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Fair Value of Financial Instruments
 6 Months Ended
Jun. 30, 2016
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 tables present the Company’s hierarchy for its assets and liabilities measured at fair value on a recurring basis at June 30, 2016 and December 31, 2015:

 

     June 30, 2016  

 

    Level 1      Level 2      Level 3      Total  

Assets

            

Fixed maturity available-for-sale (“AFS”) securities (a)

            

Corporate securities

      $ -             $ 1,022,552         $ -             $ 1,022,552   

Asset-backed securities

      -             77,637         6,760         84,397   

Commercial mortgage-backed securities

      -             81,517         -             81,517   

Residential mortgage-backed securities

      -             161,539         -             161,539   

Municipals

      -             807         -             807   

Government and government agencies

            

United States

      386,018         -             -             386,018   

Foreign

      1,525         6,717         -             8,242   
  

 

 

     

 

 

     

 

 

     

 

 

  

Total fixed maturity AFS securities (a)

      $ 387,543         $ 1,350,769         $     6,760         $ 1,745,072   

Equity AFS securities (a)

            

Banking securities

      $ -             $ 27,938         $ -             $ 27,938   

Industrial securities

      -             5,889         -             5,889   
  

 

 

     

 

 

     

 

 

     

 

 

  

Total equity AFS securities (a)

      $ -             $ 33,827         $ -             $ 33,827   

Cash equivalents (b)

      -             330,702         -             330,702   

Derivative assets (c)

      -             1,123         -             1,123   

Limited partnerships (d)

      -             59,113         10,376         69,489   

Fair value recoverable of ceded GMIB embedded derivatives (e)

      -             -             73,834         73,834   

Separate Accounts assets (f)

      5,668,318         -             -             5,668,318   
  

 

 

     

 

 

     

 

 

     

 

 

  

Total assets

      $     6,055,861         $ 1,775,534         $ 90,970         $     7,922,365   
  

 

 

     

 

 

     

 

 

     

 

 

  

Liabilities

            

Future policy benefits (embedded derivatives only) (g)

      $ -             $ -             $ 85,001         $ 85,001   

Derivative liabilities (c)

      -             2,470         -             2,470   
  

 

 

     

 

 

     

 

 

     

 

 

  

Total liabilities

      $ -             $ 2,470         $ 85,001         $ 87,471   
  

 

 

     

 

 

     

 

 

     

 

 

  

 

     December 31, 2015  

 

    Level 1      Level 2      Level 3      Total  

Assets

            

Fixed maturity AFS securities (a)

            

Corporate securities

      $ -             $ 1,016,792         $ -             $ 1,016,792   

Asset-backed securities

      -             115,988         6,666         122,654   

Commercial mortgage-backed securities

      -             71,683         -             71,683   

Residential mortgage-backed securities

      -             59,265         -             59,265   

Municipals

      -             807         -             807   

Government and government agencies

            

United States

      386,288         -             -             386,288   

Foreign

      1,499         6,349         -             7,848   
  

 

 

     

 

 

     

 

 

     

 

 

  

Total fixed maturity AFS securities (a)

      $     387,787         1,270,884         $ 6,666         $ 1,665,337   

Equity AFS securities (a)

            

Banking securities

      $ -             $ 28,673         $ -             $ 28,673   

Industrial securities

      -             5,994         -             5,994   
  

 

 

     

 

 

     

 

 

     

 

 

  

Total equity AFS securities (a)

      $ -             $ 34,667         $ -             $ 34,667   

Cash equivalents (b)

      -             234,500         -             234,500   

Derivative assets (c)

      -             10,893         -             10,893   

Limited partnerships (d)

      -             61,373         2,116         63,489   

Fair value recoverable of ceded GMIB embedded derivatives (e)

      -             -             61,426         61,426   

Separate Accounts assets (f)

      5,940,665         -             -             5,940,665   
  

 

 

     

 

 

     

 

 

     

 

 

  

Total assets

      $ 6,328,452         $ 1,612,317         $     70,208         $     8,010,977   
  

 

 

     

 

 

     

 

 

     

 

 

  

Liabilities

            

Future policy benefits (embedded derivatives only) (g)

      $ -             $ -             $ 61,129         $ 61,129   

Derivative liabilities (c)

      -             13,075         -             13,075   
  

 

 

     

 

 

     

 

 

     

 

 

  

Total liabilities

      $ -             $ 13,075         $ 61,129         $ 74,204   
  

 

 

     

 

 

     

 

 

     

 

 

  

 

(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 June 30, 2016 and December 31, 2015, there were no fixed maturity AFS securities valued using internal models.
(b)

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

Level 2 derivatives include interest rate swaps, inflation swaps, variance swaps, total return swaps, and credit default swaps for which the Company utilized readily accessible quoted index levels and broker quotes. The fair value of interest rate swaps is calculated based on the change in the underlying floating rate curve (LIBOR) at the reporting date, as compared to the fixed leg of the swap. 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 and 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. Credit default swaps are valued using a discounted cash flow model where future premium payments and protection payments are corrected for the probability of default which is modeled using an arbitrage free credit spread model.
(d)

Limited partnership investments in which management is able to determine that observable market inputs have been used and can be redeemed at the net asset value in 90 days or less are considered Level 2. The Company has investments in two limited partnerships for which the fair values are derived from management’s review of the financial information that is obtained from the private equity funds and prepared on a GAAP basis and are considered Level 3 measurements. The valuation input of these financial statements is on a one quarter lag.
(e)

Guaranteed minimum income benefit (“GMIB”) reinsurance is treated as embedded derivatives and is reported as a recoverable of ceded GMIB embedded derivatives, at fair value in the Balance Sheets.
(f)

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

The Company issued contracts containing guaranteed minimum withdrawal benefit riders (“GMWB”) and obtained 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 two 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.

For the six months ended June 30, 2016 and twelve months ended December 31, 2015, 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 June 30, 2016 and December 31, 2015:

 

     Six Months Ended
June 30, 2016		     Twelve Months Ended
December 31, 2015		  

 

    Limited
Partnerships		     Fixed
Maturity AFS
Securities		     Limited
Partnerships		     Fixed
Maturity AFS
Securities		  

Balance at beginning of period (a)

      $ 2,116        $     6,666        $     4,086        $ 8,474   

Change in unrealized losses (b)

      -            166        -            (376 ) 

Purchases

      11,145        -            -            1,999   

Sales

      (2,516 )      (65 )      (252 )      (126 ) 

Transfers into Level 3

      -            1,947        -            2,049   

Transfers out of Level 3

      -            (1,954 )      -            (5,354 ) 

Changes in valuation (c)

      (368 )      -            (1,718 )      -       

Net realized investment gains (d)

      (1 )      -            -            -       
  

 

 

    

 

 

    

 

 

    

 

 

  

Balance at end of period (a)

      $     10,376        $     6,760        $     2,116        $     6,666   
  

 

 

    

 

 

    

 

 

    

 

 

  

 

(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) in net unrealized holding gains (losses) on AFS securities arising during the period.
(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. Level 3 fixed maturity securities at June 30, 2016 remained fairly consistent with the December 31, 2015 balance due to two asset backed securities being transferred from Level 2 to Level 3 due to the unavailability of market observable data (Level 2) during the second quarter of 2016. This was offset by the same two securities being transferred from Level 3 to Level 2 due to the availability of market observable data (Level 2) during the first quarter of 2016.

 

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, an increase (decrease) in credit spread in isolation would result in a lower (higher) fair value liability measurement and an increase (decrease) in volatility in isolation would result in a higher (lower) fair value liability measurement. Changes in the Company’s credit spread and volatility assumptions have an inverse effect on the GMIB reinsurance assets.

The expected market rates of returns are based on risk-free rates, such as the current London Inter-Bank Offered Rate (“LIBOR”) forward curve. The credit spread, which is a 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 50 basis points (“bps”) and 40 bps at June 30, 2016 and December 31, 2015, 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 24.4% and 24.2% at June 30, 2016 and December 31, 2015, 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 June 30, 2016 and December 31, 2015:

 

     Six Months Ended
June 30, 2016		      Twelve Months Ended
December 31, 2015		  

 

    GMWB     GMIB
Reinsurance		     SALB      GMWB     GMIB
Reinsurance		     SALB  

Balance at beginning of period (a)

      $     60,618        $ (61,426 )      $   511         $     60,702        $ (60,573 )      $     504   

Changes in interest rates (b)

      20,657        (13,069 )      -             (1,890 )      979        -       

Changes in equity markets (b)

      3,361        808        -             9,182        (1,976 )      7   

Other (b)

      (146 )      (147 )      -             (7,376 )      144        -       
  

 

 

    

 

 

    

 

 

     

 

 

    

 

 

    

 

 

  

Balance at end of period (a)

      $ 84,490        $ (73,834 )      $ 511         $ 60,618        $ (61,426 )      $ 511   
  

 

 

    

 

 

    

 

 

     

 

 

    

 

 

    

 

 

  

 

(a)

GMWB and SALB are recorded as a component of future policy benefits in the Balance Sheets and GMIB reinsurance is recorded as recoverable of ceded GMIB embedded derivatives, at fair value in the Balance Sheets.
(b)

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

During the six months ended June 30, 2016, the change in the fair value of the GMWB and GMIB reinsurance guarantees was primarily driven by change in interest rates and equity market performance. During 2015, the change in the fair value GMWB and GMIB reinsurance guarantees was primarily driven by lower than expected equity market performance and updated policy holder behavior assumptions.

The following table provides a summary of the quantitative inputs and assumptions of the Company’s Level 3 assets and liabilities at June 30, 2016 and December 31, 2015:

 

Description

    June 30,
2016
Estimated
Fair Value		      Valuation
Techniques		     Unobservable Inputs     Range
(Weighted  Average)		  

Assets

          

Fixed maturity securities

          

Asset-backed securities

      3,821         Broker        See comment below (a)        See comment below (a)   

Asset-backed securities

      $ 2,939         Recent Purchase Price        Not applicable        Not applicable   
  

 

 

         

Total fixed maturity securities

      6,760          

Limited partnership

      10,376         Not applicable (a)        Not applicable (b)        Not applicable (b)   

Future policy benefits (embedded derivatives) - GMIB Reinsurance

      73,834         Discounted cash flows        Own credit risk        50   
          Long-term volatility        25% -30%   
  

 

 

         

Total assets

      $ 90,970          
  

 

 

         

Liabilities

          

Future policy benefits (embedded derivatives) - GMWB

      $ 84,490         Discounted cash flows        Own credit risk        50   
          Long-term volatility        25% -30%   

Future policy benefits - SALB

      511         See comment below (c)        See comment below (c)        See comment below (c)   
  

 

 

         

Total liabilities

      $ 85,001          
  

 

 

         

Description

    December 31,
2015
Estimated
Fair Value		      Valuation
Techniques		     Unobservable Inputs     Range
(Weighted Average)		  

Assets

          

Fixed maturity securities

          

Asset-backed securities

      $ 6,666         Broker        See comment below (a)        See comment below (a)   
  

 

 

         

Total fixed maturity securities

      6,666          

Limited partnership

      2,116         Not applicable (a)        Not applicable (b)        Not applicable (b)   

Future policy benefits (embedded derivatives) - GMIB Reinsurance

      61,426         Discounted cash flows       Own credit risk        40 bps   
          Long-term volatility        25%   
  

 

 

         

Total assets

      $ 70,208          
  

 

 

         

Liabilities

          

Future policy benefits (embedded derivatives) - GMWB

      $     60,618         Discounted cash flows       Own credit risk        40 bps   
          Long-term volatility        25%   

Future policy benefits - SALB

      511         See comment below (c)        See comment below (c)        See comment below (c)   
  

 

 

         

Total liabilities

      $ 61,129          
  

 

 

         

 

(a)

The Company has obtained non-binding broker quotes which cannot be corroborated by market observable data, to assist in determining the fair values of the Level 3 asset-backed securities. The Company does not receive the unobservable inputs used by the broker but performs annual reviews to approve the use of brokers and obtains an asset specialist’s review of the broker’s price.
(b)

The Company has investments in two limited partnerships for which the fair values are 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 valuations from the underlying financial statements. As a result, inputs are not developed by management to determine the fair value measurement for these investments.
(c)

The SALB is a product with fewer than 150 policies. Due to the small size of this block the liability was determined based on fees earned.

 

The following table provides the estimated fair value of the Company’s assets not carried at fair value on the Balance Sheets at June 30, 2016 and December 31, 2015:

 

     June 30, 2016  

 

    Level 1      Level 2      Level 3      Total  

Assets

            

Mortgage loans on real estate (a)

      $ -             $ -             $ 111,646         $ 111,646   

Policy loans (b)

      -             639,350         -             639,350   
  

 

 

     

 

 

     

 

 

     

 

 

  

Total assets

      $          -             $   639,350       $ 111,646         $   750,996   
  

 

 

     

 

 

     

 

 

     

 

 

  
     December 31, 2015  

 

    Level 1      Level 2      Level 3      Total  

Assets

            

Mortgage loans on real estate (a)

      $ -             $ -             $ 92,923         $ 92,923   

Policy loans (b)

      -             661,466         -             661,466   
  

 

 

     

 

 

     

 

 

     

 

 

  

Total assets

      $          -             $   661,466         $   92,923         $   754,389   
  

 

 

     

 

 

     

 

 

     

 

 

  

 

(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. The book value of policy loans approximates their fair value.