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Derivative Financial Instruments
 12 Months Ended
Dec. 31, 2014
Derivative Financial Instruments [Abstract]  
Derivative Financial Instruments

11. DERIVATIVE FINANCIAL INSTRUMENTS

The Company uses derivative financial instruments to mitigate business risks including interest rate risk exposure. The Company has the following derivatives on its consolidated balance sheets: interest rate swaps, index-based guarantees and S&P 500 Index options.

Interest Rate Swaps

In 2014, the Company began the use of interest rate swaps to reduce risks from changes in interest rates, to manage interest rate exposures arising from asset and liability mismatches, and to protect the value of investments held on the consolidated balance sheets. The interest rate swaps used by the Company are designed to qualify for hedge accounting. Therefore, recognized changes in the fair value of the interest rate swaps and the changes in fair value of the hedged items attributable to the hedged risk, are offset in net capital gains and losses. Valuations for interest rate swaps are sensitive to changes in the interest rate environment.

Interest income, interest expense and fees related to interest rate swaps are recorded as a component of net investment income.

Interest rate swaps are recognized as either other invested assets or other liabilities in the consolidated balance sheets and are reported at fair value. To qualify for hedge accounting, the Company formally documents the risk management objective and strategy for undertaking the hedging transaction and the designation of the hedge as either a fair value hedge or a cash flow hedge at the inception of the hedging transaction. Included in this documentation is how the interest rate swap is expected to hedge the designated risk related to specific assets or liabilities on the balance sheet as well as a description of the method that will be used to retrospectively and prospectively assess the hedge effectiveness, the method that will be used to measure ineffectiveness and how this ineffectiveness will be recorded.

A derivative instrument designated as part of a hedging relationship must be assessed as being highly effective in offsetting the designated risk of the hedged item. Hedge effectiveness is formally assessed at inception and periodically throughout the life of the designated hedging relationship, using qualitative and quantitative methods. Qualitative methods include comparison of critical terms of the derivative to the hedged item. Quantitative methods include regression or other statistical analysis of changes in the fair value or cash flows associated with the hedge relationship.

In the event a hedged item is disposed, the Company will terminate the related interest rate swap and recognize the gain or loss on termination in the consolidated statements of income.

Cash settlement activity of derivative contracts is reported in the consolidated statements of cash flows as a component of proceeds from or acquisition of other invested assets.

Index-based Interest Guarantees

The Company sells indexed annuities, which permit the holder to elect a fixed interest rate return or an indexed return, where interest credited to the contracts is based on the performance of the S&P 500 Index, subject to an upper limit or cap and minimum guarantees. The index-based interest guarantees do not qualify for hedge accounting. Policyholders may elect to rebalance between interest crediting options at renewal dates annually. At each renewal date, the Company has the opportunity to re-price the indexed component by changing the cap, subject to minimum guarantees. The Company estimates the fair value of the index-based interest guarantees for the current period and for all future reset periods until contract maturity. Changes in the fair value of the index-based interest guarantees are recorded to interest credited. The liability represents an estimate of the cost of the options to be purchased in the future to manage the risk related to the index-based interest guarantees. The liability for index-based interest guarantees is the present value of future cash flows attributable to the projected index growth that is in excess of cash flows attributable to fixed interest rates guarantees. The excess cash flows are discounted back to the date of the balance sheet using current market indicators for future interest rates and option costs. Cash flows depend on actuarial estimates for policyholder lapse behavior and management’s discretion in setting renewal index-based interest guarantees.

S&P 500 Index Options

The Company purchases S&P 500 Index options for its interest crediting strategy used in its indexed annuity product. The S&P 500 Index options do not qualify for hedge accounting. The S&P 500 Index options are purchased from investment banks and are selected in a manner that supports the amount of interest that is expected to be credited in the current year to annuity policyholder accounts that are dependent on the performance of the S&P 500 Index. The purchase of S&P 500 Index options is a pivotal part of the Company’s risk management strategy for indexed annuity products. The S&P 500 Index options are exclusively used for risk management. While valuations of the S&P 500 Index options are sensitive to a number of variables, valuations for S&P 500 Index options purchased are most sensitive to changes in the S&P 500 Index value and the implied volatilities of this index. Changes in the fair value of the S&P 500 Index options are recorded to net investment income. The Company generally purchases two S&P 500 Index option contracts per month, which have expiry dates of one year from the date of purchase.

Option premiums paid for the Company’s index option contracts were $9.3 million and $9.4 million for 2014 and 2013, respectively. The Company received $20.1 million and $19.3 million for options exercised in 2014 and 2013, respectively.

The following table sets forth the fair value of the Company’s derivative assets and liabilities:

December 31,
20142013
Notional FairNotional Fair
(In millions)AmountValueAmountValue
Qualifying Fair Value Hedging Instruments
Liabilities:
Other liabilities:
Interest rate swaps$ 350.0 $ 4.7 $ --- $ ---
Non-Qualifying Hedging Instruments
Assets:
Other invested assets
S&P 500 Index options 418.2 13.6 350.5 15.8
Liabilities:
Other policyholder funds:
Index-based interest guarantees --- (1) 77.0 --- (1) 67.6

(1) The underlying factors for index-based guarantees vary by contract and other criteria, such as floors and ceilings on rates and future payouts.

The following table sets forth the gross amounts of derivative instruments recorded on the consolidated balance sheets and the collateral pledged related to the derivative instruments:

December 31,
(In millions)20142013
Offsetting of Interest Rate Swaps
Interest rate swaps, liabilities$(5.1)$---
Interest rate swaps, assets0.4 ---
Net interest rate swaps(4.7)---
Accrued interest payable(2.2)---
Collateral pledged12.2 ---
Net amount$5.3 $---

The following table sets forth the amount of gains or losses recognized in the consolidated statements of income from the change in fair value of the Company’s derivative assets and liabilities:

Years ended December 31,
(In millions) 201420132012
Qualifying Fair Value Hedging Instruments
Net capital losses:
Interest rate swaps$(4.7)$---$---
Non-Qualifying Hedging Instruments
Net investment income:
S&P 500 Index options8.6 14.4 7.8
Interest credited:
Index-based interest guarantees(7.2)(9.0)(6.4)
Net (losses) gains$(3.3)$5.4 $1.4

Fluctuations in the fair value of the interest rate swaps are driven by changes in the interest rate environment. Fluctuations in the fair value of the S&P 500 Index options are related to the volatility of the S&P 500 Index. Changes in fair value of the index-based interest guarantees are sensitive to a number of variables, but are most sensitive to changes in the interest rate environment.

As a result of the Company’s annual update of the key assumptions used to value index-based interest guarantees, a process known as “unlocking,” interest credited decreased $4.0 million and $4.1 million for 2014 and 2013, respectively.

The ineffective portion of derivatives accounted for using hedge accounting was not material to the results of operations of the Company for 2014 and 2013 and 2012.

Counterparty Credit Risk

Interest rate swaps

As the Company uses a central counterparty (“CCP”) to clear all of its interest rate swaps, the Company is only exposed to the default of the CCP. Transactions with the CCP require the Company to pledge initial and variation margin collateral. At December 31, 2014, the Company pledged $12.2 million of cash and cash equivalents on its consolidated balance sheets as collateral to the CCP.

S&P 500 Index options

The Company is exposed to the credit worthiness of the institutions from which it purchases its S&P 500 Index options and these institutions’ continued abilities to perform according to the terms of the contracts. The current values for the credit exposure have been affected by fluctuations in the S&P 500 Index. The Company’s maximum credit exposure would require an increase of 4.5% in the value of the S&P 500 Index. The maximum credit risk is calculated using the cap strike price of the Company’s S&P 500 Index options less the floor price, multiplied by the notional amount of the S&P 500 Index options.

The following table sets forth the fair value of the Company’s S&P 500 Index options and its maximum credit risk exposure related to these instruments:

December 31, 2014
Assets atMaximum
(In millions)Fair ValueCredit Risk
Counterparty:
The Bank of New York Mellon$4.5 $5.4
Goldman Sachs3.5 4.4
Merrill Lynch International5.6 9.3
Total$13.6 $19.1