17. 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 Certain 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 and fixed indexed annuities:

· Foreign Currency Futures

· Variance Swaps

· Interest Rate Futures

· Equity Options

· Equity Futures

· Credit Derivatives

· Interest Rate Swaps

· Interest Rate Swaptions

· Volatility Futures

· Volatility Options

· Total Return Swaps

Accounting for Derivative Instruments

The Company records its derivative financial instruments in the consolidated condensed 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

· In connection with the issuance of inflation-adjusted funding agreements, the Company has entered into swaps to 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 equal to the amounts that are paid on the agreements.

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

· The Company uses equity, interest rate, currency, and volatility futures to mitigate the risk related to certain guaranteed minimum benefits, including GMWB, within its VA products. In general, the cost of such benefits varies with the level of equity and interest rate markets, foreign currency levels, and overall volatility. No volatility future positions were held as of June 30, 2014.

· The Company uses equity options, variance swaps, and volatility options to mitigate the risk related to certain guaranteed minimum benefits, including GMWB, within its VA products. In general, the cost of such benefits varies with the level of equity markets and overall volatility. No volatility option positions were held as of June 30, 2014.

· The Company uses interest rate swaps and interest rate swaptions to mitigate the risk related to certain guaranteed minimum benefits, including GMWB, within its VA products.

· The Company markets certain VA 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.

Derivatives Related to Fixed Annuity Contracts

· The Company uses equity and volatility futures to mitigate the risk within its fixed indexed annuity products. In general, the cost of such benefits varies with the level of equity and overall volatility.

· The Company used equity options to mitigate the risk within its fixed indexed annuity products. In general, the cost of such benefits varies with the level of equity markets.

· The Company markets certain fixed indexed annuity products. The FIA component is considered an embedded derivative, not considered to be clearly and closely related to the host contract.

Other Derivatives

· The Company uses certain interest rate swaps to mitigate the price volatility of fixed maturities. None of these positions were held as of June 30, 2014.

· The Company purchased interest rate caps to mitigate its risk with respect to the Company’s LIBOR exposure and the potential impact of European financial market distress. None of these positions were held as of June 30, 2014.

· The Company uses various swaps and other types of derivatives to manage risk related to other exposures.

· The Company markets certain IUL products. The IUL component is considered an embedded derivative, not considered to be clearly and closely related to the host contract.

· 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 following table sets forth realized investments gains and losses for the periods shown:

Realized investment gains (losses) - derivative financial instruments

	For The						For The
	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2014			2013			2014			2013
	(Dollars In Thousands)
Derivatives related to variable annuity contracts:
Interest rate futures - VA	$	6,548		$	(7,654	)	$	10,798		$	(24,138	)
Equity futures - VA	(7,259		)	(4,036		)	(9,910		)	(27,261		)
Currency futures - VA	(2,887		)	(112		)	(4,165		)	7,971
Variance swaps - VA	(823		)	2,214			(2,673		)	(8,219		)
Equity options - VA	(20,949		)	(8,131		)	(33,290		)	(36,537		)
Interest rate swaptions - VA	(4,998		)	1,639			(14,401		)	(2,463		)
Interest rate swaps - VA	45,169			(89,722		)	102,537			(106,278		)
Embedded derivative - GMWB	(47,389		)	103,315			(129,676		)	183,690
Total derivatives related to variable annuity contracts	(32,588		)	(2,487		)	(80,780		)	(13,235		)
Derivatives related to FIA contracts:
Embedded derivative - FIA	(8,307		)	(41		)	(6,574		)	(41		)
Equity futures - FIA	605			—			950			—
Volatility futures - FIA	8			—			8			—
Equity options - FIA	2,984			(19		)	3,978			(19		)
Total derivatives related to FIA contracts	(4,710		)	(60		)	(1,638		)	(60		)
Embedded derivative - IUL	(285		)	—			(285		)	—
Embedded derivative - Modco reinsurance treaties	(52,202		)	144,998			(112,371		)	161,773
Interest rate swaps	—			1,909			—			2,912
Other derivatives	(141		)	(479		)	(202		)	(124		)
Total realized gains (losses) - derivatives	$	(89,926	)	$	143,881		$	(195,276	)	$	151,266

The following table sets forth realized investments gains and losses for Modco trading portfolio that is included in realized investment gains (losses) — all other investments.

Realized investment gains (losses) - all other investments

	For The					For The
	Three Months Ended					Six Months Ended
	June 30,					June 30,
	2014		2013			2014		2013
	(Dollars In Thousands)
Modco trading portfolio(1)	$	60,989	$	(126,694	)	$	127,292	$	(142,022	)

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

The following table presents the components of the gain or loss on derivatives that qualify as a cash flow hedging relationship.

Gain (Loss) on Derivatives in Cash Flow Relationship

				Amount and Location of
	Amount of Gains (Losses)			Gains (Losses)
	Deferred in			Reclassified from			Amount and Location of
	Accumulated Other			Accumulated Other			(Losses) Recognized in
	Comprehensive Income			Comprehensive Income			Income (Loss) on
	(Loss) on Derivatives			(Loss) into Income (Loss)			Derivatives
	(Effective Portion)			(Effective Portion)			(Ineffective Portion)
				Benefits and settlement			Realized investment
				expenses			gains (losses)
	(Dollars In Thousands)
For The Three Months Ended June 30, 2014
Inflation	$	(929	)	$	(614	)	$	(165	)
Total	$	(929	)	$	(614	)	$	(165	)

For The Six Months Ended June 30, 2014
Inflation	$	(26	)	$	(1,284	)	$	(126	)
Total	$	(26	)	$	(1,284	)	$	(126	)

Gain (Loss) on Derivatives in Cash Flow Relationship

				Amount and Location of
	Amount of Gains (Losses)			Gains (Losses)
	Deferred in			Reclassified from			Amount and Location of
	Accumulated Other			Accumulated Other			(Losses) Recognized in
	Comprehensive Income			Comprehensive Income			Income (Loss) on
	(Loss) on Derivatives			(Loss) into Income (Loss)			Derivatives
	(Effective Portion)			(Effective Portion)			(Ineffective Portion)
				Benefits and settlement			Realized investment
				expenses			gains (losses)
	(Dollars In Thousands)
For The Three Months Ended June 30, 2013
Inflation	$	(4,589	)	$	(580	)	$	(558	)
Total	$	(4,589	)	$	(580	)	$	(558	)

For The Six Months Ended June 30, 2013
Inflation	$	(180	)	$	(1,077	)	$	(190	)
Total	$	(180	)	$	(1,077	)	$	(190	)

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 condensed financial statements for the periods presented below:

	As of June 30, 2014				As of December 31, 2013
	Notional		Fair		Notional		Fair
	Amount		Value		Amount		Value
	(Dollars In Thousands)
Other long-term investments
Cash flow hedges:
Inflation	$	—	$	—	$	—	$	—
Derivatives not designated as hedging instruments:
Interest rate swaps	295,000		3,681		200,000		1,961
Embedded derivative - Modco reinsurance treaties	30,105		1,226		80,376		1,517
Embedded derivative - GMWB	5,161,813		122,075		6,113,017		194,616
Interest rate futures	283,629		1,510		—		—
Equity futures	46,915		379		3,387		111
Currency futures	—		—		14,338		321
Equity options	2,051,427		120,586		1,376,205		78,277
Interest rate swaptions	625,000		15,890		625,000		30,291
Other	592		420		425		473
	$	8,494,481	$	265,767	$	8,412,748	$	307,567
Other liabilities
Cash flow hedges:
Inflation	$	182,965	$	624	$	182,965	$	1,865
Derivatives not designated as hedging instruments:
Interest rate swaps	1,180,000		59,968		1,230,000		153,322
Variance swaps	1,100		3,782		1,500		1,744
Embedded derivative - Modco reinsurance treaties	2,591,360		318,999		2,578,590		206,918
Embedded derivative - GMWB	4,418,599		95,523		2,494,142		38,388
Embedded derivative - FIA	527,698		69,615		244,424		25,324
Embedded derivative - IUL	1,057		610		—		—
Interest rate futures	71,714		37		322,902		5,221
Equity futures	102,891		1,443		164,595		6,595
Currency futures	138,916		2,364		118,008		840
Equity options	475,155		32,726		257,065		17,558
Other	358		38		230		27
	$	9,691,813	$	585,729	$	7,594,421	$	457,802

Based on the expected cash flows of the underlying hedged items, the Company expects to reclassify $0.5 million out of accumulated other comprehensive income (loss) into earnings during the next twelve months.