Fair Value of Financial Instruments

3 Months Ended

Mar. 31, 2012

Notes to Financial Statements

Fair Value of Financial Instruments

7. Fair Value of Financial Instruments

ASC 820-10 defines and establishes the framework for measuring fair value. The framework is based on inputs that are used in the valuation and a fair value hierarchy based on the quality of those inputs used to measure fair value. 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.

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 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.

Investments, in which fair value is based upon unadjusted quoted market prices, are reported as Level 1. We receive quoted market prices from an independent third party, nationally recognized pricing vendor (“pricing vendor”). When quoted prices are not available, we use a pricing vendor to give an estimated fair value in which amounts are included in Level 2 of the hierarchy. If quoted prices, or an estimated price from the pricing vendor are not available or we determine that the price is based on disorderly transactions or in inactive markets, fair value is based upon internally developed models. These internal models 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.

Management reviews all Level 2 and Level 3 market prices on a quarterly basis. Level 2 prices are grouped by asset class validated by using any combination of the following:

• Yield curve analysis
• Published index data
• Ratings data
• Spread data
• Sector specific economics / performance
• Alternative / comparable price sources (if available)
• Price stratification to prior price
• Similar traded securities

Level 3 prices are validated on an individual security basis using multiple indicators which may include any combination of the following:

• Coupon rate
• Maturity data
• Quality ratings
• Comparison price analysis
• Sector / asset class specific index data
• Vintage year / seasoning of issue (structured products)
• Cash flow analysis
• Alternative / comparable price sources (if available)

 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.

Available-for-sale debt securities

We use a pricing vendor to estimate fair value for the majority of our available-for-sale debt securities. The pricing vendor’s evaluations are based on market data and use pricing models that vary by asset class and incorporate available trade, bid and other market information. For investments that are not priced by the pricing vendor, we estimated fair value using an internal matrix. The internal matrix uses underlying source data from independent third parties for treasury yields, market spreads and average life calculations. Because our internal matrix prices are derived from observable market data, we include these estimates in Level 2 of our hierarchy.

Structured Securities

For structured securities, 90% of the fair value estimates are provided by our pricing vendor. When pricing is not available from the pricing vendor, we obtain fair value information from brokers or use internal models. These models 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.

To determine fair values for certain structured, collateralized loan obligations (“CLO”) and collateralized debt obligation (“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 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.

The majority of the internal valuations calculated for structured securities are reported in Level 3 of the valuation hierarchy.

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 consolidated 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, 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 actual portfolio experience.

Private equity investments

The valuation of non-public private equity investments requires significant management judgment due to the absence of quoted market prices, an inherent lack of liquidity and the long-term nature of such assets. Private equity investments are valued initially based upon transaction price. The carrying values of private equity investments are adjusted either upwards or downwards from the transaction price to reflect expected exit values as evidenced by financing and sale transactions with third parties, or when determination of a valuation adjustment is confirmed through ongoing reviews by senior investment managers. A variety of factors are reviewed and monitored to assess positive and negative changes in valuation including, but not limited to, current operating performance and future expectations of the particular investment, industry valuations of comparable public companies, changes in market outlook and the third-party financing environment over time. In determining valuation adjustments resulting from the investment review process, emphasis is placed on current company performance and market conditions. Private equity investments are included in Level 3 of the valuation hierarchy.

Private equity investments may also include publicly held equity securities, generally obtained through the initial public offering of privately held equity investments. Such securities are marked-to-market at the quoted public value less adjustments for regulatory or contractual sales restrictions. Discounts for restrictions are quantified by analyzing the length of the restriction period and the volatility of the equity security.

Valuation of embedded derivatives

We make guarantees on certain variable 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 of embedded derivative liabilities 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 the Company’s life insurance subsidiaries 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 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 related to variable annuity GMAB and GMWB embedded derivatives at March 31, 2012 and December 31, 2011 was a reduction of $20,090 thousand and $34,679 thousand in the reserves associated with these riders, respectively.

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 March 31, 2012
($ in thousands)	Level 1		Level 2		Level 3		Total
Assets
Available-for-sale debt securities
U.S. government and agency	$	117,456	$	69,210	$	--	$	186,666
State and political subdivision		--		110,763		--		110,763
Foreign government		--		49,156		--		49,156
Corporate		--		1,344,341		40,873		1,385,214
CMBS		--		269,315		19,597		288,912
RMBS		--		541,496		6,533		548,029
CDO/CLO		--		--		68,302		68,302
Other asset-backed		--		116,673		7,525		124,198
Derivative assets		12,454		119,452		--		131,906
Separate account assets(1)		2,538,046		99,080		--		2,637,126
Fair value option investments(2)		--		--		7,422		7,422
Total assets	$	2,667,956	$	2,719,486	$	150,252	$	5,537,694
Liabilities
Derivative liabilities	$	--	$	47,465	$	--	$	47,465
Embedded derivatives		--		--		113,828		113,828
Total liabilities	$	--	$	47,465	$	113,828	$	161,293

———————

⁽¹⁾ Excludes $40,549 thousand in limited partnerships and real estate investments accounted for on the equity method as well as $10,955 thousand in cash and cash equivalents and money market funds.

⁽²⁾ Fair value option investments at March 31, 2012 include $7,422 thousand of available-for-sale debt securities in which the fair value option has been elected. Changes in the fair value of these assets are recorded through net investment income.

There were no transfers of assets between Level 1 and Level 2 during the quarter ended March 31, 2012.

Fair Values of Financial Instruments by Level:	As of December 31, 2011
($ in thousands)	Level 1		Level 2		Level 3		Total
Assets
Available-for-sale debt securities
U.S. government and agency	$	138,947	$	36,381	$	--	$	175,328
State and political subdivision		--		82,397		--		82,397
Foreign government		--		31,877		--		31,877
Corporate		--		1,179,889		28,488		1,208,377
CMBS		--		269,514		20,441		289,955
RMBS		--		546,975		6,544		553,519
CDO/CLO		--		1,044		66,972		68,016
Other asset-backed		--		128,861		8,062		136,923
Derivative assets		16,185		97,037		--		113,222
Separate account assets(1)		2,419,655		78,325		--		2,497,980
Fair value option investments(2)		--		--		7,299		7,299
Total assets	$	2,574,787	$	2,452,300	$	137,806	$	5,164,893
Liabilities
Derivative liabilities	$	--	$	22,457	$	--	$	22,457
Embedded derivatives		--		--		120,862		120,862
Total liabilities	$	--	$	22,457	$	120,862	$	143,319

———————

⁽¹⁾ Excludes $40,086 thousand in limited partnerships and real estate investments accounted for on the equity method as well as $8,941 thousand in cash and cash equivalents and money market funds.

⁽²⁾ Fair value option investments at December 31, 2011 include $7,299 thousand of available-for-sale debt securities in which the fair value option has been elected. Changes in the fair value of these assets are recorded through net investment income.

There were no transfers of assets between Level 1 and Level 2 during the year ended December 31, 2011.

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 March 31, 2012
($ in thousands)	Asset-				Corp &						Fair Value		Total
	Backed		CDO/CLO		Other		CMBS		RMBS		Options		Assets
Balance, beginning of period	$	8,062	$	66,972	$	28,488	$	20,441	$	6,544	$	7,299	$	137,806
Purchases		--		--		12,186		--		--		--		12,186
Sales		(536)		(882)		(1,297)		(1,407)		(98)		--		(4,220)
Transfers into Level 3(1)		--		1,262		--		--		--		--		1,262
Transfers out of Level 3(2)		--		--		--		--		--		--		--
Realized gains (losses)   included in earnings		44		--		--		--		(1)		--		43
Unrealized gains (losses)   included in other comprehensive   income (loss)		(47)		857		1,476		561		57		--		2,904
Amortization/accretion		2		93		20		2		31		123		271
Balance, end of period	$	7,525	$	68,302	$	40,873	$	19,597	$	6,533	$	7,422	$	150,252

———————

⁽¹⁾ Transfers into Level 3 for the three months ended March 31, 2012 primarily represent private securities for which Level 2 input assumptions for valuation pricing were no longer applicable.

⁽²⁾ Transfers out of Level 3 for the three months ended March 31, 2012 primarily represent private securities for which reliable Level 2 input assumptions for valuation pricing became obtainable.

Level 3 Financial Assets:	Three Months Ended March 31, 2011
($ in thousands)	Asset-				Corp &						Fair Value		Total
	Backed		CDO/CLO		Other		CMBS		RMBS		Options		Assets
Balance, beginning of period	$	19,671	$	63,184	$	30,060	$	10,308	$	7,437	$	7,289	$	137,949
Purchases		2,600		--		29		11,295		4,500		--		18,424
Sales		(994)		(2,027)		(9)		(122)		(197)		--		(3,349)
Transfers into Level 3(1)		--		--		--		--		--		--		--
Transfers out of Level 3(2)		(6,411)		--		--		--		--		--		(6,411)
Realized gains (losses)   included in earnings		48		(71)		--		--		--		119		96
Unrealized gains (losses)   included in other comprehensive   income (loss)		(32)		2,960		2,683		600		(21)		61		6,251
Amortization/accretion		7		66		16		--		48		13		150
Balance, end of period	$	14,889	$	64,112	$	32,779	$	22,081	$	11,767	$	7,482	$	153,110

———————

⁽¹⁾ Transfers into Level 3 for the three months ended March 31, 2011 primarily represent private securities for which Level 2 input assumptions for valuation pricing were no longer applicable.

⁽²⁾ Transfers out of Level 3 for the three months ended March 31, 2011 primarily represent private securities for which reliable Level 2 input assumptions for valuation pricing became obtainable.

Level 3 Financial Liabilities:	Embedded Derivatives
($ in thousands)	Three Months Ended
	March 31,
	2012		2011
Balance, beginning of period	$	120,862	$	26,484
Net purchases/(sales)		14,636		13,301
Transfers into Level 3		--		--
Transfers out of Level 3		(1,585)		--
Realized (gains) losses		(20,992)		(12,160)
Unrealized (gains) losses included in other comprehensive loss		--		--
Deposits less benefits		--		--
Change in fair value(1)		907		(543)
Amortization/accretion		--		--
Balance, end of period	$	113,828	$	27,082

———————

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

The unobservable inputs used in the fair value measurement of CDO/CLO and fair value options are prepayment rates, default rates, recovery rates, and reinvestment spread. Significant changes in any of these inputs on its own may result in a significant change in the fair value measurement, particularly for subordinated tranches. Generally, for a CDO/CLO whose collateral’s weighted-average spread is higher than the assumed reinvestment spread, an increase in prepayment rates would decrease the fair value while the deal remains within its reinvestment period. If the weighted-average spread is lower than the assumed reinvestment spread, an increase in prepayment rates would increase the fair value. Keeping all other inputs unchanged, a significant increase in the annual default rates would likely result in a decrease to fair value.

The following tables present quantitative information about unobservable inputs used in the fair value measurement of internally priced assets and liabilities.

Level 3 Assets:	As of March 31, 2012
($ in thousands)	Fair Value		Valuation Technique(s)	Unobservable Input	Range
CDO/CLO	$	66,618	Discounted cash flow	Prepayment rate	20% (CLOs)
				Default rate	2.3% (CLOs), 0.5% - 0.7% (CDOs)
				Recovery rate	65% (Loans), 35% (High yield bonds),   45% (Investment grade bonds)
				Reinvestment spread	3 mo LIBOR + 400bps (CLOs)
Fair value options		7,422	Discounted cash flow	Prepayment rate	20% (CLOs)
				Default rate	2.3% (CLOs), 0.5% - 0.7% (CDOs)
				Recovery rate	65% (Loans), 35% (High yield bonds),   45% (Investment grade bonds)
				Reinvestment spread	3 mo LIBOR + 400bps (CLOs)
Other asset-backed		1,289	Discounted cash flow	Prepayment rate	20%
				Default rate	2.53% for 48 mos then .33% thereafter
				Recovery rate	65%
				Reinvestment spread	3mo LIBOR + 400bps (CLOs)
Total Level 3 assets(1)	$	75,329

———————

⁽¹⁾ Excludes $74,923 thousand of Level 3 assets which are valued based upon non-binding independent third-party broker quotes for which unobservable inputs are not reasonably available to us

Level 3 Liabilities:	As of March 31, 2012
($ in thousands)	Fair Value		Valuation Technique(s)	Unobservable Input	Range
Embedded derivatives (GMAB / GMWB)	$	19,674	Risk neutral stochastic   valuation methodology	Volatility surface	11.72% - 48.00%
				Swap curve	0.15% - 3.21%
				Mortality rate	75% of A2000 basic table
				Lapse rate	0.00% - 60.00%
				CSA	5.44%
Embedded derivatives (GPAF)	$	600	Real world single scenario   cash flow projection	Interest rate	3.46%
				Mortality rate	70% 1994 MGDB
Embedded derivatives	$	93,554	Budget method	Swap curve	0.15% - 3.21%
(Index credits)				Mortality rate	75% of A2000 basic table
				Lapse rate	1.00% - 35.00%
				CSA	5.44%
Total Level 3 liabilities	$	113,828

Fair value of financial instruments

The Company is required by U.S. GAAP to disclose the fair value of certain financial instruments including those that are not carried at fair value. The following table discloses the Company’s financial instruments where the carrying amounts and fair values differ:

Carrying Amounts and Fair Values of Financial Instruments:	As of March 31, 2012				As of December 31, 2011
($ in thousands)	Carrying		Fair		Carrying		Fair
	Value		Value		Value		Value
Financial liabilities:
Investment contracts	$	1,884,803	$	1,890,428	$	1,721,219	$	1,728,887

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.