DERIVATIVE FINANCIAL INSTRUMENTS

6 Months Ended

Jun. 30, 2012

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 certain risks, including but not limited 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 caps, 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”).

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

·Interest Rate Swaps

·Interest Rate Swaptions

·Volatility Futures

The Company has in certain periods, 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, would equal the notional value of the credit default swaps. As of June 30, 2012 and December 31, 2011, the Company did not have any open credit default swaps.

Other Derivatives

The Company has an interest rate floor agreement and an YRT premium support arrangement with PLC.

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.

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 transaction 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 on the hedged item attributable to the hedged risk are 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 financial instruments”.

Derivative Instruments Designated and Qualifying as Hedging Instruments

Cash-Flow Hedges

·In connection with the issuance of inflation-adjusted funding agreements, the Company has entered into swaps to essentially convert the floating CPI-linked interest rate on these agreements to a fixed rate. The Company pays a fixed rate on the swap and receives a floating rate primarily determined by the period’s change in the CPI. The amounts that are received on the swaps are almost equal to the amounts that are paid on the agreements.

·The Company has entered into an interest rate swap to convert LIBOR-based floating rate interest payments on a certain funding agreement to fixed rate interest payments. This structure is basically the same as that described regarding the CPI-based agreements and swaps.

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, interest rate, currency, and volatility futures to mitigate the risk related to certain guaranteed minimum benefits, including GMWB, within its variable annuity 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 equity futures resulted in net pre-tax losses of $0.2 million and $25.3 million and interest rate futures resulted in pre-tax gains of $69.2 million and $35.8 million for the three and six months ended June 30, 2012, respectively. The equity futures resulted in net pre-tax losses of $1.5 million and $19.3 million and interest rate futures resulted in pre-tax gains of $9.0 million and $3.4 million for the three and six months ended June 30, 2011, respectively. Currency futures resulted in net pre-tax gains of $1.8 million and $0.8 million and volatility futures resulted in net pre-tax gains of $0.3 million and net pre-tax losses of $0.1 million for the three and six months ended June 30, 2012, respectively. The currency futures resulted in net pre-tax losses of $0.2 million for the three and six months ended June 30, 2011.  No volatility future positions were held during the three and six months ended June 30, 2011.

·The Company uses equity options and volatility swaps to mitigate the risk related to certain guaranteed minimum benefits, including GMWB, within its variable annuity products. In general, the cost of such benefits varies with the level of equity markets and overall volatility. The equity options resulted in net pre-tax gains of $3.2 million and net pre-tax losses of $20.7 million, and the volatility swaps resulted in net pre-tax gains of $1.1 million and net pre-tax losses of $0.8 million for the three and six months ended June 30, 2012, respectively. The equity options resulted in net pre-tax losses of $4.0 million and $7.3 million, and the 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.

·The Company uses interest rate swaps and interest rate swaptions to mitigate the risk related to certain guaranteed minimum benefits, including GMWB, within its variable annuity products. The interest rate swaps resulted in net pre-tax gains of $6.0 million and $3.8 million and the interest rate swaptions resulted in net pre-tax gains of $8.8 million and $5.3 million for the three and six months ended June 30, 2012, respectively. Such positions were not held during the three and six months ended June 30, 2011.

·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 gains of $0.9 million for the three and six months ended June 30, 2011. As of June 30, 2012, no credit default swaps were outstanding.

·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 $85.5 million and $35.3 million for the three and six months ended June 30, 2012, respectively, and a pre-tax loss of $5.6 million and pre-tax gains of $2.6 million for the three and six months ended June 30, 2011, respectively, related to these embedded derivatives.

Other Derivatives

·The Company uses certain interest rate swaps to mitigate the price volatility of fixed maturities. These positions resulted in net pre-tax losses of $2.9 million and $0.9 million for the three and six months ended June 30, 2012, respectively. For the three and six months ended June 30, 2011, these positions resulted in net pre-tax losses of $3.0 million and $2.5 million, respectively.

·The Company purchased interest rate caps during 2011 to mitigate risks associated with the Company’s LIBOR exposure and the potential impact of European financial market distress. These caps resulted in net pre-tax losses of $0.4 million and $2.5 million for the three and six months ended June 30, 2012, respectively. Such positions were not held during the six months ended June 30, 2011.

·The Company has an interest rate floor agreement and a yearly renewable term (“YRT”) premium support arrangement with PLC. The Company recognized pre-tax losses of $0.1 million for the three and six months ended June 30, 2012 and pre-tax losses of $0.1 million and $0.5 million for the three and six months ended June 30, 2011, respectively, related to the interest rate floor agreement. The Company recognized a pre-tax gain of $0.6 million for the three and six months ended June 30, 2012 related to the premium support arrangement. There were no gains or losses for the three and six months ended June 30, 2011 related to the YRT premium support arrangement.

·The Company uses various swaps and other types of derivatives to manage risk related to other exposures. The Company recognized pre-tax losses of $0.9 million and $0.2 million for the three and six months ended June 30, 2012, respectively, and a pre-tax loss of $0.6 million and a pre-tax gain of $0.1 million for the three and six months ended June 30, 2011.

·The Company is involved in various modified coinsurance and funds withheld arrangements which contain embedded derivatives. Changes in the fair value of such embedded derivatives 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 $48.7 million and $38.0 million for the three and six months ended June 30, 2012, respectively, and pre-tax losses of $29.2 million and $21.4 million for the three and six months ended June 30, 2011, 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 June 30, 2012				As of December 31, 2011
	Notional		Fair		Notional		Fair
	Amount		Value		Amount		Value
	(Dollars In Thousands)
Other long-term investments
Cash flow hedges:
Inflation	$	—	$	—	$	7,068	$	1
Derivatives not designated as hedging instruments:
Interest rate swaps	225,000		5,797		125,000		5,118
Volatility swaps	600		609		—		—
Interest rate floors/YRT premium support arrangements	775,198		6,900		796,713		6,400
Embedded derivative - Modco reinsurance treaties	30,531		1,787		30,001		2,038
Embedded derivative - GMWB	1,099,744		16,628		826,790		10,665
Interest rate futures	769,749		7,065		615,445		6,393
Equity futures	—		—		49,631		837
Currency futures	14,425		323		57,912		976
Interest rate caps	3,000,000		152		3,000,000		2,666
Equity options	471,276		47,330		440,000		19,396
Interest rate swaptions	400,000		18,942		—		—
Other	224		141		224		155
	$	6,786,747	$	105,674	$	5,948,784	$	54,645
Other liabilities
Cash flow hedges:
Inflation	$	234,764	$	8,115	$	244,399	$	8,863
Interest rate	75,000		1,810		75,000		3,443
Derivatives not designated as hedging instruments:
Interest rate swaps	150,000		4,462		25,000		3,064
Volatility swaps	675		1,430		—		—
Embedded derivative - Modco reinsurance treaties	2,689,788		317,520		2,761,686		279,799
Embedded derivative - GMWB	4,489,658		199,067		3,741,688		157,813
Interest rate futures	358,884		625		270,019		1,148
Equity futures	296,141		14,964		189,765		1,454
Currency futures	111,326		1,835		14,348		126
	$	8,406,236	$	549,828	$	7,321,905	$	455,710

Gain (Loss) on Derivatives in Cash Flow Hedging Relationships

	For The Three Months Ended June 30, 2012									For The Six Months Ended June 30, 2012
	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	$	—		$	—		$	(2	)	$	—		$	—		$	(75	)
Inflation	—			—			(7,939		)	—			—			985
Gain (loss) reclassified from accumulated other comprehensive income into income (effective portion):
Interest rate	$	—		$	(858	)	$	—		$	—		$	(1,712	)	$	—
Inflation	—			(113		)	—			—			67			—
Gain (loss) recognized in income (ineffective portion):
Inflation	$	(870	)	$	—		$	—		$	(224	)	$	—		$	—

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	$	—		$	—

Based on the expected cash flows of the underlying hedged items, the Company expects to reclassify $3.6 million out of accumulated other comprehensive income (loss) 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,
	2012			2011			2012			2011
	(Dollars In Thousands)
Derivatives related to variable annuity contracts:
Interest rate futures - VA	$	69,196		$	9,039		$	35,790		$	3,369
Equity futures - VA	(220		)	(1,503		)	(25,319		)	(19,346		)
Currency futures - VA	1,764			(199		)	780			(199		)
Volatility futures - VA	343			—			(132		)	—
Volatility swaps - VA	1,063			(917		)	(821		)	(3,734		)
Equity options - VA	3,153			(3,982		)	(20,719		)	(7,259		)
Interest rate swaptions - VA	8,831			—			5,312			—
Interest rate swaps - VA	5,954			—			3,826			—
Credit default swaps - VA	—			915			—			915
Embedded derivative - GMWB	(85,456		)	(5,549		)	(35,289		)	2,575
Total derivatives related to variable annuity contracts	4,628			(2,196		)	(36,572		)	(23,679		)
Embedded derivative - Modco reinsurance treaties	(48,679		)	(29,214		)	(37,973		)	(21,372		)
Interest rate swaps	(2,916		)	(2,989		)	(879		)	(2,457		)
Interest rate caps	(351		)	—			(2,515		)	—
Interest rate floors/YRT premium support arrangements	500			(50		)	500			(451		)
Other derivatives	(950		)	(596		)	(238		)	50
Total realized gains (losses) - derivatives	$	(47,768	)	$	(35,045	)	$	(77,677	)	$	(47,909	)

From time to time, the Company is required to post and obligated to return collateral related to derivative transactions. As of June 30, 2012, the Company had posted cash and securities (at fair value) as collateral of approximately $20.2 million and $55.0 million, respectively. As of June 30, 2012, the Company received $12.0 million of cash as collateral. The Company does not net the collateral posted or received with the fair value of the derivative financial instruments for reporting purposes.

Realized investment gains (losses) - all other investments

	For The				For The
	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2012		2011		2012		2011
	(Dollars In Thousands)
Modco trading portfolio(1)	$	56,063	$	33,603	$	74,162	$	27,954

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