DERIVATIVE FINANCIAL INSTRUMENTS

6 Months Ended

Jun. 30, 2011

DERIVATIVE FINANCIAL INSTRUMENTS

DERIVATIVE FINANCIAL INSTRUMENTS

14.          DERIVATIVE FINANCIAL INSTRUMENTS

The Company utilizes a risk management strategy that incorporates the use of derivative financial instruments to reduce exposure to interest rate risk, inflation 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 minimizes its credit risk by entering into transactions with highly rated counterparties. The Company manages the market risk by establishing and monitoring limits as to the types and degrees of risk that may be undertaken. The Company monitors its use of derivatives 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.

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 options, and interest rate swaptions. The Company’s inflation risk management strategy involves the use of swaps that requires the Company to pay a fixed rate and receive a floating rate that is based on changes in the Consumer Price Index (“CPI”).

The Company uses foreign currency swaps to manage its exposure to changes in the value of foreign currency. The Company also uses equity options and futures, interest rate futures, and variance swaps to mitigate its exposure to the value of equity indexed annuity contracts and guaranteed benefits related to variable annuity contracts.

During the second quarter of 2011, the Company sold credit default protection on single name entities to mitigate the risk related to certain guaranteed minimum benefits within its variable annuity products. These contracts entitle the Company to receive periodic payments in exchange for the obligation to compensate the counterparty should the referenced security experience a credit event. The maximum potential amount of future payments (undiscounted) that the Company could be required to make under the credit derivatives is $220.0 million. As of June 30, 2011, the fair value of the credit derivatives was a liability of $2.5 million. As of June 30, 2011, the Company had no collateral posted with the counterparties to these positions. If the credit default swaps needed to be settled immediately, the Company would need to post additional payments of $2.5 million.

The Company records its derivative 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 accounting for changes in fair value of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and further, on the type of hedging relationship in accordance with GAAP. For those derivative instruments that are designated and qualify as hedging instruments, a company must designate the hedging instrument, based upon the exposure being hedged, as a fair value hedge, cash flow hedge, or a hedge related to foreign currency exposure. For derivatives that are designated and qualify as cash flow hedges, the effective portion of the gain or loss realized on the derivative instrument is reported as a component of other comprehensive income and reclassified into earnings in the same period during which the hedged transaction impacts earnings. The remaining gain or loss on these derivatives is recognized as ineffectiveness in current earnings during the period of the change. For derivatives that are designated and qualify as fair value hedges, the gain or loss on the derivative instrument as well as the offsetting loss or gain on the hedged item attributable to the hedged risk are recognized in current earnings during the period of change in fair values. Effectiveness of the Company’s hedge relationships is assessed on a quarterly basis. The Company accounts for 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 financial instruments”.

Cash-Flow Hedges

· In connection with the issuance of inflation adjusted funding agreements, the Company has entered into swaps to convert the floating CPI-linked interest rate on the contracts to a fixed rate. The Company paid a fixed rate on the swap and received a floating rate equal to the CPI change paid on the funding agreements.

· The Company has entered into interest rate swaps to convert LIBOR based floating rate interest payments on funding agreements to fixed rate interest payments.

Other Derivatives

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

· The Company uses equity, interest rate, and currency futures to mitigate the interest rate risk related to certain guaranteed minimum benefits within our variable annuity products. In general, the cost of such benefits varies with the level of equity and interest rate markets and overall volatility. The equity futures resulted in net pre-tax losses of $1.5 million and $19.3 million for the three and six months ended June 30, 2011, respectively. The interest rate futures resulted in pre-tax gains of $9.0 million and $3.4 million, and currency futures resulted in a net pre-tax loss of $0.2 million for the three and six months ended June 30, 2011, respectively. Such positions were not held during the six months ended June 30, 2010.

· The Company uses equity options and volatility swaps to mitigate the risk related to certain guaranteed minimum benefits, including guaranteed minimum withdrawal benefits, within our variable annuity products. In general, the cost of such benefits varies with the level of equity and interest rate markets and overall volatility. The equity options resulted in net pre-tax losses of $4.0 million and $7.3 million and volatility swaps resulted in net pre-tax losses of $0.9 million and $3.7 million for the three and six months ended June 30, 2011, respectively. Such positions were not held during the six months ended June 30, 2010.

· The Company markets certain variable annuity products with a GMWB rider. The GMWB component is considered an embedded derivative, not considered to be clearly and closely related to the host contract. The Company recognized pre-tax losses of $5.5 million and gains of $2.7 million for the three and six months ended June 30, 2011, and pre-tax losses of $49.3 million and $40.2 million for the three and six months ended June 30, 2010, respectively, related to these embedded derivatives.

·      The Company has an interest rate floor agreement and a yearly renewable term (“YRT”) premium support arrangement with PLC. The Company recognized an immaterial loss for the three months ended June 30, 2011 and a pre-tax loss of $0.5 million for the six months ended June 30, 2011, related to the interest rate floor agreement. There are no YRT premium support arrangement gains or losses for the three and six months ended June 30, 2011.

· The Company uses certain interest rate swaps to mitigate interest rate risk related to floating rate exposures. The Company recognized pre-tax losses of $3.0 million and $2.5 million on interest rate swaps for the three and six months ended June 30, 2011 and pre-tax losses of $6.4 million and $8.8 million on interest rate swaps for the three and six months ended June 30, 2010, respectively.

· The Company uses other types of derivatives to manage risk related to other exposures. The Company recognized pre-tax losses of $0.6 million for the three months ended June 30, 2011 and losses that were immaterial for the six months ended June 30, 2011. The Company recognized gains that were immaterial for the three months ended June 30, 2010 and pre-tax gains of $0.8 million for the six months ended June 30, 2010.

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

The tables below present 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, 2011				As of December 31, 2010
	Notional		Fair		Notional		Fair
	Amount		Value		Amount		Value
	(Dollars In Thousands)
Other long-term investments
Cash flow hedges:
Inflation	$	29,828	$	13	$	—	$	—
Derivatives not designated as hedging instruments:
Interest rate swaps	25,000		3,596		25,000		3,808
Credit default swaps	80,000		465		—		—
Interest rate floors/YRT premium support arrangements	753,339		6,250		770,261		6,700
Embedded derivative - Modco reinsurance treaties	30,030		1,988		29,563		2,687
Embedded derivative – GMWB	1,645,178		25,540		1,094,395		22,346
Equity futures	581		11		—		—
Currency futures	38,085		420		—		—
Other	414,289		6,577		100,507		6,826
	$	3,016,330	$	44,860	$	2,019,726	$	42,367
Other liabilities
Cash flow hedges:
Inflation	$	263,551	$	8,152	$	293,379	$	12,005
Interest rate	75,000		5,315		75,000		6,747
Derivatives not designated as hedging instruments:
Credit default swaps	140,000		2,944		—		—
Interest rate swaps	110,000		8,618		110,000		9,137
Embedded derivative - Modco reinsurance treaties	2,799,920		166,779		2,842,862		146,105
Embedded derivative - GMWB	2,052,821		42,481		1,493,745		41,948
Interest rate futures	381,653		3,531		598,357		16,764
Equity futures	89,808		3,045		327,321		7,231
Currency futures	13,581		2		—		—
Other	240,084		4,398		339,350		2,475
	$	6,166,418	$	245,265	$	6,080,014	$	242,412

Gain (Loss) on Derivatives in Cash Flow Hedging Relationships

	For The Three Months Ended June 30, 2011									For The Six Months Ended June 30, 2011
	Realized			Benefits and			Other			Realized		Benefits and			Other
	investment			settlement			comprehensive			investment		settlement			comprehensive
	gains (losses)			expenses			income (loss)			gains (losses)		expenses			income (loss)
	(Dollars In Thousands)
Gain (loss) recognized in other comprehensive income (effective portion):
Interest rate	$	—		$	—		$	(248	)	$	—	$	—		$	(343	)
Inflation	—			—			(5,907		)	—		—			2,184
Gain (loss) reclassified from accumulated other comprehensive income into income (effective portion):
Interest rate	$	—		$	(895	)	$	—		$	—	$	(1,778	)	$	—
Inflation	—			(250		)	—			—		(1,328		)	—
Gain (loss) recognized in income (ineffective portion):
Inflation	$	(617	)	$	—		$	—		$	28	$	—		$	—

Gain (Loss) on Derivatives in Cash Flow Hedging Relationships

	For The Three Months Ended June 30, 2010									For The Six Months Ended June 30, 2010
	Realized			Benefits and			Other			Realized			Benefits and			Other
	investment			settlement			comprehensive			investment			settlement			comprehensive
	gains (losses)			expenses			income (loss)			gains (losses)			expenses			income (loss)
	(Dollars In Thousands)
Gain (loss) recognized in other comprehensive income (effective portion):
Interest rate	$	—		$	—		$	(858	)	$	—		$	—		$	(2,116	)
Inflation	—			—			(9,314		)	—			—			(3,892		)
Gain (loss) reclassified from accumulated other comprehensive income into income (effective portion):
Interest rate	$	—		$	(1,982	)	$	—		$	—		$	(3,973	)	$	—
Inflation	—			(463		)	—			—			(1,084		)	—
Gain (loss) recognized in income (ineffective portion):
Inflation	$	(696	)	$	—		$	—		$	(336	)	$	—		$	—

Based on the expected cash flows of the underlying hedged items, the Company expects to reclassify $2.7 million out of accumulated other comprehensive income into earnings during the next twelve months.

Realized investment gains (losses) - derivative financial instruments

	For The						For The
	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2011			2010			2011			2010
	(Dollars In Thousands)
Interest rate risk
Interest rate futures	$	9,039		$	—		$	3,369		$	—
Interest rate swaps	(2,989		)	(6,382		)	(2,457		)	(8,774		)
Interest rate floors/YRT premium support arrangements	(50		)	(600		)	(451		)	(1,500		)
Credit default swaps	915			—			915			—
Embedded derivative - Modco reinsurance treaties	(29,214		)	(63,063		)	(21,372		)	(94,157		)
Embedded derivative - GMWB	(5,533		)	(49,326		)	2,662			(40,202		)
Derivatives related to equity futures	(1,503		)	—			(19,346		)	—
Derivatives related to currency futures	(199		)	—			(199		)	—
Derivatives related to volatility swaps	(917		)	—			(3,734		)	—
Derivatives related to equity options	(3,982		)	—			(7,259		)	—
Other	(612		)	25			(37		)	810
	$	(35,045	)	$	(119,346	)	$	(47,909	)	$	(143,823	)

Realized investment gains (losses) - all other investments

	For The				For The
	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2011		2010		2011		2010
	(Dollars In Thousands)
Modco trading portfolio(1)	$	33,603	$	63,967	$	27,954	$	108,060

(1)  The Company elected to include the use of alternate disclosures for trading activities