Derivative Financial Instruments

9 Months Ended

Sep. 30, 2011

Derivative Instruments and Hedging Activities Disclosure [Abstract]

Derivative Financial Instruments

Derivative Financial Instruments

The Company uses derivatives in the normal course of business, primarily in an attempt to reduce its exposure to market risk (principally interest rate risk, equity price risk and foreign currency risk) stemming from various assets and liabilities and credit risk (the ability of an obligor to make timely payment of principal and/or interest). The Company's principal objective under such risk strategies is to achieve the desired reduction in economic risk, even if the position does not receive hedge accounting treatment.

The Company's use of derivatives is limited by statutes and regulations promulgated by the various regulatory bodies to which it is subject, and by its own derivative policy. The derivative policy limits the authorization to initiate derivative transactions to certain personnel. Derivatives entered into for hedging, regardless of the choice to designate hedge accounting, shall have a maturity that effectively correlates to the underlying hedged asset or liability. The policy prohibits the use of derivatives containing greater than one-to-one leverage with respect to changes in the underlying price, rate or index. The policy also prohibits the use of borrowed funds, including funds obtained through securities lending, to engage in derivative transactions.

The Company has exposure to economic losses due to interest rate risk arising from changes in the level of, or volatility of, interest rates. The Company attempts to mitigate its exposure to interest rate risk in the normal course of portfolio management which includes rebalancing its existing portfolios of assets and liabilities. In addition, various derivative financial instruments are used to modify the interest rate risk exposures of certain assets and liabilities. These strategies include the use of interest rate swaps, interest rate caps and floors, options, futures, forwards and commitments to purchase securities. These instruments are generally used to lock interest rates or market values, to shorten or lengthen durations of fixed maturity securities or to hedge (on an economic basis) interest rate risks associated with investments and variable rate debt.

The Company has exposure to equity price risk as a result of its investment in equity securities and equity derivatives. Equity price risk results from changes in the level or volatility of equity prices, which affect the value of equity securities, or instruments that derive their value from such securities. The Company attempts to mitigate its exposure to such risks by limiting its investment in any one security or index. The Company may also manage this risk by utilizing instruments such as options, swaps, futures and collars to protect appreciation in securities held.

The Company has exposure to credit risk arising from the uncertainty associated with a financial instrument obligor's ability to make timely principal and/or interest payments. The Company attempts to mitigate this risk by limiting credit concentrations, practicing diversification and frequently monitoring the credit quality of issuers and counterparties. In addition, the Company may utilize credit derivatives such as credit default swaps (CDS) to modify the credit risk inherent in certain investments. CDS involve a transfer of credit risk from one party to another in exchange for periodic payments.

Foreign currency risk arises from the possibility that changes in foreign currency exchange rates will impact the fair value of financial instruments denominated in a foreign currency. The Company's foreign transactions are primarily denominated in British pounds, Euros and Canadian dollars. The Company typically manages this risk via asset/liability currency matching and through the use of foreign currency forwards.

In addition to the derivatives used for risk management purposes described above, the Company may also use derivatives for purposes of income enhancement. Income enhancement transactions are entered into with the intention of providing additional income or yield to a particular portfolio segment or instrument. Income enhancement transactions are limited in scope and primarily involve the sale of covered options in which the Company receives a premium in exchange for selling a call or put option.

The Company will also use CDS to sell credit protection against a specified credit event.  In selling credit protection, CDS are used to replicate fixed income securities when credit exposure to certain issuers is not available or when it is economically beneficial to transact in the derivative market compared to the cash market alternative.  Credit risk includes both the default event risk and market value exposure due to fluctuations in credit spreads.  In selling CDS protection, the Company receives a periodic premium in exchange for providing credit protection on a single name reference obligation or a credit derivative index.  If there is an event of default as defined by the CDS agreement, the Company is required to pay the counterparty the referenced notional amount of the CDS contract and in exchange, the Company is entitled to receive the referenced defaulted security or the cash equivalent.

The tables below summarize open CDS contracts where the Company sold credit protection as of September 30, 2011 and December 31, 2010. The fair value of the contracts represents the amounts that the Company would receive or pay at those dates to exit the derivative positions. The maximum amount of future payments assumes no residual value in the defaulted securities that the Company would receive as part of the contract terminationsand is equal to the notional value of the CDS contracts.

Credit Ratings of Underlying Reference Obligations

September 30, 2011	Fair Value of Credit Default Swaps		Maximum Amount of Future Payments under Credit Default Swaps		Weighted Average Years to Maturity
(In millions)
BB rated	$	—	$	5	1.7
B rated	—		3		0.7
Total	$	—	$	8	1.4

Credit Ratings of Underlying Reference Obligations

December 31, 2010	Fair Value of Credit Default Swaps		Maximum Amount of Future Payments under Credit Default Swaps		Weighted Average Years to Maturity
(In millions)
BB rated	$	1	$	5	2.5
B rated	—		3		1.5
Total	$	1	$	8	2.1

Credit exposure associated with non-performance by the counterparties to derivative instruments is generally limited to the uncollateralized fair value of the asset related to the instruments recognized on the Condensed Consolidated Balance Sheets. The Company attempts to mitigate the risk of non-performance by monitoring the creditworthiness of counterparties and diversifying derivatives to multiple counterparties. The Company generally requires that all over-the-counter derivative contracts be governed by an International Swaps and Derivatives Association Master Agreement, and exchanges collateral under the terms of these agreements with its derivative investment counterparties depending on the amount of the exposure and the credit rating of the counterparty. The Company does not offset its net derivative positions against the fair value of the collateral provided. The fair value of cash collateral provided by the Company was $1 million and $2 million at September 30, 2011 and December 31, 2010. The fair value of cash collateral received from counterparties was $1 million at September 30, 2011 and December 31, 2010.

Derivative securities are recorded at fair value. See Note E for information regarding the fair value of derivatives securities. Changes in the fair value of derivatives not held in a trading portfolio are reported in Net realized investment gains (losses) on the Condensed Consolidated Statements of Operations. Changes in the fair value of derivatives held for trading purposes are reported in Net investment income on the Condensed Consolidated Statements of Operations.

A summary of the recognized gains (losses) related to derivative financial instruments follows.

Recognized Gains (Losses)

Periods ended September 30	Three Months					Nine Months
(In millions)	2011		2010			2011			2010
Without hedge designation
Credit default swaps - purchased protection	$	—	$	(1	)	$	—		$	(1	)
Currency forwards	—		—			(1		)	—
Forward commitments for mortgage-backed securities	1		—			1			—
Total without hedge designation	1		(1		)	—			(1		)
Trading activities
Futures sold, not yet purchased	—		(4		)	—			(3		)
Total	$	1	$	(5	)	$	—		$	(4	)

A summary of the aggregate contractual or notional amounts and gross estimated fair values related to derivative financial instruments reported as Other invested assets or Other liabilities on the Condensed Consolidated Balance Sheets follows. The contractual or notional amounts for derivatives are used to calculate the exchange of contractual payments under the agreements and may not be representative of the potential for gain or loss on these instruments.

Derivative Financial Instruments

September 30, 2011	Contractual/ Notional Amount		Estimated Fair Value
(In millions)			Asset		(Liability)
Without hedge designation
Credit default swaps - purchased protection	$	20	$	—	$	(2	)
Credit default swaps - sold protection	8		—		—
Forward commitments for mortgage-backed securities	62		1		—
Equity warrants	—		1		—
Options written	1		—		—
Total without hedge designation	91		2		(2		)
Trading activities
Futures sold, not yet purchased	13		—		—
Total	$	104	$	2	$	(2	)

Derivative Financial Instruments

December 31, 2010	Contractual/ Notional Amount		Estimated Fair Value
(In millions)			Asset		(Liability)
Without hedge designation
Credit default swaps - purchased protection	$	20	$	—	$	(2	)
Credit default swaps - sold protection	8		1		—
Currency forwards	18		—		—
Equity warrants	3		—		—
Total	$	49	$	1	$	(2	)

During the three and nine months ended September 30, 2011, new derivative transactions entered into totaled approximately $229 million and $728 million in notional value while derivative termination activity totaled approximately $166 million and $673 million. This activity was primarily attributable to interest rate futures, forward commitments for mortgage-backed securities, and foreign currency forwards. During the three and nine months ended September 30, 2010, new derivative transactions entered into totaled approximately $0.9 billion and $2.1 billion in notional value while derivative termination activity totaled approximately $0.9 billion and $2.3 billion. This activity was primarily attributable to interest rate futures and forward commitments for mortgage-backed securities.