Fair Value of Financial Instruments

9 Months Ended

Sep. 30, 2011

Notes to Financial Statements

Fair Value of Financial Instruments

Fair Value of Financial Instruments

ASC 820-10 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 is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

ASC 820-10 establishes a three-level valuation hierarchy for disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels, from highest to lowest, are defined as follows:

· Level 1 – inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 1 securities include highly liquid government bonds and exchange-traded equities.

· Level 2 – inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. Examples of such instruments include government-backed mortgage products, certain collateralized mortgage and debt obligations and certain high-yield debt securities.

· Level 3 – inputs to the valuation methodology are unobservable and significant to the fair value measurement. Securities classified within Level 3 include broker quoted investments, certain residual interests in securitizations and other less liquid securities. Most valuations that are based on brokers’ prices are classified as Level 3 due to a lack of transparency in the process they use to develop prices.

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

The following tables present the financial instruments carried at fair value by ASC 820-10 valuation hierarchy (as described above).

Fair Values of Financial Instruments by Level:	As of September 30, 2011
($ in thousands)	Level 1		Level 2		Level 3		Total
Assets
Available-for-sale debt securities
U.S. government and agency	$	187,718	$	33,077	$	--	$	220,795
State and political subdivision		--		38,850		--		38,850
Foreign government		--		28,021		--		28,021
Corporate		--		946,269		56,351		1,002,620
CMBS		--		245,591		26,098		271,689
RMBS		--		495,423		7,127		502,550
CDO/CLO		--		--		55,350		55,350
Other asset-backed		-		130,205		8,439		138,644
Derivative assets		--		107,736		--		107,736
Separate account assets(1)		2,327,945		78,131		192		2,406,268
Fair value option investments		--		--		7,444		7,444
Total assets	$	2,515,663	$	2,103,303	$	161,001	$	4,779,967
Liabilities
Derivative liabilities	$	--	$	10,477	$	114,911	$	125,388
Total liabilities	$	--	$	10,477	$	114,911	$	125,388

———————

⁽¹⁾ Excludes $40,034 thousand in limited partnerships and real estate investments accounted for on the equity method as well as $7,358 thousand in cash and cash equivalents and money market funds.

There were no transfers of assets between Level 1 and Level 2 during the nine months ended September 30, 2011.

Fair Values of Financial Instruments by Level:	As of December 31, 2010
($ in thousands)	Level 1		Level 2		Level 3		Total
Assets
Available-for-sale debt securities
U.S. government and agency	$	68,724	$	29,559	$	--	$	98,283
State and political subdivision		--		32,509		--		32,509
Foreign government		--		16,086		--		16,086
Corporate		--		663,717		30,060		693,777
CMBS		--		163,647		10,308		173,955
RMBS		--		326,168		7,437		333,605
CDO/CLO		--		--		63,184		63,184
Other asset-backed		--		89,328		19,671		108,999
Derivative assets		--		90,441		--		90,441
Separate account assets(1)		2,800,500		77,195		--		2,877,695
Fair value option investments		--		4,442		7,289		11,731
Total assets	$	2,869,224	$	1,493,092	$	137,949	$	4,500,265
Liabilities
Derivative liabilities	$	--	$	8,026	$	26,485	$	34,511
Total liabilities	$	--	$	8,026	$	26,485	$	34,511

———————

⁽¹⁾ Excludes $37,949 thousand in limited partnerships and real estate investments accounted for on the equity method as well as $7,302 thousand in cash and cash equivalents and money market funds.

There were no transfers of assets between Level 1 and Level 2 during the year ended December 31, 2010.

Level 3 financial assets and liabilities

The following tables set forth a summary of changes in the fair value of our Level 3 financial assets and liabilities. Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. For example, a hypothetical derivative contract with Level 1, Level 2 and significant Level 3 inputs would be classified as a Level 3 financial instrument in its entirety. Subsequently, even if only Level 1 and Level 2 inputs are adjusted, the resulting gain or loss is classified as Level 3. Further, Level 3 instruments are frequently hedged with instruments that are classified as Level 1 or Level 2 and, accordingly, gains or losses reported as Level 3 in the table below may be offset by gains or losses attributable to instruments classified in Level 1 or 2 of the fair value hierarchy.

Level 3 Financial Assets:	Three Months Ended September 30, 2011
($ in thousands)	Asset-				Corp &						Fair Value		Total
	Backed		CDO/CLO		Other		CMBS		RMBS		Option		Assets
Balance, beginning of period	$	15,381	$	58,779	$	38,111	$	24,560	$	7,460	$	7,618	$	151,909
Purchases		--		--		21,422		5,050		--		--		26,472
Sales		(515)		(259)		(827)		(677)		(208)		--		(2,486)
Transfers into Level 3(1)		--		--		1,295		--		--		--		1,295
Transfers out of Level 3(2)		(6,917)		--		--		(2,762)		--		--		(9,679)
Realized gains (losses)   included in earnings		54		--		2		--		--		--		56
Unrealized gains (losses)   included in other comprehensive   income (loss)		429		(3,224)		(3,478)		(85)		(169)		(201)		(6,728)
Amortization/accretion		7		54		18		12		44		27		162
Balance, end of period	$	8,439	$	55,350	$	56,543	$	26,098	$	7,127	$	7,444	$	161,001

———————

⁽¹⁾ Net transfers into Level 3 for the three months ended September 30, 2011 primarily represent private securities for which Level 2 input assumptions for valuation pricing were no longer available.

⁽²⁾ Net transfers out of Level 3 for the three months ended September 30, 2011 primarily represent private securities for which reliable Level 2 input assumptions for valuation pricing became obtainable.

Level 3 Financial Assets:	Nine Months Ended September 30, 2011
($ in thousands)	Asset-				Corp &						Fair Value		Total
	Backed		CDO/CLO		Other		CMBS		RMBS		Option		Assets
Balance, beginning of period	$	19,671	$	63,184	$	30,060	$	10,308	$	7,437	$	7,289	$	137,949
Purchases		--		--		23,478		16,345		--		--		39,823
Sales		(2,500)		(6,521)		(860)		(1,261)		(549)		(19)		(11,710)
Transfers into Level 3(1)		--		--		3,366		--		--		--		3,366
Transfers out of Level 3(2)		(9,342)		--		--		--		--		--		(9,342)
Realized gains (losses)   included in earnings		43		(293)		11		--		(1)		--		(240)
Unrealized gains (losses)   included in other comprehensive   income (loss)		545		(1,266)		443		688		115		124		649
Amortization/accretion		22		246		45		18		125		50		506
Balance, end of period	$	8,439	$	55,350	$	56,543	$	26,098	$	7,127	$	7,444	$	161,001

———————

⁽¹⁾ Net transfers into Level 3 for the nine months ended September 30, 2011 primarily represent private securities for which Level 2 input assumptions for valuation pricing were no longer available.

⁽²⁾ Net transfers out of Level 3 for the nine months ended September 30, 2011 primarily represent private securities for which reliable Level 2 input assumptions for valuation pricing became obtainable.

Level 3 Financial Assets:	Three Months Ended September 30, 2010
($ in thousands)	Asset-				Corp &						Fair Value		Total
	Backed		CDO/CLO		Other		CMBS		RMBS		Option		Assets
Balance, beginning of period	$	12,771	$	63,413	$	29,669	$	12,260	$	10,647	$	--	$	128,760
Purchases		1,000		1,897		11		1,010		--		--		3,918
Sales		(1,015)		(277)		(654)		(223)		(254)		--		(2,423)
Adjustment for initial application   of accounting changes(1)		--		(7,142)		--		--		--		7,142		--
Transfers into Level 3(2)		--		--		939		--		2		--		941
Transfers out of Level 3(3)		--		(1,885)		(1,368)		(3,700)		--		--		(6,953)
Realized gains (losses)   included in earnings		66		(787)		10		--		--		--		(711)
Unrealized gains (losses)   included in other comprehensive   income (loss)		1,613		167		2,176		593		1,030		--		5,579
Amortization/accretion		(2)		3		31		1		95		--		128
Balance, end of period	$	14,433	$	55,389	$	30,814	$	9,941	$	11,520	$	7,142	$	129,239

———————

⁽¹⁾ Adjustment from available-for-sale debt securities to fair value option investments upon adoption of ASC 815, Derivatives and Hedging, as of July 1, 2010.

⁽²⁾ Transfers into Level 3 for the three months ended September 30, 2010 primarily represent private securities for which Level 2 input assumptions for valuation pricing were no longer available.

⁽³⁾ Transfers out of Level 3 for the three months ended September 30, 2010 primarily represent private securities for which reliable Level 2 input assumptions for valuation pricing became obtainable.

Level 3 Financial Assets:	Nine Months Ended September 30, 2010
($ in thousands)	Asset-				Corp &						Fair Value		Total
	Backed		CDO/CLO		Other		CMBS		RMBS		Option		Assets
Balance, beginning of period	$	18,854	$	64,999	$	41,257	$	11,784	$	15,637	$	--	$	152,531
Purchases		1,000		1,958		41,788		2,337		1,035		--		48,118
Sales		(1,898)		(936)		(53,069)		(1,987)		(2,034)		--		(59,924)
Adjustment for initial application   of accounting changes(1)		--		(7,142)		--		--		--		7,142		--
Transfers into Level 3(2)		--		--		3,276		--		38		--		3,314
Transfers out of Level 3(3)		(5,863)		(1,885)		(9,855)		(3,700)		(3,278)		--		(24,581)
Realized gains (losses)   included in earnings		71		(2,836)		98		--		(21)		--		(2,688)
Unrealized gains (losses)   included in other comprehensive   income (loss)		2,270		1,234		7,278		1,503		(175)		--		12,110
Amortization/accretion		(1)		(3)		41		4		318		--		359
Balance, end of period	$	14,433	$	55,389	$	30,814	$	9,941	$	11,520	$	7,142	$	129,239

———————

⁽¹⁾ Adjustment from available-for-sale debt securities to fair value option investments upon adoption of ASC 815, Derivatives and Hedging, as of July 1, 2010.

⁽²⁾ Transfers into Level 3 for the nine months ended September 30, 2010 primarily represent private securities for which Level 2 input assumptions for valuation pricing were no longer available.

⁽³⁾ Transfers out of Level 3 for the nine months ended September 30, 2010 primarily represent private securities for which reliable Level 2 input assumptions for valuation pricing became obtainable.

Level 3 Financial Liabilities:	Embedded Derivative Liabilities
($ in thousands)	Three Months Ended				Nine Months Ended
	September  30,				September  30,
	2011		2010		2011		2010
Balance, beginning of period	$	42,926	$	63,582	$	26,485	$	28,678
Net purchases/(sales)		20,506		3,423		48,171		5,853
Transfers into Level 3		--		--		--		--
Transfers out of Level 3		--		--		--		--
Realized (gains) losses		46,831		(17,031)		39,042		15,443
Unrealized (gains) losses included in other comprehensive loss		--		--		--		--
Deposits less benefits		--		--		--		--
Change in fair value(1)		4,648		--		1,213		--
Amortization/accretion		--		--				--
Balance, end of period	$	114,911	$	49,974	$	114,911	$	49,974

———————

⁽¹⁾ Represents change in fair value related to fixed index credits recognized in policy benefits, excluding policy holder dividends, on the statement of income.

Carrying Amounts and Fair Values	As of September 30, 2011				As of December 31, 2010
of Financial Instruments:	Carrying		Fair		Carrying		Fair
($ in thousands)	Value		Value		Value		Value
Cash and cash equivalents	$	69,108	$	69,108	$	51,059	$	51,059
Available-for-sale debt securities		2,258,519		2,258,519		1,520,398		1,520,398
Separate account assets		2,453,660		2,453,660		2,922,946		2,922,946
Policy loans		62,023		62,023		57,326		57,326
Derivative financial instruments		107,736		107,736		90,441		90,441
Fair value option investments		7,444		7,444		11,731		11,731
Financial assets	$	4,958,490	$	4,958,490	$	4,653,901	$	4,653,901
Investment contracts	$	1,466,267	$	1,474,633	$	793,142	$	804,107
Separate account liabilities		2,453,660		2,453,660		2,922,946		2,922,946
Derivative financial instruments		125,388		125,388		34,511		34,511
Financial liabilities	$	4,045,315	$	4,053,681	$	3,750,599	$	3,761,564

Fair value option investments include a structured loan asset valued at $4,442 thousand as of December 31, 2010. Fair value option investments did not include a structured loan asset as of September 30, 2011. Election of the fair value option allows current earnings recognition and is more consistent with management’s view of the securities’ underlying economics. Changes in the fair value of this asset are included in net investment income.

In addition, pursuant to ASC 815, Derivatives and Hedging, adopted on July 1, 2010, fair value option investments also include beneficial interests in four securitized financial assets for which an irrevocable election was made to use the fair value option. These securities contain an embedded derivative feature. These securities were valued at $7,444 thousand and $7,289 thousand as of September 30, 2011 and December 31, 2010, respectively.

We have an established process for determining fair values. Fair value is based upon quoted market prices, where available. If listed prices or quotes are not available, or are based on disorderly transactions or inactive markets, fair value is based upon internally developed models that use primarily market-based or independently-sourced market parameters, including interest rate yield curves, option volatilities and currency rates. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments include amounts to reflect counterparty credit quality, our own creditworthiness, liquidity and unobservable parameters that are applied consistently over time. The majority of the valuations of Level 3 assets were internally calculated or obtained from independent third-party broker quotes.

We determine fair value as the price received in an orderly transaction. Thus, we evaluate broker pricing indications, if available, to determine whether the weight of evidence indicates that markets are inactive, or transactions are disorderly. In order to determine whether the volume and level of activity for an asset or liability has significantly decreased, we compare current activity with normal market activity for the asset or liability. We may observe a notable decrease in the number of recent transactions, and the significant decline or absence of a market for new issuances for the security or a similar security. If we do receive a broker pricing indication, we look for substantiation, such as a significant increase in implied liquidity risk premiums, yields, or performance indications when compared to the expected cash flow analysis. We look to see if the pricing indications have varied substantially in a short amount of time where no fundamental event or occurrence has prompted the large variation, or if there is a significant increase in the bid-ask spread. We review published indexes that may have been historically highly correlated with the fair values that no longer are representative of an active market. For corporate positions, we utilize TRACE, for which published trade activity is made available, to assess trading activity levels. For other positions, we rely on many factors such as the observable flows through Bloomberg, trading levels and activity as reported by market participants, and industry publications that speak to trading volume and current market conditions. Using professional judgment and experience, we evaluate and weigh the relevance and significance of all applicable factors to determine if there has been a significant decrease in the volume and level of activity for an asset, or group of similar assets.

Similarly, in order to identify transactions that are not orderly, we take into consideration the activity in the market as stated above, because that can influence the determination and occurrence of an orderly transaction. In addition, we assess the period of the exposure to the market before the measurement date to determine adequacy for customary marketing activities. Also, we look to see if it was marketed to a single or limited number of participants. We assess the financial condition of the seller, if available, to determine whether observed transactions may have been forced. If the trading price is an outlier when compared to similar recent transactions, we consider whether this is an indicator of a disorderly trade. Using professional judgment and experience, we evaluate and weigh the relevance and significance of all applicable factors to determine if the evidence suggests that a transaction or group of similar transactions is not orderly.

Following is a description of our valuation methodologies for assets and liabilities measured at fair value. Such valuation methodologies were applied to all of the assets and liabilities carried at fair value.

Structured securities

For structured securities, we consider the best estimate of cash flows until maturity to determine our ability to collect principal and interest and compare this to the anticipated cash flows when the security was purchased. In addition, management judgment is used to assess the probability of collecting all amounts contractually due to us. After consideration is given to the available information relevant to assessing the collectibility, including historical events, current conditions and reasonable forecasts, an estimate of future cash flows is determined. This includes evaluating the remaining payment terms, prepayment speeds, the underlying collateral, expected defaults using current default data and the financial condition of the issuer. Other factors considered are composite credit ratings, industry forecast, analyst reports and other relevant market data are also considered, similar to those the Company believes market participants would use. For securities for which observable market data is available and substantiated, valuations reflect the quoted fair value.

To determine fair values for certain structured, CLO and CDO assets for which current pricing indications either do not exist, or are based on inactive markets or sparse transactions, we utilize model pricing using a third-party forecasting application that leverages historical trustee information for each modeled security. Principal and interest cash flows are modeled under various default scenarios for a given tranche of a security in accordance with its contractual cash flow priority of claim and subordination with respect to credit losses. The key assumptions include the level of annual default rates, loss-given-default (LGD) or recovery rate, collateral prepayment rate and reinvestment spread.

Fair value is then determined based on discounted projected cash flows. We use a discount rate based upon a combination of the current U.S. Treasury rate plus the most recent gross CDO/CLO spreads (including the corresponding swap spread) by original tranche rating, which is representative of the inherent credit risk exposure in a deal’s capital structure. A credit loss margin is then deducted from this blended rate equal to the baseline annual default rate times a loss severity rate. The rationale behind the deduction of such credit loss margins is necessary as the projected cash flows have already been default risk-adjusted, taking into account the impact of the projected credit losses in the underlying collateral.

Derivatives

Exchange-traded derivatives valued using quoted prices are classified within Level 1 of the valuation hierarchy. However, few classes of derivative contracts are listed on an exchange. Therefore, the majority of our derivative positions are valued using internally developed models that use as their basis readily observable market parameters. These positions are classified within Level 2 of the valuation hierarchy. Such derivatives include basic interest rate swaps, options and credit default swaps.

Fair values for OTC derivative financial instruments, principally forwards, options and swaps, represent the present value of amounts estimated to be received from or paid to a marketplace participant in settlement of these instruments (i.e., the amount we would expect to receive in a derivative asset assignment or would expect to pay to have a derivative liability assumed). These derivatives are valued using pricing models based on the net present value of estimated future cash flows and directly observed prices from exchange-traded derivatives or other OTC trades, while taking into account the counterparty’s credit ratings, or our own credit ratings, as appropriate. Determining the fair value for OTC derivative contracts can require a significant level of estimation and management judgment.

New and/or complex instruments may have immature or limited markets. As a result, the pricing models used for valuation often incorporate significant estimates and assumptions that market participants would use in pricing the instrument, which may impact the results of operations reported in the financial statements. For long-dated and illiquid contracts, extrapolation methods are applied to observed market data in order to estimate inputs and assumptions that are not directly observable. This enables us to mark to market all positions consistently when only a subset of prices is directly observable. Values for OTC derivatives are verified using observed information about the costs of hedging the risk and other trades in the market. As the markets for these products develop, we continually refine our pricing models to correlate more closely to the market risk of these instruments.

Retained interest in securitization

Retained interests in securitizations do not trade in an active, open market with readily observable prices. Accordingly, we estimate the fair value of certain retained interests in securitizations using discounted cash flow (“DCF”) models.

For certain other retained interests in securitizations (such as interest-only strips), a single interest rate path DCF model is used and generally includes assumptions based upon projected finance charges related to the securitized assets, estimated net credit losses, prepayment assumptions and contractual interest paid to third-party investors. Changes in the assumptions used may have a significant impact on our valuation of retained interests and such interests are, therefore, typically classified within Level 3 of the valuation hierarchy.

We compare the fair value estimates and assumptions to observable market data where available and to recent market activity and actual portfolio experience.

Separate accounts

Separate account assets are primarily invested in mutual funds but also have investments in fixed maturity and equity securities. The separate account investments are valued in the same manner, and using the same pricing sources and inputs, as the fixed maturity, equity security and short-term investments of the Company. Mutual funds are included in Level 1. Most debt securities and short-term investments are included in Level 2.

Fair value of investment contracts

We determine the fair value of guaranteed interest contracts by using a discount rate equal to the appropriate U.S. Treasury rate plus 100 basis points to calculate the present value of projected contractual liability payments through final maturity. We determine the fair value of deferred annuities and supplementary contracts without life contingencies with an interest guarantee of one year or less at the amount of the policy reserve. In determining the fair value of deferred annuities and supplementary contracts without life contingencies with interest guarantees greater than one year, we use a discount rate equal to the appropriate U.S. Treasury rate plus 100 basis points to calculate the present value of the projected account value of the policy at the end of the current guarantee period.

Deposit type funds, including pension deposit administration contracts, dividend accumulations, and other funds left on deposit not involving life contingencies, have interest guarantees of less than one year for which interest credited is closely tied to rates earned on owned assets. For these liabilities, we assume fair value to be equal to the stated liability balances.

Valuation of embedded derivatives

We make guarantees on certain variable and fixed indexed annuity contracts, including GMAB and GMWB as well as provide credits based on the performance of certain indices (“index credits”) on our fixed indexed annuity contracts that meet the definition of an embedded derivative. The GMAB and GMWB embedded derivative liabilities associated with our variable annuity contracts are accounted for at fair value using a risk neutral stochastic valuation methodology with changes in fair value recorded in realized investment gains. The inputs to our fair value methodology include information derived from the asset derivatives market, including the volatility surface and the swap curve. Several additional inputs are not obtained from independent sources, but instead reflect our internally developed assumptions related to mortality rates, lapse rates and policyholder behavior. The fair value of the embedded derivative liabilities associated with the index credits on our fixed indexed annuity contracts is calculated using the budget method with changes in fair value recorded in policy benefits. The initial value under the budget method is established based on the fair value of the options used to hedge the liabilities. The budget amount for future years is based on the impact of projected interest rates on the discounted liabilities. Several additional inputs reflect our internally developed assumptions related to lapse rates and policyholder behavior. As there are significant unobservable inputs included in our fair value methodology for these embedded derivative liabilities, we consider the above-described methodology as a whole to be Level 3 within the fair value hierarchy.

Our fair value calculation includes a credit standing adjustment (the “CSA”). The CSA represents the adjustment that market participants would make to reflect the risk that guaranteed benefit obligations may not be fulfilled (“non-performance risk”). In analyzing various alternatives to the CSA calculation, we determined that we could not use credit default swap spreads as there are no such observable instruments on PNX’s life insurance subsidiaries, including us, nor could we consistently obtain an observable price on the surplus notes issued by Phoenix Life, as the surplus notes are not actively traded. Therefore, when discounting the rider cash flows for calculation of the fair value of the liability, we calculated the CSA that reflects the credit spread (based on a Standard & Poor’s BB- credit rating) for financial services companies similar to the Company’s life insurance subsidiaries. This average credit spread is recalculated every quarter and, therefore, the fair value will change with the passage of time even in the absence of any other changes that would affect the valuation. The impact of the CSA, net of the reinsurance impact from a contract with Phoenix Life, at September 30, 2011 and December 31, 2010 was a reduction of
$40,082 thousand and $19,231 thousand in the reserves associated with these riders, respectively.