Fair Value of Financial Instruments

9 Months Ended

Sep. 30, 2011

Fair Value of Financial Instruments

Note 2. Fair Value of Financial Instruments

Fair Value Measurements

ASC 820 defines fair value, establishes a framework for measuring fair value, establishes a fair value hierarchy based on the quality of inputs used to measure fair value and enhances disclosure requirements for fair value measurements.

Fair Value Hierarchy

The Company has categorized its financial instruments into a three level hierarchy which is based on the priority of the inputs to the valuation technique. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure fair value fall within different levels of the hierarchy, the category level is based on the lowest priority level input that is significant to the fair value measurement of the instrument.

Assets and liabilities recorded at fair value on the Balance Sheets are categorized as follows:

Level 1. Unadjusted quoted prices for identical assets or liabilities in an active market.

Level 2. Quoted prices in markets that are not active or inputs that are observable either directly or indirectly for substantially the full term of the asset or liability. Level 2 inputs include the following:

a) Quoted prices for similar assets or liabilities in active markets

b) Quoted prices for identical or similar assets or liabilities in non-active markets

c) Inputs other than quoted market prices that are observable

d) Inputs that are derived principally from or corroborated by observable market data through correlation or other means

Level 3. Prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. They reflect management’s own assumptions about the assumptions a market participant would use in pricing the asset or liability.

The Company recognizes transfers between levels at the beginning of the quarter.

The following table presents the Company’s hierarchy for its assets and liabilities measured at fair value on a recurring basis:

	September 30, 2011
	Level 1		Level 2		Level 3		Total
Assets
Fixed maturity available-for-sale (“AFS”) securities (a)
Corporate securities	$	-	$	1,154,468	$	-	$	1,154,468
Asset-backed securities		-		99,590		9,995		109,585
Commercial mortgage-backed securities		-		128,003		-		128,003
Residential mortgage-backed securities		-		86,558		1,721		88,279
Municipals		-		1,200		-		1,200
Government and government agencies
United States		354,790		-		-		354,790
Foreign		3,795		6,300		-		10,095
Total fixed maturity AFS securities (a)		358,585		1,476,119		11,716		1,846,420
Fixed maturity trading securities (a) - corporate securities		-		2,542		-		2,542
Equity securities (a)
Banking securities		-		24,661		-		24,661
Other financial services securities		-		368		-		368
Industrial securities		-		5,777		-		5,777
Total equity securities (a)		-		30,806		-		30,806
Cash equivalents (b)		-		304,859		-		304,859
Derivative assets (f)		-		3,824		-		3,824
Limited partnerships (c)		-		-		10,541		10,541
Separate Accounts assets (d)		6,793,453		-		-		6,793,453
Total assets	$	7,152,038	$	1,818,150	$	22,257	$	8,992,445
Liabilities
Future policy benefits (embedded derivatives only) (e)	$	-	$	-	$	24,692	$	24,692
Total liabilities	$	-	$	-	$	24,692	$	24,692

	December 31, 2010
	Level 1		Level 2		Level 3			Total
Assets
Fixed maturity AFS securities (a)
Corporate securities	$	-	$	1,120,974	$	-		$	1,120,974
Asset-backed securities		-		91,210		11,244			102,454
Commercial mortgage-backed securities		-		139,330		504			139,834
Residential mortgage-backed securities		-		101,263		2,886			104,149
Municipals		-		1,475		-			1,475
Government and government agencies
United States		149,652		-		-			149,652
Foreign		3,699		6,157		-			9,856
Total fixed maturity AFS securities (a)		153,351		1,460,409		14,634			1,628,394
Fixed maturity trading securities (a) - corporate securities		-		23,138		-			23,138
Equity securities (a)
Banking securities		-		7,054		-			7,054
Other financial services securities		-		520		-			520
Industrial securities		-		5,416		-			5,416
Total equity securities (a)		-		12,990		-			12,990
Cash equivalents (b)		-		317,321		-			317,321
Limited partnerships (c)		-		-		9,415			9,415
Separate Accounts assets (d)		8,163,032		-		-			8,163,032
Total assets	$	8,316,383	$	1,813,858	$	24,049		$	10,154,290
Liabilities
Future policy benefits (embedded derivatives only) (e)	$	-	$	-	$	(25,416	)	$	(25,416	)
Derivative liabilities (f)		-		353		-			353
Total liabilities	$	-	$	353	$	(25,416	)	$	(25,063	)

(a) Securities are classified as Level 1 if the fair value is determined by observable inputs that reflect quoted prices for identical assets in active markets that the Company has the ability to access at the measurement date. Level 1 securities primarily include highly liquid U.S. Treasury and U.S. government agency securities. Securities are classified as Level 2 if the fair value is determined by observable inputs, other than quoted prices included in Level 1, for the asset or prices for similar assets. Securities are classified as Level 3 if the valuations are derived from techniques in which one or more of the significant inputs are unobservable. Level 3 consists principally of fixed maturity securities whose fair value is estimated based on non-binding broker quotes and internal models. These models primarily use projected cash flows discounted using relevant risk spreads and market interest rate curves. At September 30, 2011, less than 0.5% of fixed maturity AFS securities were valued using internal models.

(b) Cash equivalents are primarily valued at amortized cost, which approximates fair value. Operating cash is not included in the abovementioned table.

(c) The Company has an investment in a limited partnership for which the fair value was derived from management’s review of the underlying financial statements that were prepared on a GAAP basis. The remaining limited partnership is carried at cost and is not included in the abovementioned table.

(d) Separate Accounts assets are carried at the net asset value provided by the fund managers.

(e) The Company issued contracts containing guaranteed minimum withdrawal benefit riders (“GMWB”) and obtained reinsurance on guaranteed minimum income benefit riders (“GMIB reinsurance”). GMWB and GMIB reinsurance are treated as embedded derivatives and are required to be reported separately from the host variable annuity contract. The fair value of these guarantees is calculated as the present value of future expected payments to policyholders less the present value of assessed rider fees attributable to the guarantees. Given the complexity and long-term nature of these guarantees, their fair values are determined using stochastic techniques under a variety of market return, discount rates and actuarial assumptions. Since many of the assumptions are unobservable and are considered to be significant inputs to the liability valuation, the liability included in future policy benefits has been reflected within Level 3 of the fair value hierarchy.

(f) Derivative assets and liabilities are classified as Level 1 if the fair value is determined by observable inputs that reflect quoted prices for identical assets in active markets that the Company has the ability to access at the measurement date. Derivatives are classified as Level 2 if the fair value is determined by observable inputs, other than quoted prices included in Level 1, for the identical asset or prices for similar assets. Derivatives are classified as Level 3 if the valuations are derived from techniques in which one or more of the significant inputs are unobservable. Level 2 derivatives include variance swaps for which the Company utilized readily accessible quoted index levels and broker quotes. The fair value for the variance swaps is calculated as the difference between the estimated volatility of the underlying Standard & Poor’s (“S&P”) index at maturity to the actual volatility of the underlying S&P index at initiation (i.e., strike) multiplied by the notional value of the swap.

During 2011, there were no transfers between Level 1 and 2, respectively.

The following table provides a summary of the change in fair value of the Company’s Level 3 assets at September 30, 2011 and December 31, 2010:

	September 30, 2011						December 31, 2010
	Limited Partnership			Fixed Maturity AFS Securities			Limited Partnership			Fixed Maturity AFS Securities
Balance at beginning of period (a)	$	9,415		$	14,634		$	7,604		$	37,041
Change in unrealized gains (b)		-			868			-			4,125
Purchases		-			-			-			27,941
Sales		(2,088	)		(3,310	)		(712	)		(3,781	)
Transfers into Level 3		-			4			-			3,256
Transfers out of Level 3		-			(508	)		-			(54,058	)
Changes in valuation (c)		2,062			28			2,137			110
Net realized investment gains (d)		1,152			-			386			-
Balance at end of period (a)	$	10,541		$	11,716		$	9,415		$	14,634

(a) Recorded as a component of limited partnerships and fixed maturity AFS securities in the Balance Sheets.

(b) Recorded as a component of other comprehensive income (loss).

(c) Recorded as a component of net investment income in the Statements of Income.

(d) Recorded as a component of net realized investment gains (losses) for fixed maturity AFS securities and net investment income for limited partnerships in the Statements of Income.

In certain circumstances, the Company will obtain non-binding broker quotes from brokers to assist in the determination of fair value. If those quotes can be corroborated by other market observable data, the investments will be classified as Level 2 investments. If not, the investments are classified as Level 3 due to the unobservable nature of the brokers’ valuation processes. The decrease in Level 3 fixed maturity AFS securities at September 30, 2011 was primarily due to sales and availability of market observable data (Level 2). At December 31, 2010, the decrease was also due to an increase in market activity.

The Company’s Level 3 liabilities (assets) consist of provisions for GMWB and GMIB reinsurance. The fair value of these guarantees is calculated as the present value of future expected payments to policyholders less the present value of assessed rider fees attributable to the guarantees. Given the complexity and long-term nature of these guarantees which are unlike instruments available in financial markets, their fair values are determined using stochastic techniques under a variety of market return scenarios. A variety of factors are considered, including expected market rates of return, equity and interest rate volatility, credit spread, correlations of market returns, discount rates and actuarial assumptions.

The expected returns are based on risk-free rates, such as the current London Inter-Bank Offered Rate (“LIBOR”) forward curve. The credit spread is set by using the credit default swap (“CDS”) spreads of a reference portfolio of life insurance companies, adjusted to reflect the subordination of senior debt holders at the holding company level to the position of policyholders at the operating company level (who have priority in payments to other creditors).

For equity volatility, the Company uses a term structure assumption with market-based implied volatility inputs for the first five years and a long-term forward rate assumption of 25% thereafter. The volume of observable option trading from which volatilities are derived generally declines as the contracts’ term increases, therefore, the volatility curve grades from implied volatilities for five years to the ultimate rate. The resulting volatility assumption in year 20 for the S&P 500 index (expressed as a spot rate) was 25.6% at September 30, 2011 and 24.8% at December 31, 2010. Correlations of market returns across underlying indices are based on historical market returns and their inter-relationships over a number of years preceding the valuation date. Assumptions regarding policyholder behavior, such as lapses, included in the models are derived in the same way as the assumptions used to measure insurance liabilities. These assumptions are reviewed at each valuation date and updated based on historical experience and observable market data as required.

The following table provides a summary of the changes in fair value of the Company’s Level 3 liabilities (assets) at September 30, 2011 and December 31, 2010:

	September 30, 2011					December 31, 2010
	GMWB		GMIB Reinsurance			GMWB			GMIB Reinsurance
Balance at beginning of period (b)	$	31,001	$	(56,417	)	$	45,987		$	(58,746	)
Changes in interest rates (a)		60,596		(28,533	)		20,355			(8,533	)
Changes in equity markets (a)		32,414		(14,864	)		(10,022	)		4,653
Other (a)		495		-			(25,319	)		6,209
Balance at end of period (b)	$	124,506	$	(99,814	)	$	31,001		$	(56,417	)

(a) Recorded as a component of policy benefits in the Statements of Income.

(b) Recorded as a component of future policy benefits in the Balance Sheets.

During the nine months ended September 30, 2011, the increase in the GMWB and GMIB reinsurance reserves was primarily driven by the reduction in interest rates and lower than expected equity market performance during third quarter 2011. During 2010, the decrease in the GMWB and GMIB reinsurance reserves was principally driven by the improved equity markets and updated policyholder behavior assumptions offset by a decline in risk neutral rates.