DERIVATIVE FINANCIAL INSTRUMENTS

9 Months Ended

Sep. 30, 2011

DERIVATIVE FINANCIAL INSTRUMENTS

DERIVATIVE FINANCIAL INSTRUMENTS

14.          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 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 attempts to minimize 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.

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 options, and interest rate caps. 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”).

Derivatives Related to Risk Mitigation of Variable Annuity Contracts

The Company uses the following types of derivative contracts to mitigate its exposure to certain guaranteed benefits related to variable annuity contracts:

· Foreign Currency Futures

· Variance Swaps

· Interest Rate Futures

· Equity Options

· Equity Futures

· Credit Derivatives

The Company has sold credit protection under single name credit default swaps and credit default swap indices for which it receives a premium to insure credit risk. Such credit derivatives are a part of the Company’s program to mitigate risks related to certain minimum guaranteed benefits of variable annuity contracts and are designed to offset some portion of the Company’s nonperformance risk. The Company will only make a payment in the event there is a credit event. A credit event payment will typically be equal to the notional value of the swap contract less an auction-determined recovery rate, to the percentage extent described. A credit event is generally defined to include material default, bankruptcy, or debt restructuring. The Company’s maximum amount at risk, assuming the value of all referenced credit obligations is zero, equals the notional value of the credit default swaps.

The following table includes the estimated fair value, maximum amount of future payments, and the maturity dates of written credit default swaps, segregated by counterparty exposure:

									Maximum
	Reason for	Nature of	Number of			Upfront fee	Unrealized		potential
Maturity	entering	recourse	instruments	Fair Value(3)		received	gain (loss)		payout(4)
(Dollars In Thousands)
12/20/21	(1)	(2)	3	(35,883	)	29,515	(6,368	)	700,000	(5)
12/20/21	(1)	(2)	1	(9,934	)	8,153	(1,781	)	200,000
12/20/21	(1)	(2)	1	(4,823	)	4,990	167		100,000
			5	(50,640	)	42,658	(7,982	)	1,000,000

(1)	The Company wrote these positions to mitigate the Company’s non-performance risk related to certain guaranteed minimum withdrawal benefits within its variable annuity products.
(2)	The Company does not have the right to demand indemnification or compensation from third parties in the case of a loss (payment) on the contract.
(3)	Broker quotes are used to determine the market value of credit derivatives.
(4)	The underlying reference entity is the Markit CDX North America Investment Grade Index, Series 17, which is comprised of 125 equally weighted credit default swaps on investment grade entities. The maximum potential payout assumes the recovery value on each investment grade entity is zero.
(5)	The Company has posted $20 million of collateral with this counterparty for over-the-counter derivative positions.

The following table includes the credit ratings of the underlying entities that make up the index as of September 30, 2011:

	Credit rating of
Rating	underlying index
AA	4.0	%
A	34.0
BBB	62.0
	100.0	%

Accounting for Derivative Instruments

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”.

Derivative Instruments Designated and Qualify as Hedging 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 an interest rate swap to convert LIBOR based floating rate interest payments on funding agreement to fixed rate interest payments.

Derivative Instruments Not Designated and Not Qualifying as Hedging Instruments

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.

Derivatives related to variable annuity contracts

· 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 a net pre-tax gain of $11.5 million and a pre-tax loss of $7.8 million, interest rate futures resulted in pre-tax gains of $144.2 million and $147.6 million, and currency futures resulted in net pre-tax gains of $2.4 million and $2.2 million, for the three and nine months ended September 30, 2011, respectively.

· The Company uses equity options, volatility swaps, and interest rate 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 gains of $30.1 million and $22.8 million, the volatility swaps resulted in net pre-tax gains of $3.5 million and a loss of $0.2 million, and the interest rate swaps resulted in a net pre-tax gain of $5.8 million and $5.8 million for the three and nine months ended September 30, 2011, respectively. Such positions were not held during the nine months ended September 30, 2010.

· The Company entered into credit default swaps to partially mitigate the Company’s non-performance risk related to certain guaranteed minimum withdrawal benefits within our variable annuity products. The Company reported net pre-tax losses of $24.0 million and $23.0 million for the three and nine months ended September 30, 2011 related to credit default swaps from the change in swaps’ fair value premium income and a realized loss on terminated contracts of $17.6 million.

· 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 $150.1 million and $147.6 million for the three and nine months ended September 30, 2011, and pre-tax losses of $19.1 million and $59.3 million for the three and nine months ended September 30, 2010, respectively, related to these embedded derivatives.

Other Derivatives

· The Company uses certain interest rate swaps to mitigate the price volatility of fixed maturities. The Company recognized pre-tax losses of $8.2 million and $10.6 million on interest rate swaps for the three and nine months ended September 30, 2011 and pre-tax losses of $4.7 million and $13.5 million on interest rate swaps for the three and nine months ended September 30, 2010, respectively.

· The Company purchased interest rate caps in the three months ended September 30, 2011. These caps mitigate the Company’s credit risk with respect to its holding of the debt of certain European banks. These banks in turn hold sovereign debt of certain European governments. These caps resulted in net pre-tax losses of $2.6 million for the three and nine months ended September 30, 2011.

· The Company has an interest rate floor agreement and a yearly renewable term (“YRT”) premium support arrangement with PLC. The Company recognized an immaterial gain for the three months ended September 30, 2011 and a pre-tax loss of $0.4 million for the nine months ended September 30, 2011, related to the interest rate floor agreement. There are no YRT premium support arrangement gains or losses for the three and nine months ended September 30, 2011.

· 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 and nine months ended September 30, 2011. The Company recognized losses of $0.4 million for the three months ended September 30, 2010 and pre-tax gains of $0.4 million for the nine months ended September 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 Company recognized pre-tax losses of $109.5 million and $130.9 million for the three and nine months ended September 30, 2011 and pre-tax losses of $85.5 million and $179.7 million for the three and nine months ended September 30, 2010, respectively.

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 September 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	$	12,084	$	3	$	—	$	—
Derivatives not designated as hedging instruments:
Interest rate swaps	100,000		5,808		25,000		3,808
Interest rate floors/YRT premium support arrangements	752,482		6,300		770,261		6,700
Embedded derivative - Modco reinsurance treaties	29,964		2,173		29,563		2,687
Embedded derivative — GMWB	685,478		6,314		1,099,902		22,378
Interest rate futures	1,246,697		51,748		—		—
Equity futures	231,664		10,102		—		—
Currency futures	74,661		2,071		—		—
Interest rate caps	3,000,000		2,885		—		—
Other	505,214		27,922		95,000		6,794
	$	6,638,244	$	115,326	$	2,019,726	$	42,367
Other liabilities
Cash flow hedges:
Inflation	$	251,467	$	11,727	$	293,379	$	12,005
Interest rate	75,000		3,415		75,000		6,747
Derivatives not designated as hedging instruments:
Credit default swaps	1,000,000		50,640		—		—
Interest rate swaps	25,000		2,817		110,000		9,137
Embedded derivative - Modco reinsurance treaties	2,787,486		276,508		2,842,862		146,105
Embedded derivative - GMWB	3,484,749		173,476		1,494,657		41,990
Interest rate futures	113,536		133		598,357		16,764
Equity futures	—		—		327,321		7,231
Other	—		—		338,438		2,433
	$	7,737,238	$	518,716	$	6,080,014	$	242,412

Gain (Loss) on Derivatives in Cash Flow Hedging Relationships

	For The Three Months Ended September 30, 2011									For The Nine Months Ended September 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	$	—		$	—		$	38		$	—		$	—		$	(304	)
Inflation	—			—			(3,162		)	—			—			(978		)
Gain (loss) reclassified from accumulated other comprehensive income into income (effective portion):
Interest rate	$	—		$	(911	)	$	—		$	—		$	(2,689	)	$	—
Inflation	—			488			—			—			(840		)	—
Gain (loss) recognized in income (ineffective portion):
Inflation	$	(485	)	$	—		$	—		$	(457	)	$	—		$	—

Gain (Loss) on Derivatives in Cash Flow Hedging Relationships

	For The Three Months Ended September 30, 2010								For The Nine Months Ended September 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	$	—	$	—		$	(842	)	$	—		$	—		$	(2,958	)
Inflation	—		—			1,532			—			—			(2,360		)
Gain (loss) reclassified from accumulated other comprehensive income into income (effective portion):
Interest rate	$	—	$	(1,774	)	$	—		$	—		$	(5,747	)	$	—
Inflation	—		(965		)	—			—			(2,049		)	—
Gain (loss) recognized in income (ineffective portion):
Inflation	$	25	$	—		$	—		$	(311	)	$	—		$	—

Based on the expected cash flows of the underlying hedged items, the Company expects to reclassify $3.9 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						Nine Months Ended
	September 30,						September 30,
	2011			2010			2011			2010
	(Dollars In Thousands)
Derivatives related to variable annuity contracts:
Interest rate futures - VA	$	144,182		$	23,047		$	147,550		$	23,047
Equity futures - VA	11,524			(8,444		)	(7,822		)	(8,444		)
Currency futures - VA	2,376			—			2,177			—
Volatility swaps - VA	3,495			—			(239		)	—
Equity options - VA	30,072			—			22,813			—
Interest rate swaps - VA	5,808			—			5,808			—
Credit default swaps - VA	(23,897		)	—			(22,981		)	—
Embedded derivative - GMWB	(150,125		)	(19,101		)	(147,550		)	(59,296		)
Total derivatives related to variable annuity contracts	23,435			(4,498		)	(244		)	(44,693		)
Embedded derivative - Modco reinsurance treaties	(109,542		)	(85,496		)	(130,914		)	(179,654		)
Interest rate swaps	(8,185		)	(4,676		)	(10,642		)	(13,450		)
Interest rate caps	(2,581		)	—			(2,581		)	—
Interest rate floors/YRT premium support arrangements	50			(400		)	(402		)	(1,899		)
Other	(622		)	(404		)	(571		)	399
Total realized gains (losses) - derivatives	$	(97,445	)	$	(95,474	)	$	(145,354	)	$	(239,297	)

Realized investment gains (losses) - all other investments

	For The				For The
	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2011		2010		2011		2010
	(Dollars In Thousands)
Modco trading portfolio(1)	$	123,760	$	96,689	$	151,714	$	204,749

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