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Derivative and Hedging Instruments

12 Months Ended

Dec. 31, 2020

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 2020 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 quoted prices, 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,		2020						2019
		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	$	82	$	1	$	–	$	350	$	–	$	5
	Foreign currency swaps		57		–		4		86		3		1
Cash flow hedges	Foreign currency swaps		1,756		24		468		1,790		39		407
	Equity contracts		127		6		–		132		16		–
Net investment hedges	Forward contracts		628		1		10		2,822		7		22
Total derivatives in qualifying hedge accounting relationships			2,650		32		482		5,180		65		435
Derivatives not designated in qualifying hedge accounting relationships
	Interest rate swaps		287,182		21,332		12,190		283,172		15,159		8,140
	Interest rate futures		16,750		–		–		13,069		–		–
	Interest rate options		11,622		663		–		12,248		423		–
	Foreign currency swaps		31,491		838		1,659		26,329		606		1,399
	Currency rate futures		3,467		–		–		3,387		–		–
	Forward contracts		38,853		3,833		565		33,432		2,337		273
	Equity contracts		15,738		1,092		66		14,582		853		37
	Credit default swaps		241		3		–		502		6		–
	Equity futures		10,984		–		–		10,576		–		–
Total derivatives not designated in qualifying hedge accounting relationships			416,328		27,761		14,480		397,297		19,384		9,849
Total derivatives		$	418,978	$	27,793	$	14,962	$	402,477	$	19,449	$	10,284

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 8.


	Remaining term to maturity
As at December 31, 2020	Less than 1 year		1 to 3 years		3 to 5 years		Over 5 years		Total
Derivative assets	$	1,656	$	3,524	$	1,228	$	21,385	$	27,793
Derivative liabilities		386		250		555		13,771		14,962

	Remaining term to maturity
As at December 31, 2019	Less than 1 year		1 to 3 years		3 to 5 years		Over 5 years		Total
Derivative assets	$	1,248	$	1,659	$	1,309	$	15,233	$	19,449
Derivative liabilities		332		145		218		9,589		10,284

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										Risk- weighted amount (2)
As at December 31, 2020	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	$	7,567	$	20,852	$	110,166	$	138,585	$	21,803	$	(12,816	)	$	8,987		$	8,773	$	1,181
Cleared swap contracts		2,314		18,784		127,581		148,679		432		(424	)		8			–		–
Forward contracts		11,092		18,355		1,259		30,706		3,739		(462	)		3,277			603		80
Futures		16,750		–		–		16,750		–		–			–			–		–
Options purchased		1,572		3,922		6,128		11,622		664		–			664			665		93
Subtotal		39,295		61,913		245,134		346,342		26,638		(13,702	)		12,936			10,041		1,354
Foreign exchange
Swap contracts		1,670		8,490		23,144		33,304		855		(2,195	)		(1,340	)		2,979		327
Forward contracts		8,741		34		–		8,775		95		(113	)		(18	)		160		18
Futures		3,467		–		–		3,467		–		–			–			–		–
Credit derivatives		192		49		–		241		3		–			3			–		–
Equity contracts
Swap contracts		1,227		289		–		1,516		43		(51	)		(8	)		384		46
Futures		10,984		–		–		10,984		–		–			–			–		–
Options purchased		8,168		6,181		–		14,349		1,051		(15	)		1,036			5,116		664
Subtotal including accrued interest		73,744		76,956		268,278		418,978		28,685		(16,076	)		12,609			18,680		2,409
Less accrued interest		–		–		–		–		892		(1,114	)		(222	)		–		–
Total	$	73,744	$	76,956	$	268,278	$	418,978	$	27,793	$	(14,962	)	$	12,831		$	18,680	$	2,409

	Remaining term to maturity (notional amounts)								Fair value										Risk- weighted amount (2)
As at December 31, 2019	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	$	5,105	$	22,288	$	112,863	$	140,256	$	15,627	$	(8,910	)	$	6,717		$	6,891	$	957
Cleared swap contracts		3,932		11,499		127,835		143,266		238		(240	)		(2	)		–		–
Forward contracts		11,709		15,089		1,283		28,081		2,312		(253	)		2,059			398		53
Futures		13,069		–		–		13,069		–		–			–			–		–
Options purchased		1,266		4,454		6,528		12,248		423		–			423			560		77
Subtotal		35,081		53,330		248,509		336,920		18,600		(9,403	)		9,197			7,849		1,087
Foreign exchange
Swap contracts		998		7,519		19,688		28,205		642		(1,864	)		(1,222	)		2,515		279
Forward contracts		8,173		–		–		8,173		32		(42	)		(10	)		138		16
Futures		3,387		–		–		3,387		–		–			–			–		–
Credit derivatives		275		227		–		502		6		–			6			–		–
Equity contracts
Swap contracts		1,233		164		–		1,397		43		(16	)		27			236		29
Futures		10,576		–		–		10,576		–		–			–			–		–
Options purchased		6,604		6,633		80		13,317		821		(20	)		801			3,418		448
Subtotal including accrued interest		66,327		67,873		268,277		402,477		20,144		(11,345	)		8,799			14,156		1,859
Less accrued interest		–		–		–		–		695		(1,061	)		(366	)		–		–
Total	$	66,327	$	67,873	$	268,277	$	402,477	$	19,449	$	(10,284	)	$	9,165		$	14,156	$	1,859

(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 $419 billion (2019 – $402 billion) includes $183 billion (2019 – $128 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, 2020	Fair value		Level 1		Level 2		Level 3
Derivative assets
Interest rate contracts	$	25,735	$	–	$	21,902	$	3,833
Foreign exchange contracts		957		–		957		–
Equity contracts		1,098		–		1,051		47
Credit default swaps		3		–		3		–
Total derivative assets	$	27,793	$	–	$	23,913	$	3,880
Derivative liabilities
Interest rate contracts	$	12,652	$	–	$	12,271	$	381
Foreign exchange contracts		2,244		–		2,239		5
Equity contracts		66		–		15		51
Total derivative liabilities	$	14,962	$	–	$	14,525	$	437

As at December 31, 2019	Fair value		Level 1		Level 2		Level 3
Derivative assets
Interest rate contracts	$	17,894	$	–	$	15,801	$	2,093
Foreign exchange contracts		680		–		680		–
Equity contracts		869		–		821		48
Credit default swaps		6		–		6		–
Total derivative assets	$	19,449	$	–	$	17,308	$	2,141
Derivative liabilities
Interest rate contracts	$	8,397	$	–	$	7,730	$	667
Foreign exchange contracts		1,850		–		1,849		1
Equity contracts		37		–		20		17
Total derivative liabilities	$	10,284	$	–	$	9,599	$	685

Level 3 roll forward information for net derivative contracts measured using significant unobservable inputs is disclosed in note 3(g).

(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, 2020	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 liabilities	$	4		$	(2	)	$	2
Foreign currency swaps	Fixed rate assets		(2	)		3			1
Total		$	2		$	1		$	3

For the year ended December 31, 2019	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 liabilities	$	8		$	(6	)	$	2
Foreign currency swaps	Fixed rate assets		(1	)		2			1
Total		$	7		$	(4	)	$	3

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, 2020	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
Foreign currency swaps	Fixed rate assets	$	1		$	–		$	–
	Floating rate liabilities		(64	)		14			–
	Fixed rate liabilities		(14	)		(2	)		–
Equity contracts	Stock-based compensation		(2	)		16			–
Total		$	(79	)	$	28		$	–

For the year ended December 31, 2019	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
Foreign currency swaps	Fixed rate assets	$	(2	)	$	1		$	–
	Floating rate liabilities		(40	)		37			–
	Fixed rate liabilities		(41	)		(35	)		–
Forward contracts	Forecasted expenses		–			(9	)		–
Equity contracts	Stock-based compensation		35			(9	)		–
Total		$	(48	)	$	(15	)	$	–

The Company anticipates that net losses of approximately $11 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 16 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, 2020	Gains (losses) deferred in AOCI			Gains (losses) reclassified from AOCI into investment income		Ineffectiveness recognized in investment income
Non-functional currency denominated debt	$	161		$	–	$	–
Forward contracts		(53	)		–		–
Total	$	108		$	–	$	–
For the year ended December 31, 2019	Gains (losses) deferred in AOCI			Gains (losses) reclassified from AOCI into investment income		Ineffectiveness recognized in investment income
Non-functional currency denominated debt	$	279		$	–	$	–
Forward contracts		80			–		–
Total	$	359		$	–	$	–

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 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,	2020			2019
Interest rate swaps	$	2,423		$	1,483
Interest rate futures		894			571
Interest rate options		291			96
Foreign currency swaps		(55	)		(242	)
Currency rate futures		(47	)		88
Forward contracts		3,785			2,815
Equity futures		(1,111	)		(2,436	)
Equity contracts		322			277
Credit default swaps		(4	)		(3	)
Total	$	6,498		$	2,649

(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, 2020, reinsurance ceded guaranteed minimum income benefits had a fair value of $1,007 (2019 – $981) and reinsurance assumed guaranteed minimum income benefits had a fair value of $112 (2019 – $109). 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, 2020, these embedded derivatives had a fair value of $(229) (2019 – $(137)).

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.