21. DERIVATIVE FINANCIAL INSTRUMENTS

Types of Derivative Instruments and Derivative Strategies

The Company utilizes a risk management strategy that incorporates the use of derivative financial instruments to reduce exposure to certain risks, including but not limited to, interest rate risk, inflation risk, currency exchange risk, volatility risk, and equity market risk. These strategies are developed through the Company's analysis of data from financial simulation models and other internal and industry sources, and are then incorporated into the Company's risk management program.

Derivative instruments expose the Company to credit and market risk and could result in material changes from period to period. The Company attempts to minimize its credit risk by entering into transactions with highly rated counterparties. The Company manages the market risk by establishing and monitoring limits as to the types and degrees of risk that may be undertaken. The Company monitors its use of derivatives in connection with its overall asset/liability management programs and risk management strategies. In addition, all derivative programs are monitored by our risk management department.

Derivatives Related to Interest Rate Risk Management

Derivative instruments that are used as part of the Company's interest rate risk management strategy include interest rate swaps, interest rate futures, interest rate caps, and interest rate swaptions. The Company's inflation risk management strategy involves the use of swaps that requires the Company to pay a fixed rate and receive a floating rate that is based on changes in the Consumer Price Index ("CPI").

Derivatives Related to Risk Mitigation of Variable Annuity Contracts

The Company may use the following types of derivative contracts to mitigate its exposure to certain guaranteed benefits related to variable annuity contracts:

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Foreign Currency Futures

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Variance Swaps

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Interest Rate Futures

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Equity Options

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Equity Futures

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Credit Derivatives

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Interest Rate Swaps

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Interest Rate Swaptions

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Volatility Futures

The Company has in certain periods, sold credit protection under single name credit default swaps and credit default swap indices for which it receives a premium to insure credit risk. Such credit derivatives are a part of the Company's program to mitigate risks related to certain minimum guaranteed benefits of variable annuity contracts and are designed to offset some portion of the Company's nonperformance risk. The Company will only make a payment in the event there is a credit event. A credit event payment will typically be equal to the notional value of the swap contract less an auction-determined recovery rate, to the percentage extent described. A credit event is generally defined to include material default, bankruptcy, or debt restructuring. The Company's maximum amount at risk, assuming the value of all referenced credit obligations is zero, would equal the notional value of the credit default swaps. As of December 31, 2012 and 2011, the Company did not have any open credit default swaps.

Accounting for Derivative Instruments

The Company records its derivative financial instruments in the consolidated balance sheet in "other long-term investments" and "other liabilities" in accordance with GAAP, which requires that all derivative instruments be recognized in the balance sheet at fair value. The change in the fair value of derivative financial instruments is reported either in the statement of income or in other comprehensive income (loss), depending upon whether it qualified for and also has been properly identified as being part of a hedging relationship, and also on the type of hedging relationship that exists.

For a derivative financial instrument to be accounted for as an accounting hedge, it must be identified and documented as such on the date of designation. For cash flow hedges, the effective portion of their realized gain or loss is reported as a component of other comprehensive income and reclassified into earnings in the same period during which the hedged item impacts earnings. Any remaining gain or loss, the ineffective portion, is recognized in current earnings. For fair value hedge derivatives, their gain or loss as well as the offsetting loss or gain attributable to the hedged risk of the hedged item is recognized in current earnings. Effectiveness of the Company's hedge relationships is assessed on a quarterly basis.

The Company reports changes in fair values of derivatives that are not part of a qualifying hedge relationship through earnings in the period of change. Changes in the fair value of derivatives that are recognized in current earnings are reported in "Realized investment gains (losses)—Derivative financial instruments".

Derivative Instruments Designated and Qualifying as Hedging Instruments

Cash-Flow Hedges

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In connection with the issuance of inflation-adjusted funding agreements, the Company has entered into swaps to essentially convert the floating CPI-linked interest rate on these agreements to a fixed rate. The Company pays a fixed rate on the swap and receives a floating rate primarily determined by the period's change in the CPI. The amounts that are received on the swaps are almost equal to the amounts that are paid on the agreements.

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The Company has entered into an interest rate swap to convert LIBOR-based floating rate interest payments on a certain funding agreement to fixed rate interest payments. This structure is basically the same as that described regarding the CPI-based agreements and swaps. As of December 31, 2012, the Company no longer held these positions.

Derivative Instruments Not Designated and Not Qualifying as Hedging Instruments

The Company uses various other derivative instruments for risk management purposes that do not qualify for hedge accounting treatment. Changes in the fair value of these derivatives are recognized in earnings during the period of change.

Derivatives related to variable annuity contracts

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The Company uses equity, interest rate, currency, and volatility futures to mitigate the risk related to certain guaranteed minimum benefits, including GMWB, within our variable annuity products. In general, the cost of such benefits varies with the level of equity and interest rate markets, foreign currency levels, and overall volatility. The equity futures resulted in net pre-tax losses of $50.8 million and $30.1 million and interest rate futures resulted in pre-tax gains of $21.1 million and $164.2 million for the year ended December 31, 2012 and 2011, respectively. Currency futures resulted in net pre-tax losses of $2.8 million and net pre-tax gains of $3.0 million, for the year ended December 31, 2012 and 2011, respectively. Volatility futures resulted in pre-tax losses of $0.1 million for the year ended December 31, 2012. Such positions were not held during the year ended December 31, 2011.

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The Company uses equity options and volatility swaps to mitigate the risk related to certain guaranteed minimum benefits, including GMWB, within our variable annuity products. In general, the cost of such benefits varies with the level of equity markets and overall volatility. The equity options resulted in net pre-tax losses of $37.4 million and $15.1 million and the volatility swaps resulted in net pre-tax losses of $11.8 million and $0.2 million for the year ended December 31, 2012 and 2011, respectively.

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The Company uses interest rate swaps and interest rate swaptions to mitigate the risk related to certain guaranteed minimum benefits, including GMWB, within its variable annuity products. The interest rate swaps resulted in net pre-tax gains of $3.3 million and $7.7 million for the year ended December 31, 2012 and 2011, respectively. The interest rate swaptions resulted in net pre-tax losses of $2.3 million for the year ended December 31, 2012. Such positions were not held during the year ended December 31, 2011.

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The Company entered into credit default swaps to partially mitigate the Company's non-performance risk related to certain guaranteed minimum withdrawal benefits within its variable annuity products. The Company reported net pre-tax losses of $7.9 million for the year ended December 31, 2011. Net settlements received were $2.5 million, offset by termination losses of $10.4 million. As of December 31, 2011, the Company did not hold any remaining credit default swaps. Such positions were not held during the year ended December 31, 2012.

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The Company markets certain variable annuity products with a GMWB rider. The GMWB component is considered an embedded derivative, not considered to be clearly and closely related to the host contract. The Company recognized pre-tax losses of $22.1 million and $127.5 million for the year ended December 31, 2012 and 2011, respectively, related to these embedded derivatives.

Other Derivatives

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The Company previously entered into credit default swaps to enhance the return on its investment portfolio. The Company reported net pre-tax losses of $0.5 million for the year ended December 31, 2011 related to their change in fair value and premium income earned. As of December 31, 2012 and 2011, no credit default swaps were outstanding.

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The Company uses certain interest rate swaps to mitigate the price volatility of fixed maturities. The Company recognized pre-tax losses of $0.1 million and $11.3 million on interest rate swaps for the year ended December 31, 2012 and 2011, respectively.

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The Company purchased interest rate caps during 2011 to mitigate its risk with respect to the Company's LIBOR exposure and the potential impact of European financial market distress. These caps resulted in net pre-tax losses of $2.7 million and $2.8 million for the year ended December 31, 2012 and 2011, respectively.

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The Company uses various swaps and other types of derivatives to manage risk related to other exposures. The Company recognized pre-tax losses of $0.1 million and $0.5 million for the year ended December 31, 2012 and 2011, respectively.

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The Company is involved in various modified coinsurance and funds withheld arrangements which contain embedded derivatives. Changes in their fair value are recorded in current period earnings. The investment portfolios that support the related modified coinsurance reserves and funds withheld arrangements had fair value changes which substantially offset the gains or losses on these embedded derivatives. The Company recognized pre-tax losses of $132.8 million and $134.3 million for the year ended December 31, 2012 and 2011, respectively.

The tables below present information about the nature and accounting treatment of the Company's primary derivative financial instruments and the location in and effect on the consolidated financial statements for the periods presented below:

	As of December 31,

	2012				2011
	Notional Amount		Fair Value		Notional Amount		Fair Value
	(Dollars In Thousands)
Other long-term investments
Cash flow hedges:
Inflation	$	—	$	—	$	7,068	$	1
Derivatives not designated as hedging instruments:
Interest rate swaps		355,000		6,532		125,000		5,118
Volatility swaps		500		406		—		—
Embedded derivative—Modco reinsurance treaties		30,244		1,330		30,001		2,038
Embedded derivative—GMWB		1,640,075		30,261		826,790		10,665
Interest rate futures		—		—		615,445		6,393
Equity futures		147,581		595		49,631		837
Currency futures		15,944		784		57,912		976
Interest rate caps		3,000,000		—		3,000,000		2,666
Equity options		573,493		61,833		440,000		19,396
Interest rate swaptions		400,000		11,370		—		—
Other		224		253		224		155

	$	6,163,061	$	113,364	$	5,152,071	$	48,245

Other liabilities
Cash flow hedges:
Inflation	$	182,965	$	5,027	$	244,399	$	8,863
Interest rate		—		—		75,000		3,443
Derivatives not designated as hedging instruments:
Interest rate swaps		400,000		10,025		25,000		3,064
Volatility swaps		2,675		12,198		—		—
Embedded derivative—Modco reinsurance treaties		2,655,134		411,907		2,761,686		279,799
Embedded derivative—GMWB		5,253,961		199,530		3,741,688		157,813
Interest rate futures		893,476		13,970		270,019		1,148
Equity futures		152,364		3,316		189,765		1,454
Currency futures		131,979		1,901		14,348		126

	$	9,672,554	$	657,874	$	7,321,905	$	455,710

Gain (Loss) on Derivatives in Cash Flow Relationship

	For The Year Ended December 31, 2012									For The Year Ended December 31, 2011

	Realized investment gains (losses)			Benefits and settlement expenses			Other comprehensive income (loss)			Realized investment gains (losses)			Benefits and settlement expenses			Other comprehensive income (loss)
	(Dollars In Thousands)
Gain (loss) recognized in other comprehensive income (loss) (effective portion):
Interest rate	$	—		$	—		$	(77	)	$	—		$	—		$	(272	)
Inflation		—			—			3,067			—			—			2,468
Gain (loss) reclassified from accumulated other comprehensive income (loss) into income (effective portion):
Interest rate	$	—		$	(2,261	)	$	—		$	—		$	(3,581	)	$	—
Inflation		—			(938	)		—			—			(276	)		—
Gain (loss) recognized in income (ineffective portion):
Inflation	$	(177	)	$	—		$	—		$	(359	)	$	—		$	—

Based on the expected cash flows of the underlying hedged items, the Company expects to reclassify $1.7 million out of accumulated other comprehensive income (loss) into earnings during the next twelve months.

Realized investment gains (losses)—derivative financial instruments

	For The Year Ended December 31,

	2012			2011			2010
	(Dollars In Thousands)
Derivatives related to variable annuity contracts:
Interest rate futures—VA	$	21,138		$	164,221		$	(11,778	)
Equity futures—VA		(50,797	)		(30,061	)		(42,258	)
Currency futures—VA		(2,763	)		2,977			—
Volatility futures—VA		(132	)		—			—
Volatility swaps—VA		(11,792	)		(239	)		(2,433	)
Equity options—VA		(37,370	)		(15,051	)		(1,824	)
Interest rate swaptions—VA		(2,260	)		—			—
Interest rate swaps—VA		3,264			7,718			—
Credit default swaps—VA		—			(7,851	)		—
Embedded derivative—GMWB		(22,120	)		(127,537	)		(5,728	)

Total derivatives related to variable annuity contracts		(102,832	)		(5,823	)		(64,021	)
Embedded derivative—Modco reinsurance treaties		(132,816	)		(134,340	)		(67,989	)
Interest rate swaps		(87	)		(11,264	)		(8,427	)
Interest rate caps		(2,666	)		(2,801	)		—
Credit default swaps		—			(548	)		1,389
Other derivatives		(79	)		(475	)		799

Total realized gains (losses)—derivatives	$	(238,480	)	$	(155,251	)	$	(138,249	)

From time to time, the Company is required to post and obligated to return collateral related to derivative transactions. As of December 31, 2012, the Company had posted cash and securities (at fair value) as collateral of approximately $34.8 million and $54.9 million, respectively. As of December 31, 2012, the Company received $11.6 million of cash as collateral. The Company does not net the collateral posted or received with the fair value of the derivative financial instruments for reporting purposes.

Realized investment gains (losses)—all other investments

	For The Year Ended December 31,

	2012		2011		2010
	(Dollars In Thousands)
Modco trading portfolio⁽¹⁾	$	177,986	$	164,224	$	109,399

⁽¹⁾: The Company elected to include the use of alternate disclosures for trading activities.