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Derivative Instruments
 3 Months Ended
Mar. 31, 2013
Derivative Instruments [Abstract]  
Derivative Instruments

5. Derivative Instruments

Derivatives, except embedded derivatives, are carried on the Company's condensed consolidated balance sheets in other invested assets or other liabilities, at fair value. Embedded derivative liabilities on modified coinsurance or funds withheld arrangements are included on the condensed consolidated balance sheets with the host contract in funds withheld at interest, at fair value. Embedded derivative liabilities on indexed annuity and variable annuity products are included on the condensed consolidated balance sheets with the host contract in interest-sensitive contract liabilities, at fair value. Embedded derivative assets are included on the condensed consolidated balance sheets in reinsurance ceded receivables. The following table presents the notional amounts and fair value of derivative instruments as of March 31, 2013 and December 31, 2012 (dollars in thousands):

     March 31, 2013  December 31, 2012
      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$ 1,566,403 $ 99,860 $ 15,642  $ 2,195,059 $ 123,085 $ 17,867
 Interest rate options  240,000   16,054   --    --   --   --
 Financial futures  113,046   --   --    127,877   --   --
 Foreign currency forwards  70,000   --   7,014    74,400   1,017   2,105
 Consumer price index swaps  85,332   945   --    85,135   1,446   --
 Credit default swaps  716,700   2,160   5,431    714,000   2,228   5,922
 Equity options  812,494   54,791   --    696,776   62,514   --
 Synthetic guaranteed investment contracts  3,185,035   --   --    2,018,073   --   --
 Embedded derivatives in:                  
  Modified coinsurance or funds                  
   withheld arrangements  --   --   156,189    --   --   243,177
  Indexed annuity products  --   --   769,685    --   --   740,256
  Variable annuity products  --   --   120,791    --   --   172,105
 Total non-hedging derivatives  6,789,010   173,810   1,074,752    5,911,320   190,290   1,181,432
                       
Derivatives designated as                  
 hedging instruments:                  
 Interest rate swaps  55,098   254   2,273    57,275   344   786
 Foreign currency swaps  632,921   1,172   11,719    629,512   --   27,398
 Total hedging derivatives  688,019   1,426   13,992    686,787   344   28,184
Total derivatives$ 7,477,029 $ 175,236 $ 1,088,744  $ 6,598,107 $ 190,634 $ 1,209,616

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 March 31, 2013 and December 31, 2012, the Company held interest rate swaps that were designated and qualified as cash flow hedges of interest rate risk. As of March 31, 2013 and December 31, 2012, 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 March 31, 2013 and December 31, 2012, 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 2012 Annual 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.

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 months ended March 31, 2013 and 2012 (dollars in thousands):

 Three months ended March 31,
 2013 2012
Accumulated other comprehensive income (loss), balance beginning of period$ 403 $ (828)
Gains (losses) deferred in other comprehensive income (loss) on the effective portion of cash flow hedges   1,863   323
Amounts reclassified to investment income  (305)   (357)
Accumulated other comprehensive income (loss), balance end of period$ 1,961 $ (862)

As of March 31, 2013, 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 months ended March 31, 2013 and 2012.

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 months ended March 31, 2013 and 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 March 31, 2013:               
Interest rate swaps $ 1,863 $ -- $ 305 $ (17) $ --
                
For the three months ended March 31, 2012:               
Interest rate swaps $ 323 $ -- $ 357 $ (24) $ --

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 months ended March 31, 2013 and 2012 (dollars in thousands):

   Derivative Gains (Losses) Deferred in AOCI   
   For the three months ended March 31,   
Type of NIFO Hedge (1) (2) 2013 2012   
           
Foreign currency swaps $ 10,922 $ (10,645)   
           
(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 loss recorded in AOCI related to these hedges was $5.5 million and $16.4 million at March 31, 2013 and December 31, 2012, 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 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 March 31, 2013 and 2012, the Company recognized investment related losses of $60.4 million and $93.3 million, respectively, related to derivatives (not including embedded derivatives) that do not qualify or have not been qualified for hedge accounting.

A summary of the effect of non-hedging derivatives, including embedded derivatives, on the Company’s income statement for the three months ended March 31, 2013 and 2012 is as follows (dollars in thousands):
            
       Gain (Loss) for the Three Months Ended
       March 31,
Type of Non-hedging Derivative Income Statement Location of Gain (Loss) 2013 2012
Interest rate swaps Investment related gains (losses), net $ (22,265) $ (47,352)
Interest rate options Investment related gains (losses), net   1,982   --
Financial futures Investment related gains (losses), net   (6,881)   (17,409)
Foreign currency forwards Investment related gains (losses), net   (5,659)   (1,608)
CPI swaps Investment related gains (losses), net   (871)   (802)
Credit default swaps Investment related gains (losses), net   3,904   11,813
Equity options Investment related gains (losses), net   (30,623)   (37,983)
Embedded derivatives in:         
 Modco or funds withheld arrangementsInvestment related gains (losses), net   90,257   (9,428)
 Indexed annuity products Policy acquisition costs and other insurance      
     expenses   --   (998)
 Indexed annuity products Interest credited   (32,996)   (18,741)
 Variable annuity products Investment related gains (losses), net   51,314   146,375
Total non-hedging derivatives    $ 48,162 $ 23,867

Types of Derivatives Used by the Company

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.

Interest Rate Options

Interest rate options, commonly referred to as swaptions, are used by the Company primarily to hedge living benefit guarantees embedded in certain variable annuity products. A swaption, used to hedge against adverse changes in interest rates, is an option to enter into a swap with a forward starting effective date. The Company pays an upfront premium for the right to exercise this option in the future.

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 termination of the currency swap by each party.

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 following table presents the estimated fair value, maximum amount of future payments and weighted average years to maturity of credit default swaps sold by the Company at March 31, 2013 and December 31, 2012 (dollars in thousands):

   March 31, 2013  December 31, 2012
Rating Agency Designation of Referenced Credit Obligations(1) Estimated Fair Value of Credit Default Swaps Maximum Amount of Future Payments under Credit Default Swaps(2) Weighted Average Years to Maturity(3) Estimated Fair Value of Credit Default Swaps Maximum Amount of Future Payments under Credit Default Swaps(2) Weighted Average Years to Maturity(3)
AAA/AA-/A+/A/A-                
Single name credit default swaps $ (1,630) $ 124,500  5.7 $ (2,077) $ 124,500  5.9
Credit default swaps referencing indices    --   --  --   --   --  --
 Subtotal   (1,630)   124,500  5.7   (2,077)   124,500  5.9
                  
BBB+/BBB/BBB-                
Single name credit default swaps   (2,030)   138,200  5.7   (2,345)   135,500  5.5
Credit default swaps referencing indices    565   430,000  4.7   937   430,000  5.0
 Subtotal   (1,465)   568,200  5.0   (1,408)   565,500  5.1
                  
BB+                
Single name credit default swaps   (110)   6,000  4.2   (222)   6,000  4.5
Credit default swaps referencing indices    --   --  --   --   --  --
 Subtotal   (110)   6,000  4.2   (222)   6,000  4.5
                  
Total $ (3,205) $ 698,700  5.1 $ (3,707) $ 696,000  5.2
                  
(1)The rating agency designations are based on ratings from Standard and Poor's ("S&P").
(2)Assumes the value of the referenced credit obligations is zero.
(3)The weighted average years to maturity of the credit default swaps is calculated based on weighted average notional amounts.

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 Guaranteed Investment Contracts

The Company sells fee-based synthetic guaranteed investment contracts 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 a decrease in investment related gains (losses), net of $1.7 million and $63.5 million for the three months ended March 31, 2013 and 2012, respectively, associated with the Company's own credit risk. Changes in fair values of embedded derivatives on variable annuity contracts are net of a decrease in investment related gains (losses), net of $11.9 million and $37.0 million for the three months ended March 31, 2013 and 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 March 31, 2013 and 2012 are reflected in the following table (dollars in thousands):

  Three months ended
  March 31,
  2013 2012
Embedded derivatives in modco or funds withheld arrangements included     
 in investment related gains$ 90,257 $ (9,428)
After the associated amortization of DAC and taxes, the related amounts included in net income  21,624   1,933
       
Embedded derivatives in variable annuity contracts included in investment related gains  51,314   146,375
After the associated amortization of DAC and taxes, the related amounts included in net income  12,192   15,082
Amounts related to embedded derivatives in equity-indexed annuities included     
 in benefits and expenses  (32,996)   (19,739)
After the associated amortization of DAC and taxes, the related amounts included in net income  (29,550)   13,870

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 March 31, 2013 and December 31, 2012 are reflected in the following table (dollars in thousands):

   March 31, 2013 December 31, 2012  
Estimated fair value of derivatives in net asset position$ 133,157 $ 136,558  
 Cash provided as collateral(1)  6,250   27,867  
 Securities pledged to counterparties as collateral(2)  14,118   1,565  
 Cash pledged from counterparties as collateral(3)  (126,329)   (136,414)  
 Securities pledged from counterparties as collateral(4)  (17,664)   (22,458)  
Net credit exposure$ 9,532 $ 7,118  
          
Margin account related to exchange-traded futures(5)$ 3,529 $ 5,605  
          
(1)Consists of receivable from counterparty, included in other assets.     
(2)Included in other invested assets, primarily consists of U.S. Treasury securities.  
(3)Included in cash and cash equivalents, with obligation to return cash collateral recorded in other liabilities.  
(4)Consists of U.S. Treasury securities.     
(5)Included in cash and cash equivalents.