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:

Quoted prices for similar assets or liabilities in active markets

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

Inputs other than quoted market prices that are observable

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, 2012
	Level 1		Level 2		Level 3			Total
Assets
Fixed maturity available-for-sale (“AFS”) securities (a)
Corporate securities	$	-	$	1,281,875	$	-		$	1,281,875
Asset-backed securities		-		97,101		4,814			101,915
Commercial mortgage-backed securities		-		112,250		-			112,250
Residential mortgage-backed securities		-		101,767		344			102,111
Municipals		-		1,188		-			1,188
Government and government agencies
United States		361,649		-		-			361,649
Foreign		3,840		7,153		-			10,993

Total fixed maturity AFS securities (a)		365,489		1,601,334		5,158			1,971,981
Equity securities (a)
Banking securities		-		33,377		-			33,377
Other financial services securities		-		468		-			468
Industrial securities		-		6,344		-			6,344

Total equity securities (a)		-		40,189		-			40,189
Cash equivalents (b)		-		308,657		-			308,657
Limited partnerships (c)		-		-		6,692			6,692
Separate Accounts assets (d)		7,116,735		-		-			7,116,735

Total assets	$	7,482,224	$	1,950,180	$	11,850		$	9,444,254


Liabilities
Future policy benefits (embedded derivatives only) (e)	$	-	$	-	$	(14,399	)	$	(14,399	)
Derivative liabilities (f)		-		2,685		-			2,685

Total liabilities	$	-	$	2,685	$	(14,399	)	$	(11,714	)


	December 31, 2011
	Level 1		Level 2		Level 3		Total
Assets
Fixed maturity AFS securities (a)
Corporate securities	$	-	$	1,164,173	$	-	$	1,164,173
Asset-backed securities		-		96,783		9,365		106,148
Commercial mortgage-backed securities		-		119,050		-		119,050
Residential mortgage-backed securities		-		82,770		1,449		84,219
Municipals		-		1,210		-		1,210
Government and government agencies
United States		356,960		-		-		356,960
Foreign		3,779		6,542		-		10,321

Total fixed maturity AFS securities (a)		360,739		1,470,528		10,814		1,842,081
Fixed maturity trading securities (a) - corporate securities		-		2,521		-		2,521
Equity securities (a)
Banking securities		-		24,993		-		24,993
Other financial services securities		-		394		-		394
Industrial securities		-		5,653		-		5,653

Total equity securities (a)		-		31,040		-		31,040
Cash equivalents (b)		-		336,130		-		336,130
Limited partnerships (c)		-		-		8,119		8,119
Separate Accounts assets (d)		7,007,468		-		-		7,007,468

Total assets	$	7,368,207	$	1,840,219	$	18,933	$	9,227,359


Liabilities
Future policy benefits (embedded derivatives only) (e)	$	-	$	-	$	14,120	$	14,120
Derivative liabilities (f)		-		1,341		-		1,341


Total liabilities	$	-	$	1,341	$	14,120	$	15,461

(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 internal models primarily use projected cash flows discounted using relevant risk spreads and market interest rate curves. At September 30, 2012 and December 31, 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.

(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 contract. In addition, the Company issues SALB contracts which are required to be reported at fair value. The fair value of these guarantees is calculated as the present value of future expected payments to policyholders less the present value of assessed 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 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 500 Composite Price Index (“S&P”) 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 2012 and 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, 2012 and December 31, 2011:


	September 30, 2012						December 31, 2011
	Limited Partnership			Fixed Maturity AFS Securities			Limited Partnership			Fixed Maturity AFS Securities
Balance at beginning of period (a)	$	8,119		$	10,814		$	9,415		$	14,634

Change in unrealized gains (b)		-			605			-			840
Sales		(1,097	)		(6,832	)		(2,663	)		(4,191	)
Transfers into Level 3		-			-			-			4
Transfers out of Level 3		-			-			-			(508	)
Changes in valuation (c)		(330	)		300			215			35
Net realized investment gains (d)		-			271			1,152			-


Balance at end of period (a)	$	6,692		$	5,158		$	8,119		$	10,814

(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 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, 2012 was primarily due to sales. The decrease in Level 3 fixed maturity AFS securities at December 31, 2011 was primarily due to sales and availability of market observable data (Level 2).

The Company’s Level 3 liabilities (assets) consist of provisions for GMWB, SALB 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 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. For GMWB and SALB, increases (decreases) in credit spread in isolation would result in a lower (higher) fair value measurement and increases (decreases) in volatility in isolation would result in a higher (lower) fair value measurement. Changes in the Company’s credit spread and volatility assumption have an inverse reaction for GMIB reinsurance, due to this reserve being an asset.

The expected returns are based on risk-free rates, such as the current London Inter-Bank Offered Rate (“LIBOR”) forward curve. The credit spread, which is the most significant unobservable input, 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). The credit spread was 105 basis points (“bps”) and 135 bps at September 30, 2012 and December 31, 2011, respectively.

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 24.6% at September 30, 2012 and 25.7% at December 31, 2011. 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, 2012 and December 31, 2011:


	September 30, 2012						December 31, 2011
	GMWB			GMIB Reinsurance			GMWB		GMIB Reinsurance
Balance at beginning of period (b)	$	108,637		$	(94,517	)	$	31,001	$	(56,417	)

Changes in interest rates (a)		5,537			(8,081	)		55,032		(27,361	)
Changes in equity markets (a)		(22,204	)		9,419			20,561		(9,759	)
Other (a)		(13,718	)		528			2,043		(980	)


Balance at end of period (b)	$	78,252		$	(92,651	)	$	108,637	$	(94,517	)

(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 2012, the change in the GMWB and GMIB reinsurance reserves was primarily driven by updated policyholder behavior assumptions, decrease in risk neutral rates, change in volatility and favorable equity market performance. The SALB reserve was $1 due to low sales volume in the first nine months of 2012. During 2011, the change in GMWB and GMIB reinsurance reserves was primarily driven by the reduction in risk neutral rates and lower equity market performance.

The Level 3 assets at September 30, 2012 consist of residential mortgage-backed securities (“RMBS”) and asset-backed securities (“ABS”) that are valued using a discounted cash flow approach. This approach utilizes assumptions that are typically developed based upon assumptions observed for similar securities, to the extent possible, with reviews performed on any significant changes in measurements from one period to the next. The primary unobservable assumptions used in the fair value measurement of these securities are prepayment rates, probability of default, and loss severity in the event of default. Increases (decreases) in any of those inputs would result in a lower (higher) fair value measurement. Typically, changes in the assumptions used for the probability of default and loss severity move in the same direction, while changes in the assumption used for prepayment rates would move in the opposite direction.

The following table provides a summary of the quantitative inputs and assumptions of the Company’s Level 3 assets and liabilities at September 30, 2012:


Description	September 30, 2012 Estimated Fair Value			Valuation Techniques	Unobservable Inputs	Range (Weighted Average)
Assets
Structured securities
Asset-backed securities	$	4,814
Residential mortgage-backed securities		344

Total structured securities		5,158		Discounted cash flows	Constant prepayment rate	1% -10% (8.8%)
					Probability of default	5% -12% (5.9%)
					Loss severity	65% - 103% (98.1%)

Limited partnership		6,692		Not applicable ⁽¹⁾	Not applicable ⁽¹⁾	Not applicable ⁽¹⁾

Total assets	$	11,850


Liabilities
Future policy benefits (embedded derivatives) - GMWB	$	78,252		Discounted cash flow	Own credit risk	105 bps
					Long-term volatility	25%
Future policy benefits (embedded derivatives) - GMIB Reinsurance		(92,651	)	Discounted cash flow	Own credit risk	105 bps
					Long-term volatility	25%

Total liabilities	$	(14,399	)

(1)

The Company has an investment in a limited partnership for which the fair value is derived from management’s review of the underlying financial statements that were prepared on a GAAP basis. Management did not make any adjustments to the valuation from the underlying financial statements. As a result, inputs are not developed by management to determine the fair value measurement for this investment.

The following table provides the estimated fair value of the Company’s assets not carried at fair value on the Balance Sheets at September 30, 2012 and December 31, 2011:


	September 30, 2012
	Level 1		Level 2		Level 3		Total
Assets
Mortgage loans on real estate (a)	$	-	$	-	$	60,430	$	60,430
Policy loans (b)		-		766,812		-		766,812

Total assets	$	-	$	766,812	$	60,430	$	827,242


	December 31, 2011
	Level 1		Level 2		Level 3		Total
Assets
Mortgage loans on real estate (a)	$	-	$	-	$	61,833	$	61,833
Policy loans (b)		-		792,602		-		792,602

Total assets	$	-	$	792,602	$	61,833	$	854,435

(a)	The fair value of mortgage loans on real estate is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and/or similar remaining maturities.

(b)	Policy loans are stated at unpaid principal balance. Fair value is estimated as equal to the book value of the loan.