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, 2013
	Level 1		Level 2		Level 3			Total
Assets
Fixed maturity available-for-sale (“AFS”) securities (a)
Corporate securities	$	-	$	1,173,598	$	1,801		$	1,175,399
Asset-backed securities		-		119,434		14,813			134,247
Commercial mortgage-backed securities		-		112,338		-			112,338
Residential mortgage-backed securities		-		85,441		-			85,441
Municipals		-		885		-			885
Government and government agencies
United States		420,514		-		-			420,514
Foreign		3,665		6,219		-			9,884

Total fixed maturity AFS securities (a)		424,179		1,497,915		16,614			1,938,708
Equity securities (a)
Banking securities		-		28,095		-			28,095
Industrial securities		236		6,153		-			6,389

Total equity securities (a)		236		34,248		-			34,484
Cash equivalents (b)		-		232,192		-			232,192
Limited partnerships (c)		-		-		4,802			4,802
Separate Accounts assets (d)		7,105,367		-		-			7,105,367

Total assets	$	7,529,782	$	1,764,355	$	21,416		$	9,315,553


Liabilities
Future policy benefits (embedded derivatives only) (e)	$	-	$	-	$	(34,398	)	$	(34,398	)
Derivative liabilities (f)		-		166,784		-			166,784

Total liabilities	$	-	$	166,784	$	(34,398	)	$	132,386


	December 31, 2012
	Level 1		Level 2		Level 3			Total
Assets
Fixed maturity AFS securities (a)
Corporate securities	$	-	$	1,284,009	$	-		$	1,284,009
Asset-backed securities		-		104,664		-			104,664
Commercial mortgage-backed securities		-		109,050		-			109,050
Residential mortgage-backed securities		-		97,144		91			97,235
Municipals		-		1,104		-			1,104
Government and government agencies
United States		357,366		-		-			357,366
Foreign		3,802		7,222		-			11,024

Total fixed maturity AFS securities (a)		361,168		1,603,193		91			1,964,452
Equity securities (a)
Banking securities		-		34,234		-			34,234
Other financial services securities		-		491		-			491
Industrial securities		233		6,253		-			6,486

Total equity securities (a)		233		40,978		-			41,211
Cash equivalents (b)		-		299,716		-			299,716
Limited partnerships (c)		-		-		6,548			6,548
Separate Accounts assets (d)		6,968,855		-		-			6,968,855

Total assets	$	7,330,256	$	1,943,887	$	6,639		$	9,280,782


Liabilities
Future policy benefits (embedded derivatives only) (e)	$	-	$	-	$	(17,397	)	$	(17,397	)
Derivative liabilities (f)		-		11,711		-			11,711


Total liabilities	$	-	$	11,711	$	(17,397	)	$	(5,686	)

(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, 2013 and December 31, 2012, less than 0.5% of fixed maturity AFS securities were valued using internal models, respectively.

(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)

Derivatives 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 inflation swaps, variance swaps, total return swaps and equity collars for which the Company utilized readily accessible quoted index levels and broker quotes. The fair value for inflation swaps is calculated as the difference between the consumer price index (or related readily accessible quoted inflation index level) at the reporting date from the last reset date, multiplied by the notional value of the swap. The fair value for the variance swaps is calculated as the difference between the estimated volatility of the underlying Standard & Poor’s 500 Composite Stock 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. Total return swaps are valued based on the change in the underlying equity index as of the last reset date. Fair value for the equity collar’s put and call options is calculated using the Black-Scholes model using market observable inputs for the underlying market price and volatility surface.

During 2013 and 2012, 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, 2013 and December 31, 2012:


	September 30, 2013						December 31, 2012
	Limited Partnership			Fixed Maturity AFS Securities			Limited Partnership			Fixed Maturity AFS Securities
Balance at beginning of period (a)	$	6,548		$	91		$	8,119		$	10,814

Change in unrealized gains (losses) (b)		-			(193	)		-			608
Purchases		-			16,810			-			-
Sales		(1,099	)		(101	)		(1,455	)		(7,088	)
Transfers into Level 3		-			3,677			-			-
Transfers out of Level 3		-			(3,677	)		-			(4,814	)
Changes in valuation (c)		(647	)		7			(116	)		300
Net realized investment gains (d)		-			-			-			271


Balance at end of period (a)	$	4,802		$	16,614		$	6,548		$	91

(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.

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

(d)	Recorded as a component of net realized investment gains 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 increase in Level 3 fixed maturity AFS securities at September 30, 2013 was due to five securities being purchased at Level 3 within the period with four being asset backed securities (“ABS”) and the other being a corporate bond. The decrease in Level 3 fixed maturity AFS securities at December 31, 2012 was primarily due to a bond that was transferred out of Level 3 due to the availability of market observable data from an external pricing source.

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 55 basis points (“bps”) and 80 bps at September 30, 2013 and December 31, 2012, 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 (expressed as a spot rate) was 24.0% and 24.4% at September 30, 2013 and December 31, 2012, respectively. 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, 2013 and December 31, 2012:


	September 30, 2013						December 31, 2012
	GMWB			GMIB Reinsurance			GMWB			GMIB Reinsurance
Balance at beginning of period (b)	$	74,022		$	(91,419	)	$	108,637		$	(94,517	)

Changes in interest rates (a)		(28,178	)		17,550			2,560			(7,176	)
Changes in equity markets (a)		(12,385	)		16,884			(24,762	)		9,746
Other (a)		(4,683	)		(6,230	)		(12,413	)		528

Balance at end of period (b)	$	28,776		$	(63,215	)	$	74,022		$	(91,419	)

(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, 2013, the change in GMWB and GMIB reinsurance reserves was primarily driven by updated policyholder behavior assumptions and favorable equity market performance. During 2012, the change in GMWB and GMIB reinsurance reserves was primarily driven by updated policyholder behavior assumptions, decreased risk neutral rates, changes in volatility and favorable equity market performance. At September 30, 2013 the SALB reserve was $41, due to low sales volume.

The following table provides a summary of the quantitative inputs and assumptions of the Company’s Level 3 assets and liabilities at September 30, 2013 and December 31, 2012:


Description	September 30, 2013 Estimated Fair Value			Valuation Techniques	Unobservable Inputs	Range (Weighted Average)
Assets
Fixed maturity securities
Corporate securities	$	1,801		Broker	Not applicable	Not applicable
Asset-backed securities		14,813		Broker & recent purchase price	Not applicable	Not applicable
				Broker & recent purchase price
Total fixed maturity securities		16,614
Limited partnership		4,802		Not applicable ₍₁₎	Not applicable ₍₁₎	Not applicable ₍₁₎

Total assets	$	21,416


Liabilities
Future policy benefits (embedded derivatives) - GMWB	$	28,776		Discounted cash flow	Own credit risk	55 bps
					Long-term volatility	25%
Future policy benefits (embedded derivatives) - GMIB Reinsurance		(63,215	)	Discounted cash flow	Own credit risk	55 bps
					Long-term volatility	25%
Future policy benefits - SALB		41		See comment below ₍₂₎	See comment below ₍₂₎	See comment below ₍₂₎

Total liabilities	$	(34,398	)


Description	December 31, 2012 Estimated Fair Value			Valuation Techniques	Unobservable Inputs	Range (Weighted Average)
Assets
Structured securities
Residential mortgage-backed securities	$	91

Total structured securities		91		Discounted cash flows	Constant prepayment rate	1%
					Probability of default	12%
					Loss severity	65%

Limited partnership		6,548		Not applicable ⁽¹⁾	Not applicable ⁽¹⁾	Not applicable ⁽¹⁾

Total assets	$	6,639


Liabilities
Future policy benefits (embedded derivatives) - GMWB	$	74,022		Discounted cash flow	Own credit risk	80 bps
					Long-term volatility	25%
Future policy benefits (embedded derivatives) - GMIB Reinsurance		(91,419	)	Discounted cash flow	Own credit risk	80 bps
					Long-term volatility	25%

Total liabilities	$	(17,397	)

(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.

(2)	The SALB is a relatively new product with fewer than 100 policies. Due to the small size of this block the liability was determined based on fees earned.

The Level 3 assets at December 31, 2012 consist of residential mortgage-backed securities (“RMBS”) 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 the estimated fair value of the Company’s assets not carried at fair value on the Balance Sheets at September 30, 2013 and December 31, 2012:


	September 30, 2013
	Level 1		Level 2		Level 3		Total
Assets
Mortgage loans on real estate (a)	$	-	$	-	$	52,380	$	52,380
Policy loans (b)		-		721,033		-		721,033

Total assets	$	-	$	721,033	$	52,380	$	773,413


	December 31, 2012
	Level 1		Level 2		Level 3		Total
Assets
Mortgage loans on real estate (a)	$	-	$	-	$	59,548	$	59,548
Policy loans (b)		-		752,437		-		752,437

Total assets	$	-	$	752,437	$	59,548	$	811,985

(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.