
 Embedded derivatives in:                  
  Modified coinsurance or funds                  
   withheld arrangements(2)  --   --   320,501    --   --   361,456
  Indexed annuity products(3)  --   4,192   751,112    --   4,945   751,523
  Variable annuity products(3)  --   --   202,693    --   --   276,718
 Total non-hedging derivatives  5,838,762   390,802   1,452,853    4,311,173   286,532   1,419,348
                       
Derivatives designated as                  
 hedging instruments:                  
 Interest rate swaps(1)  57,181   3,901   --    56,250   133   960
 Foreign currency swaps(1)  629,512   --   32,757    621,578   286   23,996
 Total hedging derivatives  686,693   3,901   32,757    677,828   419   24,956
Total derivatives$ 6,525,455 $ 394,703 $ 1,485,610  $ 4,989,001 $ 286,951 $ 1,444,304
                       
(1)Carried on the Company’s condensed consolidated balance sheets in other invested assets or other liabilities, at fair value.
(2)Embedded liability is included on the condensed consolidated balance sheets with the host contract in funds withheld at interest, at fair value.
(3)Embedded liability is included on the condensed consolidated balance sheets with the host contract in interest-sensitive contract liabilities, at fair value. Embedded asset is included on the condensed consolidated balance sheets in reinsurance ceded receivables.

Accounting for Derivative Instruments and Hedging Activities

The Company does not enter into derivative instruments for speculative purposes. As discussed below under “Non-qualifying Derivatives and Derivatives for Purposes Other Than Hedging,” the Company uses various derivative instruments for risk management purposes that either do not qualify or have not been qualified for hedge accounting treatment, including derivatives used to economically hedge changes in the fair value of liabilities associated with the reinsurance of variable annuities with guaranteed living benefits. As of September 30, 2012 and December 31, 2011, the Company held interest rate swaps that were designated and qualified as cash flow hedges of interest rate risk. As of September 30, 2012 and December 31, 2011, the Company held foreign currency swaps that were designated and qualified as hedges of a portion of its net investment in its foreign operations. As of September 30, 2012 and December 31, 2011, the Company also had derivative instruments that were not designated as hedging instruments. See Note 2 – “Summary of Significant Accounting Policies” of the Company's DAC Current Report for a detailed discussion of the accounting treatment for derivative instruments, including embedded derivatives. Derivative instruments are carried at fair value and generally require an insignificant amount of cash at inception of the contracts.

Fair Value Hedges

During the fourth quarter of 2011 the Company removed the fair value hedge designation for its interest rate swaps. However, prior to the fourth quarter of 2011 the Company designated and accounted for certain interest rate swaps that convert fixed rate investments to floating rate investments as fair value hedges when they meet the requirements of the general accounting principles for Derivatives and Hedging. The gain or loss on the hedged item attributable to the hedged benchmark interest rate and the offsetting gain or loss on the related interest rate swaps for the three and nine months ended September 30, 2011 were (dollars in thousands):

Type of Fair Value Hedge   Hedged Item  Gains (Losses) Recognized for Derivatives  Gains (Losses) Recognized for Hedged Items  Ineffectiveness Recognized in Investment Related Gains (Losses)
             
For the three months ended September 30, 2011:       
Interest rate swaps  Fixed rate fixed maturities $ (655) $ 913 $ 258
             
For the nine months ended September 30, 2011:       
Interest rate swaps  Fixed rate fixed maturities $ (921) $ 1,509 $ 588

A regression analysis was used, both at the inception of the hedge and on an ongoing basis, to determine whether each derivative used in a hedge transaction is highly effective in offsetting changes in the hedged item. All components of each derivative's gain or loss were included in the assessment of hedge effectiveness.

Cash Flow Hedges

The Company designates and accounts for certain interest rate swaps, in which the cash flows are denominated in different currencies, commonly referred to as cross-currency swaps, as cash flow hedges when they meet the requirements of the general accounting principles for Derivatives and Hedging.

The following table presents the components of AOCI, before income tax, and the condensed consolidated income statement classification where the gain or loss is recognized related to cash flow hedges for the three and nine months ended September 30, 2012 (dollars in thousands):

 Three months ended Nine months ended
 September 30, 2012 September 30, 2012
Accumulated other comprehensive income (loss), balance beginning of period$ (719) $ (828)
Gains (losses) deferred in other comprehensive income (loss) on the effective portion of cash flow hedges   (2,831)   (2,044)
Amounts reclassified to investment related gains (losses), net  --   --
Amounts reclassified to investment income  (351)   (1,029)
Accumulated other comprehensive income (loss), balance end of period$ (3,901) $ (3,901)

As of September 30, 2012, the before-tax deferred net gains on derivative instruments recorded in AOCI that are expected to be reclassified to earnings during the next twelve months are $0.8 million. This expectation is based on the anticipated interest payments on hedged investments in fixed maturity securities that will occur over the next twelve months, at which time the Company will recognize the deferred net gains (losses) as an adjustment to investment income over the term of the investment cash flows. There were no hedged forecasted transactions, other than the receipt or payment of variable interest payments on existing financial instruments, for the three and nine months ended September 30, 2012. The Company had no derivative instruments that were designated and qualified as cash flow hedges for the three and nine months ended September 30, 2011.

The following table presents the effects of derivatives in cash flow hedging relationships on the condensed consolidated statements of income and AOCI for the three and nine months ended September 30, 2012 (dollars in thousands):

Derivatives in Cash Flow Hedging Relationships Amount of Gains (Losses) Deferred in AOCI on Derivatives Amount and Location of Gains (Losses) Reclassified from AOCI into Income (Loss) Amount and Location of Gains (Losses) Recognized in Income (Loss) on Derivatives
  (Effective Portion) (Effective Portion) (Ineffective Portion and Amounts Excluded from Effectiveness Testing)
     Investment Related Gains (Losses) Investment Income Investment Related Gains (Losses) Investment Income
For the three months ended September 30, 2012:         
Interest rate swaps $ (2,831) $ -- $ 351 $ (3) $ --
                
For the nine months ended September 30, 2012:         
Interest rate swaps $ (2,044) $ -- $ 1,029 $ -- $ --

Hedges of Net Investments in Foreign Operations

The Company uses foreign currency swaps to hedge a portion of its net investment in certain foreign operations against adverse movements in exchange rates. The following table illustrates the Company's net investments in foreign operations (“NIFO”) hedges for the three and nine months ended September 30, 2012 and 2011 (dollars in thousands):

   Derivative Gains (Losses) Deferred in AOCI
   For the three months ended For the nine months ended
Type of NIFO Hedge (1) (2) 2012 2011 2012  2011
              
Foreign currency swaps $ (19,454) $ 50,974 $ (23,457) $ 25,954
              
(1)There were no sales or substantial liquidations of net investments in foreign operations that would have required the reclassification of gains or losses from accumulated other comprehensive income (loss) into investment income during the periods presented.
(2)There was no ineffectiveness recognized for the Company's hedges of net investments in foreign operations.

The cumulative foreign currency translation gain (loss) recorded in AOCI related to these hedges was $(19.4) million and $4.1 million at September 30, 2012 and December 31, 2011, respectively. If a foreign operation was sold or substantially liquidated, the amounts in AOCI would be reclassified to the condensed consolidated statements of income. A pro rata portion would be reclassified upon partial sale of a foreign operation.

Non-qualifying Derivatives and Derivatives for Purposes Other Than Hedging

The Company uses various other derivative instruments for risk management purposes that either do not qualify or have not been qualified for hedge accounting treatment, including derivatives used to economically hedge changes in the fair value of liabilities associated with the reinsurance of variable annuities with guaranteed living benefits. The gain or loss related to the change in fair value for these derivative instruments is recognized in investment related gains (losses), in the condensed consolidated statements of income, except where otherwise noted. For the three months ended September 30, 2012 and 2011, the Company recognized investment related gains (losses) of $(20.6) million and $200.8 million, respectively, and $(31.8) million and $203.4 million for the nine months ended September 30, 2012 and 2011, respectively, related to derivatives (not including embedded derivatives) that do not qualify or have not been qualified for hedge accounting.

Interest Rate Swaps

Interest rate swaps are used by the Company primarily to reduce market risks from changes in interest rates and to alter interest rate exposure arising from mismatches between assets and liabilities (duration mismatches). With an interest rate swap, the Company agrees with another party to exchange, at specified intervals, the difference between two rates, which can be either fixed-rate or floating-rate interest amounts, tied to an agreed-upon notional principal amount. These transactions are executed pursuant to master agreements that provide for a single net payment or individual gross payments at each due date.

Financial Futures

Exchange-traded equity futures are used primarily to economically hedge liabilities embedded in certain variable annuity products. With exchange-traded equity futures transactions, the Company agrees to purchase or sell a specified number of contracts, the value of which is determined by the relevant stock indices, and to post variation margin on a daily basis in an amount equal to the difference between the daily estimated fair values of those contracts. The Company enters into exchange-traded equity futures with regulated futures commission merchants that are members of the exchange.

 

 

Equity Options

Equity index options are used by the Company primarily to hedge minimum guarantees embedded in certain variable annuity products. To hedge against adverse changes in equity indices volatility, the Company buys put options. The contracts are net settled in cash based on differentials in the indices at the time of exercise and the strike price.

Consumer Price Index Swaps

Consumer price index (“CPI”) swaps are used by the Company primarily to economically hedge liabilities embedded in certain insurance products where value is directly affected by changes in a designated benchmark consumer price index. With a CPI swap transaction, the Company agrees with another party to exchange the actual amount of inflation realized over a specified period of time for a fixed amount of inflation determined at inception. These transactions are executed pursuant to master agreements that provide for a single net payment or individual gross payments to be made by the counterparty at each due date. Most of these swaps will require a single payment to be made by one counterparty at the maturity date of the swap.

Foreign Currency Swaps

Foreign currency swaps are used by the Company to reduce the risk from fluctuations in foreign currency exchange rates associated with its assets and liabilities denominated in foreign currencies. With a foreign currency swap transaction, the Company agrees with another party to exchange, at specified intervals, the difference between one currency and another at a forward exchange rate calculated by reference to an agreed upon principal amount. The principal amount of each currency is exchanged at the inception and termination of the currency swap by each party. The Company may also use foreign currency swaps to economically hedge the foreign currency risk associated with certain of its net investments in foreign operations.

Foreign Currency Forwards

Foreign currency forwards are used by the Company to reduce the risk from fluctuations in foreign currency exchange rates associated with its assets and liabilities denominated in foreign currencies. With a foreign currency forward transaction, the Company agrees with another party to deliver a specified amount of an identified currency at a specified future date. The price is agreed upon at the time of the contract and payment for such a contract is made in a different currency at the specified future date.

Credit Default Swaps

The Company sells protection under single name credit default swaps and credit default swap index tranches to diversify its credit risk exposure in certain portfolios and, in combination with purchasing securities, to replicate characteristics of similar investments based on the credit quality and term of the credit default swap. Credit default triggers for indexed reference entities and single name reference entities are defined in the contracts. The Company's maximum exposure to credit loss equals the notional value for credit default swaps. In the event of default for credit default swaps, the Company is typically required to pay the protection holder the full notional value less a recovery rate determined at auction.

The Company's maximum amount at risk on credit default swaps, assuming the value of the underlying referenced securities is zero, was $622.5 million and $614.0 million at September 30, 2012 and December 31, 2011, respectively.

The Company also purchases credit default swaps to reduce its risk against a drop in bond prices due to credit concerns of certain bond issuers. If a credit event, as defined by the contract, occurs, the Company is able to put the bond back to the counterparty at par.

Synthetic GICs

The Company sells fee-based synthetic GICs which include investment-only, stable value contracts, to retirement plans. The assets are owned by the trustees of such plans, who invest the assets under the terms of investment guidelines agreed to with the Company. The contracts contain a guarantee of a minimum rate of return on participant balances supported by the underlying assets, and a guarantee of liquidity to meet certain participant-initiated plan cash flow requirements. These contracts are accounted for as derivatives, recorded at fair value and classified as interest rate derivatives.

Embedded Derivatives

The Company has certain embedded derivatives which are required to be separated from their host contracts and reported as derivatives. Host contracts include reinsurance treaties structured on a modified coinsurance (“modco”) or funds withheld basis. Changes in fair values of embedded derivatives on modco or funds withheld treaties are net of an increase (decrease) in investment related gains, net of $(6.2) million and $25.4 million for the three months and $(63.4) million and $1.1 million for the nine months ended September 30, 2012 and 2011, respectively, associated with the Company's own credit risk. Changes in fair values of embedded derivatives on variable annuity contracts are net of an increase (decrease) in investment related gains (losses), net of $(28.3) million and $23.2 million for the three and nine months ended September 30, 2012, respectively, associated with the Company's own credit risk. Additionally, the Company reinsures equity-indexed annuity and variable annuity contracts with benefits that are considered embedded derivatives, including guaranteed minimum withdrawal benefits, guaranteed minimum accumulation benefits, and guaranteed minimum income benefits. The related gains (losses) and the effect on net income after amortization of deferred acquisition costs (“DAC”) and income taxes for the three months ended September 30, 2012 and 2011 are reflected in the following table (dollars in thousands):

  Three months ended Nine months ended
  September 30, September 30,
  2012 2011 2012 2011
Embedded derivatives in modco or funds withheld arrangements included           
 in investment related gains$ 54,836 $ (102,574) $ 40,955 $ (1,514)
After the associated amortization of DAC and taxes, the related amounts included in net income  11,228   (22,403)   10,563   568
             
Embedded derivatives in variable annuity contracts included in investment related gains  2,579   (260,239)   74,025   (253,445)
After the associated amortization of DAC and taxes, the related amounts included in net income  1,588   (25,263)   494   (23,876)
Amounts related to embedded derivatives in equity-indexed annuities included           
 in benefits and expenses  (33,821)   14,360   (26,422)   (58,987)
After the associated amortization of DAC and taxes, the related amounts included in net income  (22,529)   23,002   6,465   (26,840)

Non-hedging Derivatives         
            
A summary of the effect of non-hedging derivatives, including embedded derivatives, on the Company’s income statement for the three and nine months ended September 30, 2012 and 2011 is as follows (dollars in thousands):
            
       Gain (Loss) for the Three Months Ended
       September 30,
Type of Non-hedging Derivative Income Statement Location of Gain (Loss) 2012 2011
Interest rate swaps Investment related gains (losses), net $ (1,437) $ 142,907
Financial futures Investment related gains (losses), net   (3,977)   36,217
Foreign currency forwards Investment related gains (losses), net   519   1,374
CPI swaps Investment related gains (losses), net   422   (219)
Credit default swaps Investment related gains (losses), net   7,817   (10,018)
Equity options Investment related gains (losses), net   (23,916)   30,530
Embedded derivatives in:         
 Modified coinsurance or funds withheld        
  arrangements Investment related gains (losses), net   54,836   (102,574)
 Indexed annuity products Policy acquisition costs and other insurance      
     expenses   (224)   (3,172)
 Indexed annuity products Interest credited   (33,597)   17,531
 Variable annuity products Investment related gains (losses), net   2,579   (260,239)
Total non-hedging derivatives    $ 3,022 $ (147,663)
            
       Gain (Loss) for the Nine Months Ended
       September 30,
Type of Non-hedging Derivative Income Statement Location of Gain (Loss) 2012 2011
Interest rate swaps Investment related gains (losses), net $ 24,553 $ 157,520
Financial futures Investment related gains (losses), net   (10,312)   21,920
Foreign currency forwards Investment related gains (losses), net   (574)   1,114
CPI swaps Investment related gains (losses), net   (1,811)   1,096
Credit default swaps Investment related gains (losses), net   14,835   (8,138)
Equity options Investment related gains (losses), net   (58,532)   29,880
Embedded derivatives in:         
 Modified coinsurance or funds withheld        
  arrangements Investment related gains (losses), net   40,955   (1,514)
 Indexed annuity products Policy acquisition costs and other insurance      
     expenses   (363)   8,947
 Indexed annuity products Interest credited   (26,059)   (67,935)
 Variable annuity products Investment related gains (losses), net   74,025   (253,445)
Total non-hedging derivatives    $ 56,717 $ (110,555)

Credit Risk

The Company manages its credit risk related to over-the-counter derivatives by entering into transactions with creditworthy counterparties, maintaining collateral arrangements and through the use of master agreements that provide for a single net payment to be made by one counterparty to another at each due date and upon termination. As exchange-traded futures are affected through regulated exchanges, and positions are marked to market on a daily basis, the Company has minimal exposure to credit-related losses in the event of nonperformance by counterparties.

The Company enters into various collateral arrangements, which require both the posting and accepting of collateral in connection with its derivative instruments. Collateral agreements contain attachment thresholds that may vary depending on the posting party's ratings. Additionally, a decline in the Company's or the counterparty's credit ratings to specified levels could result in potential settlement of the derivative positions under the Company's agreements with its counterparties. The Company also has exchange-traded futures, which require the maintenance of a margin account.

The Company's credit exposure related to derivative contracts is generally limited to the fair value at the reporting date plus or minus any collateral posted or held by the Company. Information regarding the Company's credit exposure related to its over-the-counter derivative contracts and margin account for exchange-traded futures at September 30, 2012 and December 31, 2011 are reflected in the following table (dollars in thousands):

   September 30, 2012 December 31, 2011  
Estimated fair value of derivatives in net asset position$ 179,206 $ 227,399  
 Securities pledged to counterparties as collateral(1)  35,093   27,052  
 Cash pledged from counterparties as collateral(2)  (178,584)   (241,480)  
 Securities pledged from counterparties as collateral(3)  (25,049)   (997)  
Net credit exposure$ 10,666 $ 11,974  
          
Margin account related to exchange-traded futures(4)$ 5,376 $ 18,153  
          
(1)Consists of U.S. Treasury securities, included in other invested assets.     
(2)Included in cash and cash equivalents, with obligation to return cash collateral recorded in other liabilities.  
(3)Consists of U.S. Treasury securities.     
(4)Included in cash and cash equivalents.