DERIVATIVE FINANCIAL INSTRUMENTS

Types of Derivative Instruments and Derivative Strategies

The Company utilizes a risk management strategy that incorporates the use of derivative financial instruments to reduce exposure to certain risks, including but not limited to, interest rate risk, currency exchange risk, volatility risk, and equity market risk. These strategies are developed through the Company’s analysis of data from financial simulation models and other internal and industry sources, and are then incorporated into the Company’s risk management program.

Derivative instruments expose the Company to credit and market risk and could result in material changes from period to period. The Company attempts to minimize its credit in connection with its overall asset/liability management programs and risk management strategies. In addition, all derivative programs are monitored by our risk management department.

Derivatives Related to Interest Rate Risk Management

Derivative instruments that are used as part of the Company’s interest rate risk management strategy include interest rate swaps, interest rate futures, interest rate caps, and interest rate swaptions.

Derivatives Related to Foreign Currency Exchange Risk Management

Derivative instruments that are used as part of the Company’s foreign currency exchange risk management strategy include foreign currency swaps, foreign currency futures, foreign equity futures, and foreign equity options.

Derivatives Related to Risk Mitigation of Certain Annuity Contracts

The Company may use the following types of derivative contracts to mitigate its exposure to certain guaranteed benefits related to variable annuity (“VA”) contracts, fixed indexed annuities, and indexed universal life contracts:


•	Foreign Currency Futures


•	Variance Swaps


•	Interest Rate Futures


•	Equity Options


•	Equity Futures


•	Credit derivatives


•	Interest Rate Swaps


•	Interest Rate Swaptions


•	Volatility Futures


•	Volatility Options


•	Funds Withheld Agreement


•	Total Return Swaps

Other Derivatives

The Company and certain of its subsidiaries have derivatives with PLC. These derivatives consist of an interest support agreement, YRT premium support agreements, and portfolio maintenance agreements with PLC.

The Company has a funds withheld account that consists of various derivative instruments held by us that is used to hedge the GLWB and GMDB riders. The economic performance of derivatives in the funds withheld account is ceded to Shades Creek. The funds withheld account is accounted for as a derivative financial instrument.

Accounting for Derivative Instruments

The Company records its derivative financial instruments in the consolidated balance sheet in other long-term investments and other liabilities in accordance with GAAP, which requires that all derivative instruments be recognized in the balance sheet at fair value. The change in the fair value of derivative financial instruments is reported either in the statement of income or in other comprehensive income (loss), depending upon whether it qualified for and also has been properly identified as being part of a hedging relationship, and also on the type of hedging relationship that exists.

It is the Company's policy not to offset assets and liabilities associated with open derivative contracts. However, the Chicago Mercantile Exchange (“CME”) rules characterize variation margin transfers as settlement payments, as opposed to adjustments to collateral. As a result, derivative assets and liabilities associated with centrally cleared derivatives for which the CME serves as the central clearing party are presented as if these derivatives had been settled as of the reporting date.

For a derivative financial instrument to be accounted for as an accounting hedge, it must be identified and documented as such on the date of designation. For cash flow hedges, the effective portion of their realized gain or loss is reported as a component of other comprehensive income and reclassified into earnings in the same period during which the hedged item impacts earnings. Any remaining gain or loss, the ineffective portion, is recognized in current earnings. For fair value hedge derivatives, their gain or loss as well as the offsetting loss or gain attributable to the hedged risk of the hedged item is recognized in current earnings. Effectiveness of the Company’s hedge relationships is assessed on a quarterly basis.

The Company reports changes in fair values of derivatives that are not part of a qualifying hedge relationship through earnings in the period of change. Changes in the fair value of derivatives that are recognized in current earnings are reported in Realized investment gains (losses).

Derivative Instruments Designated and Qualifying as Hedging Instruments

Cash-Flow Hedges


•	To hedge a fixed rate note denominated in a foreign currency, the Company entered into a fixed-to-fixed foreign currency swap in order to hedge the foreign currency exchange risk associated with the note. The cash flows received on the swap are identical to the cash flows paid on the note.


•	To hedge a floating rate note, the Company entered into an interest rate swap to exchange the floating rate on the note for a fixed rate in order to hedge the interest rate risk associated with the note. The cash flows received on the swap are identical to the cash flow variability paid on the note.

Derivative Instruments Not Designated and Not Qualifying as Hedging Instruments

The Company uses various other derivative instruments for risk management purposes that do not qualify for hedge accounting treatment. Changes in the fair value of these derivatives are recognized in earnings during the period of change.

Derivatives Related to Variable Annuity Contracts

•

The Company uses equity futures, equity options, total return swaps, interest rate futures, interest rate swaps, interest rate swaptions, currency futures, volatility futures, volatility options, and variance swaps to mitigate the risk related to certain guaranteed minimum benefits, including GLWB, within its VA products. In general, the cost of such benefits varies with the level of equity and interest rate markets, foreign currency levels, and overall volatility.


•	The Company markets certain VA products with a GLWB rider. The GLWB component is considered an embedded derivative, not considered to be clearly and closely related to the host contract.


•	The Company has a funds withheld account that consists of various derivative instruments held by the Company that are used to hedge the GLWB and GMDB riders. The economic performance of derivatives in the funds withheld account is ceded to Shades Creek. The funds withheld account is accounted for as a derivative financial instrument.

Derivatives Related to Fixed Annuity Contracts


•	The Company uses equity futures and options to mitigate the risk within its fixed indexed annuity products. In general, the cost of such benefits varies with the level of equity markets and overall volatility.


•	The Company markets certain fixed indexed annuity products. The FIA component is considered an embedded derivative as it is not considered to be clearly and closely related to the host contract.

Derivatives Related to Indexed Universal Life Contracts


•	The Company uses equity futures and options to mitigate the risk within its indexed universal life products. In general, the cost of such benefits varies with the level of equity markets.


•	The Company markets certain IUL products. The IUL component is considered an embedded derivative as it is not considered to be clearly and closely related to the host contract.

Other Derivatives


•	The Company and certain of its subsidiaries have an interest support agreement, YRT premium support agreements, and portfolio maintenance agreements with PLC.


•	The Company uses various swaps and other types of derivatives to manage risk related to other exposures.

•

The Company is involved in various modified coinsurance and funds withheld arrangements which contain embedded derivatives. Changes in their fair value are recorded in current period earnings. The investment portfolios that support the related modified coinsurance reserves and funds withheld arrangements had fair value changes which substantially offset the gains or losses on these embedded derivatives.

The following table sets forth realized investments gains and losses for the periods shown:

Realized investment gains (losses) - derivative financial instruments



	For The Three Months Ended June 30,						For The Six Months Ended June 30,
	2019			2018			2019			2018
	(Dollars In Thousands)
Derivatives related to VA contracts:
Interest rate futures	$	(11,280	)	$	1,552		$	(17,302	)	$	(15,340	)
Equity futures	2,559			(10,864		)	32,297			(17,292		)
Currency futures	(397		)	12,063			1,847			4,480
Equity options	(21,702		)	(38,216		)	(93,397		)	(26,200		)
Interest rate swaptions	—			—			—			(14		)
Interest rate swaps	117,934			(26,149		)	192,795			(89,859		)
Total return swaps	(8,545		)	(10,055		)	(48,572		)	(3,565		)
Embedded derivative - GLWB	(69,602		)	11,191			(102,989		)	32,664
Funds withheld derivative	18,771			38,853			80,548			30,897
Total derivatives related to VA contracts	27,738			(21,625		)	45,227			(84,229		)
Derivatives related to FIA contracts:
Embedded derivative	(24,819		)	(4,927		)	(63,633		)	6,403
Equity futures	431			(167		)	2			(328		)
Equity options	13,191			7,398			55,241			2,729
Total derivatives related to FIA contracts	(11,197		)	2,304			(8,390		)	8,804
Derivatives related to IUL contracts:
Embedded derivative	(11,286		)	(1,226		)	(24,656		)	8,658
Equity futures	85			—			256			136
Equity options	2,606			2,086			8,786			836
Total derivatives related to IUL contracts	(8,595		)	860			(15,614		)	9,630
Embedded derivative - Modco reinsurance treaties	(70,679		)	45,183			(155,677		)	127,841
Derivatives with PLC⁽¹⁾	8,922			(9,696		)	7,269			1,847
Other derivatives	(1,455		)	34			(1,389		)	(7		)
Total realized gains (losses) - derivatives	$	(55,266	)	$	17,060		$	(128,574	)	$	63,886

(1) These derivatives include the Interest, YRT premium support, and portfolio maintenance agreements between certain of the Company’s subsidiaries and PLC.

The following table presents the components of the gain or loss on derivatives that qualify as a cash flow hedging relationship.

Gain (Loss) on Derivatives in Cash Flow Hedging Relationship



	Amount of Gains (Losses) Deferred in Accumulated Other Comprehensive Income (Loss) on Derivatives			Amount and Location of Gains (Losses) Reclassified from Accumulated Other Comprehensive Income (Loss) into Income (Loss)			Amount and Location of (Losses) Recognized in Income (Loss) on Derivatives
	(Effective Portion)			(Effective Portion)			(Ineffective Portion)
				Benefits and settlement expenses			Realized investment gains (losses)
	(Dollars In Thousands)
For The Three Months Ended June 30, 2019
Foreign currency swaps	$	(1,733	)	$	(188	)	$	—
Interest rate swaps	(1,796		)	(148		)	—
Total	$	(3,529	)	$	(336	)	$	—

For The Six Months Ended June 30, 2019
Foreign currency swaps	$	(3,626	)	$	(394	)	$	—
Interest rate swaps	(2,391		)	(220		)	—
Total	$	(6,017	)	$	(614	)	$	—

For The Three Months Ended June 30, 2018
Foreign currency swaps	$	2,967		$	(205	)	$	—
Total	$	2,967		$	(205	)	$	—

For The Six Months Ended June 30, 2018
Foreign currency swaps	$	3,582		$	(318	)	$	—
Total	$	3,582		$	(318	)	$	—

Based on expected cash flows of the underlying hedged items, the Company expects to reclassify $2.9 million out of accumulated other comprehensive income (loss) into earnings during the next twelve months.

The table below presents information about the nature and accounting treatment of the Company’s primary derivative financial instruments and the location in and effect on the consolidated condensed financial statements for the periods presented below:



	As of
	June 30, 2019				December 31, 2018
	Notional Amount		Fair Value		Notional Amount		Fair Value
	(Dollars In Thousands)
Other long-term investments
Derivatives not designated as hedging instruments:
Interest rate swaps	$	2,188,000	$	90,599	$	1,515,500	$	28,501
Total return swaps	132,044		1,065		138,070		3,971
Derivatives with PLC⁽¹⁾	2,843,171		95,610		2,856,351		90,049
Embedded derivative - Modco reinsurance treaties	1,248,634		13,738		585,294		7,072
Embedded derivative - GLWB	1,198,236		34,235		1,919,861		54,221
Interest rate futures	393,518		8,703		286,208		10,302
Equity futures	101,064		639		12,633		483
Equity options	6,176,649		431,694		5,624,081		220,092
Other	157		173		157		136
	$	14,281,473	$	676,456	$	12,938,155	$	414,827
Other liabilities
Cash flow hedges:
Interest rate swaps	$	350,000	$	—	$	350,000	$	—
Foreign currency swaps	117,178		2,309		117,178		904
Derivatives not designated as hedging instruments:
Interest rate swaps	70,000		—		775,000		11,367
Total return swaps	361,607		1,112		768,177		23,054
Embedded derivative - Modco reinsurance treaties	2,287,547		188,853		1,795,287		32,828
Funds withheld derivative	1,915,424		91,118		1,992,562		95,142
Embedded derivative - GLWB	2,874,833		216,157		2,152,698		97,528
Embedded derivative - FIA	2,739,208		298,721		2,576,033		217,288
Embedded derivative - IUL	262,828		136,660		233,550		90,231
Interest rate futures	901,165		16,464		863,706		20,100
Equity futures	225,125		2,967		659,357		33,753
Currency futures	256,513		1,105		202,747		2,163
Equity options	4,008,015		198,159		4,199,687		34,178
Other	13,109		1,644		3,288		252
	$	16,382,552	$	1,155,269	$	16,689,270	$	658,788

(1) These derivatives include the Interest, YRT premium support, and portfolio maintenance agreements between certain of the Company’s subsidiaries and PLC.