Derivative Financial Instruments

9 Months Ended

Sep. 30, 2011

Derivative Financial Instruments

Derivative Financial Instruments

5.  Derivative Financial Instruments

The Company uses derivative financial instruments for risk management purposes associated with certain invested assets and policy liabilities.  Derivatives are not used for speculative purposes.  As detailed below, derivatives are used to (a) hedge the economic effects of interest rate and stock market movements on the Company’s guaranteed minimum withdrawal benefit, also referred to as guaranteed lifetime withdrawal benefit, (“GMWB”) liabilities, (b) hedge the economic effect of a large increase in interest rates on the Company’s general account life insurance, group pension liabilities and separate account life insurance liabilities, (c) hedge the economic risks of other transactions such as future asset acquisitions or dispositions, the timing of liability pricing, currency risks on non-US dollar denominated assets, and fee revenue based on equity market performance, and (d) convert floating rate assets to fixed rate assets for asset/liability management purposes.

Derivative transactions are entered into pursuant to master agreements that provide for a single net payment to be made by one party to the other on a daily basis, periodic payment dates, or at the due date, expiration or termination of the agreement.

The Company controls the credit risk of its derivative contracts through credit approvals, limits, monitoring procedures, and in many cases, requiring collateral.  The Company’s exposure is limited to the portion of the fair value of derivative instruments that exceeds the value of the collateral held and not to the notional or contractual amounts of the derivatives.  The Company incorporates the market’s perception of its own and the counterparty’s non-performance risk through review of credit spreads in determining the fair value of the portion of its over-the-counter (“OTC”) derivative assets and liabilities that are uncollateralized.  Fair values were adjusted accordingly based on an internal carry value adjustment model at September 30, 2011 and December 31, 2010.  No losses have been incurred due to non-performance by any of the counterparties.

Collateral agreements are regularly entered into as part of the underlying agreements with counterparties to mitigate counterparty credit risk.  Certain of these arrangements require collateral when the fair value exceeds certain thresholds and also include credit contingent provisions that provide for a reduction of these thresholds in the event of downgrade in the credit ratings of the Company and/or the counterparty.

At September 30, 2011 and December 31, 2010, the Company was not obligated to pledge unrestricted cash collateral to any counterparty in the normal course of business.  The Company received $4,165 and $7,790 of unrestricted cash collateral from derivative counterparties to satisfy collateral netting agreements at September 30, 2011 and December 31, 2010, respectively.

Cash collateral received is included in other assets and the obligation to return is included in other liabilities.  The cash collateral is reinvested in a government money market fund.

Cash flow hedges - Interest rate swap agreements are used to convert the interest rate on certain debt securities from a floating rate to a fixed rate.  Foreign currency exchange contracts are used to manage the foreign exchange rate risk associated with bonds denominated in other than U.S. dollars.  Interest rate futures are used to manage the interest rate risks of forecasted acquisitions of fixed rate maturity investments.  These derivatives are primarily structured to hedge interest rate risk inherent in the assumptions used to price certain liabilities.  The Company’s derivatives treated as cash flow hedges are eligible for hedge accounting.

At September 30, 2011, the Company estimates that $7,971 of net derivative gains included in accumulated other comprehensive income (loss) will be reclassified into net income within the next twelve months.

Fair value hedges - Interest rate futures are used to manage the risk of the change in the fair value of certain fixed rate maturity investments.  The Company’s derivatives treated as fair value hedges are eligible for hedge accounting.

Derivatives not designated as hedging instruments

GMWB Derivative Instruments - The Company introduced a variable annuity product with a GMWB during 2010.  This product utilizes an investment risk hedging program including purchases of the following derivative instruments: exchange-traded interest rate swap futures and exchange-traded equity index futures on certain indices.  The Company anticipates adding OTC interest rate swaps as the product sales volume grows.  While these derivatives are economic hedges and used to manage risk, the Company will not elect hedge accounting on these transactions.  Although the hedge program is actively managed, it may not exactly offset changes in the GMWB liability due to, among other things, divergence between the performance of the underlying investments and the hedge instruments, high levels of volatility in the equity and interest rate markets and differences between actual contractholder behavior and what is assumed.  The performance of the underlying investments compared to the hedge instruments is further impacted by a time lag, since the data is not reported and incorporated into the required hedge position on a real time basis.

Interest Rate Risk Derivative Instruments - Interest rate risk derivative instruments are used to hedge the economic effect of a large increase in interest rates on the Company’s general account life insurance and group pension liabilities as well as certain separate account life insurance liabilities.  While these derivatives are economic hedges and used to manage risk, the Company did not elect hedge accounting on these transactions.

The hedging program for the general account life insurance and group pension liabilities incorporates a combination of static hedges and dynamic (i.e. frequently re-balanced based on interest rate movements) hedges. These hedges are used to manage the potential variability in future interest payments due to a change in credited interest rates and the related change in cash flows due to increased surrenders. The Company has purchased the following derivative instruments: (a) OTC interest rate swaptions as static hedges and (b) OTC interest rate swaps, exchange-traded interest rate swap futures, and exchange-traded Eurodollar interest rate futures as dynamic hedges.

The hedging program for certain separate account life insurance liabilities is also a combination of static and dynamic hedges using OTC interest rate swaptions, OTC interest rate swaps, exchange-traded interest rate swap futures, and exchange-traded Eurodollar interest rate futures. These hedges are used to manage the potential change of cash flows due to increased surrenders. The costs and performance of these hedges are passed directly to the associated separate account liabilities through an adjustment to the liability credited rates.  The notional amount of the Company’s swaptions associated with the separate account liabilities was approximately 30% and 28% of the total swaption notional amount at September 30, 2011 and December 31, 2010, respectively. The notional amount of the derivatives used in the dynamic hedging program associated with separate account liabilities was approximately 3% and 5% of the total notional within that program at September 30, 2011 and December 31, 2010, respectively.

Other Derivative Instruments - Interest rate futures are used to manage the interest rate risks of forecasted acquisitions of fixed rate maturity investments and forecasted liability pricing.  The Company utilizes futures on equity indices to hedge its equity based fee income.  Although these derivatives are economic hedges and are used to manage risk, the Company did not elect hedge accounting on these transactions.

The following tables summarize derivative financial instruments at September 30, 2011 and December 31, 2010:

	September 30, 2011
			Net derivatives			Asset derivatives		Liability derivatives
	Notional amount		Fair value			Fair value (1)		Fair value (1)
Hedge designation/derivative type:
Derivatives designated as hedges:
Cash flow hedges:
Interest rate swaps	$	184,200	$	20,542		$	20,542	$	—
Foreign currency exchange contracts	30,000		(638		)	—		638
Total cash flow hedges	214,200		19,904			20,542		638
Fair value hedges:
Interest rate futures	43,300		—			—		—
Total fair value hedges	43,300		—			—		—
Total derivatives designated as hedges	257,500		19,904			20,542		638
Derivatives not designated as hedges:
GMWB derivative instruments:
Interest rate swap futures	10,900		—			—		—
Futures on equity indices	4,014		—			—		—
Total GMWB derivative instruments	14,914		—			—		—
Interest rate risk derivative instruments:
Interest rate swaps	307,135		(10,652		)	4,604		15,256
Interest rate futures	355		—			—		—
Interest rate swap futures	32,800		—			—		—
Interest rate swaptions	941,850		1,415			1,415		—
Total interest rate risk derivative instruments	1,282,140		(9,237		)	6,019		15,256
Other derivative instruments:
Interest rate futures	15,900		—			—		—
Total other derivative instruments	15,900		—			—		—
Total derivatives not designated as hedges	1,312,954		(9,237		)	6,019		15,256
Total cash flow hedges, fair value hedges and derivatives not designated as hedges	$	1,570,454	$	10,667		$	26,561	$	15,894

(1)  The estimated fair value of all derivatives in an asset position are reported within other assets and the estimated fair value of all derivatives in a liability position are reported within other liabilities in the condensed consolidated balance sheets.

	December 31, 2010
			Net derivatives			Asset derivatives		Liability derivatives
	Notional amount		Fair value			Fair value (1)		Fair value (1)
Hedge designation/derivative type:
Derivatives designated as hedges:
Cash flow hedges:
Interest rate swaps	$	90,700	$	10,255		$	10,386	$	131
Foreign currency exchange contracts	30,000		(252		)	—		252
Interest rate futures	80,700		—			—		—
Total cash flow hedges	201,400		10,003			10,386		383
Fair value hedges:
Interest rate futures	128,900		—			—		—
Total fair value hedges	128,900		—			—		—
Total derivatives designated as hedges	330,300		10,003			10,386		383
Derivatives not designated as hedges:
GMWB derivative instruments:
Interest rate swap futures	5,300		—			—		—
Futures on equity indices	680		—			—		—
Total GMWB derivative instruments	5,980		—			—		—
Interest rate risk derivative instruments:
Interest rate swaps	612,902		4,036			9,484		5,448
Interest rate futures	2,460		—			—		—
Interest rate swap futures	44,600		—			—		—
Interest rate swaptions	1,083,000		4,956			4,956		—
Total interest rate risk derivative instruments	1,742,962		8,992			14,440		5,448
Total derivatives not designated as hedges	1,748,942		8,992			14,440		5,448
Total cash flow hedges, fair value hedges and derivatives not designated as hedges	$	2,079,242	$	18,995		$	24,826	$	5,831

(1) The estimated fair value of all derivatives in an asset position are reported within other assets and the estimated fair value of all derivatives in a liability position are reported within other liabilities in the condensed consolidated balance sheets.

Notional amounts are used to express the extent of the Company’s involvement in derivative transactions and represent a standard measurement of the volume of its derivative activity.  Notional amounts represent those amounts used to calculate contractual flows to be exchanged.  Notional amounts are not paid or received.

The Company had 117 swap transactions during the nine months ended September 30, 2011 and the year ended December 31, 2010. The average notional amount on these swap transactions were $16,066 and $19,745 during the nine months ended September 30, 2011 and the year ended December 31, 2010, respectively.  The Company had 1,207 and 979 futures transactions with an average number of contracts per transaction of 20 and 26 during the nine months ended September 30, 2011 and the year ended December 31, 2010, respectively.  The Company had 31 swaption transactions with an average notional amount of $6,479 during the nine months ended September 30, 2011.  During the year ended December 31, 2010, the Company had three swaptions expire.

The change in notional amount of derivatives since December 31, 2010 was primarily due to the following:

· The decrease of $305,767 in interest rate swaps was the result of an overall reduction in the interest rate risk hedging program as part of an ongoing review of liability risks and projected hedge gains, as well as a decrease in interest rates.

· The decrease of $141,150 in interest rate swaptions in the interest rate risk hedging program was due to expiring swaptions replaced by other interest rate derivatives.

The Company recognized total derivative gains (losses) in net investment income of ($9,761) and ($2,476) for the three-month periods ended September 30, 2011 and 2010, respectively.  The Company recognized total derivative gains (losses) in net investment income of ($13,413) and ($15,352) for the nine-month periods ended September 30, 2011 and 2010, respectively.  The Company realized net investment gains (losses) on closed derivative positions of ($23,877) and ($15,664) for the three-month periods ended September 30, 2011 and 2010, respectively.  The Company realized net investment gains (losses) on closed derivative positions of ($32,189) and ($22,078) for the nine-month periods ended September 30, 2011 and 2010, respectively.  The preceding amounts are all shown net of any gains (losses) on the hedged assets in a fair value hedge that has been recorded in net investment income.

The following six tables present the effect of derivative instruments in the condensed consolidated statement of income for the three and nine-month periods ended September 30, 2011 and 2010 reported by cash flow hedges, fair value hedges and economic hedges:

	Gain (loss) recognized										Gain (loss) recognized in net income on
	in AOCI on derivatives					Gain (loss) reclassified from AOCI					derivatives (Ineffective portion and amount
	(Effective portion)					into net income (Effective portion)					excluded from effectiveness testing)
										Income							Income
	Three months ended September 30,					Three months ended September 30,				statement	Three months ended September 30,						statement
	2011		2010			2011		2010		location	2011			2010			location
Cash flow hedges:
Interest rate swaps	$	17,720	$	7,743		$	702	$	350	(A)	$	(2	)	$	24		(A)
Foreign currency exchange contracts	2,347		(3,026		)	—		—			—			—
Interest rate futures	—		—			—		—			(49		)	176			(A)
Interest rate futures	—		14			10		26		(A)	3,976			(650		)	(B)
Total cash flow hedges	$	20,067	$	4,731		$	712	$	376		$	3,925		$	(450	)

(A)  Net investment income.

(B)  Realized investment gains (losses), net.  Represents realized gains (losses) on closed positions.

	Gain (loss) recognized											Gain (loss) recognized in net income on
	in AOCI on derivatives						Gain (loss) reclassified from AOCI					derivatives (Ineffective portion and amount
	(Effective portion)						into net income (Effective portion)					excluded from effectiveness testing)
											Income						Income
	Nine months ended September 30,						Nine months ended September 30,				statement	Nine months ended September 30,					statement
	2011			2010			2011		2010		location	2011			2010		location
Cash flow hedges:
Interest rate swaps	$	20,974		$	22,941		$	1,995	$	977	(A)	$	5		$	7	(A)
Foreign currency exchange contracts	(386		)	1,949			—		—			—			—
Interest rate futures	—			—			—		—			(84		)	176		(A)
Interest rate futures	(1,431		)	(466		)	32		80		(A)	6			7		(B)
Total cash flow hedges	$	19,157		$	24,424		$	2,027	$	1,057		$	(73	)	$	190

(A)  Net investment income.

(B)  Realized investment gains (losses), net.  Represents realized gains (losses) on closed positions.

	Gain (loss) on derivatives							Gain (loss) on hedged assets
	recognized in net income							recognized in net income
							Income					Income
	Three months ended September 30,						statement	Three months ended September 30,				statement
	2011			2010			location	2011		2010		location
Fair value hedges:
Interest rate futures	$	(1,276	)	$	(505	)	(A)	$	—	$	—
Interest rate futures	(5,478		)	(3,087		)	(B)	—		—
Items hedged in interest rate futures	—			—				3,756		2,141		(A)
Items hedged in interest rate futures	—			—				1,926		—		(B)
Total fair value hedges (1)	$	(6,754	)	$	(3,592	)		$	5,682	$	2,141

(1)   Hedge ineffectiveness of ($1,072) and ($1,451) for the three months ended September 30, 2011 and 2010, respectively, was recognized.

(A)  Net investment income.

(B)  Realized investment gains (losses), net.  Represents realized gains (losses) on closed positions.

	Gain (loss) on derivatives							Gain (loss) on hedged assets
	recognized in net income							recognized in net income
							Income					Income
	Nine months ended September 30,						statement	Nine months ended September 30,				statement
	2011			2010			location	2011		2010		location
Fair value hedges:
Interest rate futures	$	(516	)	$	(2,861	)	(A)	$	—	$	—
Interest rate futures	(7,362		)	(5,417		)	(B)	—		—
Items hedged in interest rate futures	—			—				2,699		7,210		(A)
Items hedged in interest rate futures	—			—				3,563		—		(B)
Total fair value hedges (1)	$	(7,878	)	$	(8,278	)		$	6,262	$	7,210

(1)   Hedge ineffectiveness of ($1,616) and ($1,068) for the nine months ended September 30, 2011 and 2010, respectively, was recognized.

(A)  Net investment income.

(B)  Realized investment gains (losses), net.  Represents realized gains (losses) on closed positions.

	Gain (loss) on derivatives recognized in				Gain (loss) on derivatives recognized in
	net income				net income
	Three months ended			Income statement	Three months ended			Income statement
	September 30, 2011			location	September 30, 2010			location
Derivatives not designated as hedging instruments:
GMWB derivative instruments:
Interest rate swap futures	$	753		(A)	$	(44	)	(A)
Interest rate swap futures	1,650			(B)	185			(B)
Futures on equity indices	150			(A)	(25		)	(A)
Futures on equity indices	75			(B)	(12		)	(B)
Total GMWB derivative instruments	2,628				104
Interest rate risk derivative instruments:
Interest rate swaps	(12,671		)	(A)	(5,991		)	(A)
Interest rate swaps	(23,727		)	(B)	(5,013		)	(B)
Interest rate futures	(478		)	(A)	(7		)	(A)
Interest rate futures	4,827			(B)	(165		)	(B)
Interest rate swaptions	(677		)	(A)	(439		)	(A)
Interest rate swaptions	(202		)	(B)	—
Total interest rate risk derivative instruments	(32,928		)		(11,615		)
Other derivative instruments:
Interest rate futures	21			(A)	1,818			(A)
Interest rate futures	(6,924		)	(B)	(6,922		)	(B)
Total other derivative instruments	(6,903		)		(5,104		)
Total derivatives not designated as hedging instruments	$	(37,203	)		$	(16,615	)

(A)  Net investment income

(B)  Realized investment gains (losses), net.  Represents realized gains (losses) on closed positions.

	Gain (loss) on derivatives recognized in				Gain (loss) on derivatives recognized in
	net income				net income
	Nine months ended			Income statement	Nine months ended			Income statement
	September 30, 2011			location	September 30, 2010			location
Derivatives not designated as hedging instruments:
GMWB derivative instruments:
Interest rate swap futures	$	547		(A)	$	(6	)	(A)
Interest rate swap futures	1,852			(B)	185			(B)
Futures on equity indices	126			(A)	(17		)	(A)
Futures on equity indices	41			(B)	(12		)	(B)
Total GMWB derivative instruments	2,566				150
Interest rate risk derivative instruments:
Interest rate swaps	(14,688		)	(A)	(10,489		)	(A)
Interest rate swaps	(27,767		)	(B)	(5,013		)	(B)
Interest rate futures	(35		)	(A)	(9		)	(A)
Interest rate futures	4,488			(B)	(165		)	(B)
Interest rate swaptions	(3,515		)	(A)	(5,984		)	(A)
Interest rate swaptions	(431		)	(B)	—
Total interest rate risk derivative instruments	(41,948		)		(21,660		)
Other derivative instruments:
Interest rate futures	21			(A)	(4,436		)	(A)
Interest rate futures	(6,924		)	(B)	(11,663		)	(B)
Futures on equity indices	345			(B)	—
Total other derivative instruments	(6,558		)		(16,099		)
Total derivatives not designated as hedging instruments	$	(45,940	)		$	(37,609	)

(A)  Net investment income

(B)  Realized investment gains (losses), net.  Represents realized gains (losses) on closed positions.