(5) Fair Value of Financial Instruments

Fair value is the price that would be received upon the sale of an asset in an orderly transaction between market participants at the measurement date. Fair value measurements are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our view of market assumptions in the absence of observable market information. We classify and disclose all invested assets carried at fair value in one of the following three categories:

•

Level 1. Quoted prices for identical instruments in active markets. Level 1 primarily consists of financial instruments whose value is based on quoted market prices in active markets, such as exchange-traded common stocks and actively traded mutual fund investments;

•

Level 2. Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs are observable in active markets. Level 2 includes those financial instruments that are valued using industry-standard pricing methodologies, models or other valuation methodologies. Various inputs are considered in deriving the fair value of the underlying financial instrument, including interest rate and yield curves, credit spread, and foreign exchange rates. All significant inputs are observable, or derived from observable information in the marketplace or are supported by observable levels at which transactions are executed in the marketplace. Financial instruments in this category primarily include: certain public and private corporate fixed-maturity and equity securities; government or agency securities; certain mortgage- and asset-backed securities and bifurcated conversion options; and

•

Level 3. Valuations derived from valuation techniques in which one or more significant inputs are unobservable. Level 3 consists of financial instruments whose fair value is estimated based on industry-standard pricing methodologies and models using significant inputs not based on, nor corroborated by, readily available market information. Valuations for this category primarily consist of non-binding broker quotes. Financial instruments in this category primarily include less liquid mortgage- and asset-backed securities.

As of each reporting period, all assets and liabilities recorded at fair value are classified in their entirety based on the lowest level of input (Level 3 being the lowest) that is significant to the fair value measurement. Significant levels of estimation and judgment are required to determine the fair value of certain of our investments. The factors influencing these estimations and judgments are subject to change in subsequent reporting periods.

The estimated fair value and hierarchy classifications for assets and liabilities that are measured at fair value on a recurring basis were as follows:

	December 31, 2017
	Level 1		Level 2		Level 3		Total
	(In thousands)
Fair value assets:
Available-for-sale fixed-maturity securities:
U.S. government and agencies	$	-	$	11,813	$	-	$	11,813
Foreign government		-		144,489		-		144,489
States and political subdivisions		-		56,127		-		56,127
Corporates		3,240		1,373,039		3		1,376,282
Residential mortgage-backed securities		-		122,544		414		122,958
Commercial mortgage-backed securities		-		135,392		-		135,392
Other asset-backed securities		-		80,781		-		80,781
Total available-for-sale fixed-maturity securities		3,240		1,924,185		417		1,927,842
Available-for-sale equity securities		39,026		1,931		150		41,107
Trading securities		1,428		4,800		-		6,228
Separate accounts		-		2,572,872		-		2,572,872
Total fair value assets	$	43,694	$	4,503,788	$	567	$	4,548,049
Fair value liabilities:
Separate accounts	$	-	$	2,572,872	$	-	$	2,572,872
Total fair value liabilities	$	-	$	2,572,872	$	-	$	2,572,872

	December 31, 2016
	Level 1		Level 2		Level 3		Total
	(In thousands)
Fair value assets:
Available-for-sale fixed-maturity securities:
U.S. government and agencies	$	-	$	10,474	$	-	$	10,474
Foreign government		-		129,306		-		129,306
States and political subdivisions		-		45,724		-		45,724
Corporates		3,113		1,322,257		3		1,325,373
Residential mortgage-backed securities		-		98,966		585		99,551
Commercial mortgage-backed securities		-		109,443		-		109,443
Other asset-backed securities		-		65,075		7,492		72,567
Total available-for-sale fixed-maturity securities		3,113		1,781,245		8,080		1,792,438
Available-for-sale equity securities		39,556		5,256		82		44,894
Trading securities		51		7,332		-		7,383
Separate accounts		-		2,287,953		-		2,287,953
Total fair value assets	$	42,720	$	4,081,786	$	8,162	$	4,132,668
Fair value liabilities:
Separate accounts	$	-	$	2,287,953	$	-	$	2,287,953
Total fair value liabilities	$	-	$	2,287,953	$	-	$	2,287,953

In assessing fair value of our investments, we use a third-party pricing service for approximately 94% of our securities that are measured at fair value on a recurring basis. The remaining securities are primarily thinly traded securities, such as private placements, and are valued using models based on observable inputs on public corporate spreads having similar characteristics (e.g., sector, average life and quality rating) and liquidity and yield based on quality rating, average life and treasury yields. All observable data inputs are corroborated by independent third-party data. In the absence of sufficient observable inputs, we utilize non-binding broker quotes, which are reflected in our Level 3 classification as we are unable to evaluate the valuation technique(s) or significant inputs used to develop the quotes. Therefore, we do not internally develop the quantitative unobservable inputs used in measuring the fair value of Level 3 investments. However, we do corroborate pricing information provided by our third-party pricing servicing by performing a review of selected securities. Our review activities include obtaining detailed information about the assumptions, inputs and methodologies used in pricing the security; documenting this information; and corroborating it by comparison to independently obtained prices and or independently developed pricing methodologies.

Furthermore, we perform internal reasonableness assessments on fair value determinations within our portfolio throughout the quarter and at quarter-end, including pricing variance analyses and comparisons to alternative pricing sources and benchmark returns. If a fair value appears unusual relative to these assessments, we will re-examine the inputs and may challenge a fair value assessment made by the pricing service. If there is a known pricing error, we will request a reassessment by the pricing service. If the pricing service is unable to perform the reassessment on a timely basis, we will determine the appropriate price by requesting a reassessment from an alternative pricing service or other qualified source as necessary. We do not adjust quotes or prices except in a rare circumstance to resolve a known error.

Because many fixed-maturity securities do not trade on a daily basis, third-party pricing services generally determine fair value using industry-standard methodologies, which vary by asset class. For corporates, governments, and agency securities, these methodologies include developing prices by incorporating available market information such as U.S. Treasury curves, benchmarking of similar securities including new issues, sector groupings, quotes from market participants and matrix pricing. Observable information is compiled and integrates relevant credit information, perceived market movements and sector news. Additionally, security prices are periodically back-tested to validate and/or refine models as conditions warrant. Market indicators and industry and economic events are also monitored as triggers to obtain additional data. For certain structured securities (such as mortgage-and asset-backed securities) with limited trading activity, third-party pricing services generally use industry-standard pricing methodologies that incorporate market information, such as index prices or discounting expected future cash flows based on underlying collateral, and quotes from market participants, to estimate fair value. If these measures are not deemed observable for a particular security, the security will be classified as Level 3 in the fair value hierarchy.

Where specific market information is unavailable for certain securities, pricing models produce estimates of fair value primarily using Level 2 inputs along with certain Level 3 inputs. These models include matrix pricing. The pricing matrix uses current treasury rates and credit spreads received from third-party sources to estimate fair value. The credit spreads incorporate the issuer’s industry- or issuer-specific credit characteristics and the security’s time to maturity, if warranted. Remaining unpriced securities are valued using an estimate of fair value based on indicative market prices that include significant unobservable inputs not based on, nor corroborated by, market information, including the utilization of non-binding broker quotes.

The roll-forward of the Level 3 assets measured at fair value on a recurring basis was as follows:

	Year ended December 31,
	2017			2016
	(In thousands)
Level 3 assets, beginning of period	$	8,162		$	783
Net unrealized gains (losses) included in other comprehensive income		232			(23	)
Realized gains (losses) and accretion (amortization) recognized in earnings, including OTTI		26			7
Purchases		-			7,556
Settlements		(958	)		(162	)
Transfers into Level 3		-			1
Transfers out of Level 3⁽¹⁾		(6,895	)		-
Level 3 assets, end of period	$	567		$	8,162

⁽¹⁾	During the year ended December 31, 2017, transfers out of Level 3 assets primarily consisted of newly issued fixed-maturity securities purchased in the fourth quarter of 2016 for which observable inputs, most notably quoted prices, used to derive valuations were not yet readily available.

We obtain independent pricing quotes based on observable inputs as of the end of the reporting period for all securities in Level 2. Those inputs include benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, market bids/offers, quoted prices for similar instruments in markets that are not active, and other relevant data. We monitor these inputs for market indicators, industry and economic events. We recognize transfers into new levels and out of previous levels as of the end of the reporting period, including interim reporting periods, as applicable. There were no material transfers between Level 1 and Level 2 or between Level 1 and Level 3 during the years ended December 31, 2017 and 2016.

Invested assets included in the transfer from Level 3 to Level 2 primarily were fixed-maturity investments for which we were able to obtain independent pricing quotes based on observable inputs.

The carrying values and estimated fair values of our financial instruments were as follows:

	December 31, 2017				December 31, 2016
	Carrying value		Estimated fair value		Carrying value		Estimated fair value
	(In thousands)
Assets:
Fixed-maturity securities (available-for-sale)	$	1,927,842	$	1,927,842	$	1,792,438	$	1,792,438
Fixed-maturity securities (held-to-maturity)		737,150		779,472		503,230		513,015
Equity securities (available-for-sale)		41,107		41,107		44,894		44,894
Trading securities		6,228		6,228		7,383		7,383
Policy loans		32,816		32,816		30,916		30,916
Deposit asset underlying 10% coinsurance agreement		217,336		217,336		202,435		202,435
Separate accounts		2,572,872		2,572,872		2,287,953		2,287,953
Liabilities:
Notes payable⁽¹⁾	$	373,288	$	400,628	$	372,919	$	401,340
Surplus note⁽¹⁾		736,381		778,050		502,491		512,669
Separate accounts		2,572,872		2,572,872		2,287,953		2,287,953

⁽¹⁾	Carrying value amounts shown are net of issuance costs.

The fair values of financial instruments presented above are estimates of the fair values at a specific point in time using various sources and methods, including market quotations and a complex matrix system that takes into account issuer sector, quality, and spreads in the current marketplace.

Recurring fair value measurements. Estimated fair values of investments in AFS fixed-maturity securities are principally a function of current spreads and interest rates that are corroborated by independent third-party data. Therefore, the fair values presented are indicative of amounts we could realize or settle at the respective balance sheet date. We do not necessarily intend to dispose of or liquidate such instruments prior to maturity. Trading securities, which primarily consist of fixed-maturity securities, are carried at fair value. Equity securities, including common and nonredeemable preferred stocks, are carried at fair value. Segregated funds in separate accounts are carried at the underlying value of the variable insurance contracts, which is fair value.

Nonrecurring fair value measurements. The estimated fair value of the held-to-maturity fixed-maturity security, which is classified as a Level 3 fair value measurement, is derived using the credit spread on similarly rated debt securities and the hypothetical spread of the security’s credit enhancement feature. Policy loans, which are categorized as Level 3 fair value measurements, are carried at the unpaid principal balances. The fair value of policy loans approximate the unpaid principal balances as the timing of repayment is uncertain and the loans are collateralized by the amount of the policy. The deposit asset underlying 10% coinsurance agreement represents the value of the assets necessary to back the economic reserves held in support of the reinsurance agreement. The carrying value of this deposit asset approximates fair value, which is categorized as Level 3 in the fair value hierarchy. Notes payable represent our publicly-traded senior notes and are valued as a Level 2 fair value measurement using the quoted market price for our notes. The estimated fair value of the Surplus Note is derived by using an assumed credit spread we would expect if Vidalia Re was a credit-rated entity and the hypothetical spread of the Surplus Note’s subordinated structure. The Surplus Note is classified as a Level 3 fair value measurement.

The carrying amounts for cash and cash equivalents, receivables, accrued investment income, accounts payable, cash collateral and payables for security transactions approximate their fair values due to the short-term nature of these instruments. Consequently, such financial instruments are not included in the above table.