13. 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 may use 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

Other Derivatives

Certain of the Company’s subsidiaries have derivatives with PLC. These derivatives consist of an interest support agreement, a YRT premium support agreement, and portfolio maintenance agreements 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 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 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.

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 $23.2 million and $25.1 million and interest rate futures resulted in net pre-tax losses of $16.5 million and $33.4 million for the three months ended March 31, 2013 and 2012, respectively. Currency futures resulted in a net pre-tax gain of $8.1 million and a net pre-tax loss of $1.0 million for the three months ended March 31, 2013 and 2012, respectively. Volatility futures resulted in no pre-tax gains or losses for the three months ended March 31, 2013 and pre-tax losses of $0.5 million for the three months ended March 31, 2012. No volatility future positions were held during the three months ended March 31, 2013.

· 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 losses of $28.4 million and $23.9 million and the volatility swaps resulted in net pre-tax losses of $10.4 million and $1.9 million for the three months ended March 31, 2013 and 2012, 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 losses of $16.6 million and $2.1 million for the three months ended March 31, 2013 and 2012, respectively. The interest rate swaptions resulted in net pre-tax losses of $4.1 million and $3.5 million for the three months ended March 31, 2013 and 2012, respectively.

· 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 gains of $80.4 million and $50.2 million for the three months ended March 31, 2013 and 2012, 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 gains of $1.0 million and $2.0 million on interest rate swaps for the three months ended March 31, 2013 and 2012, respectively.

· The Company purchased interest rate caps during 2011 to mitigate its risk with respect to the Company’s LIBOR exposure and the potential impact of European financial market distress. These caps resulted in insignificant losses for the three months ended March 31, 2013 and pre-tax losses of $2.2 million for the three months ended March 31, 2012.

· Certain of the Company’s subsidiaries have an interest support agreement, YRT premium support agreement, and two portfolio maintenance agreements with PLC. The Company recognized pre-tax losses of $3.9 million for the three months ended March 31, 2013 and no gain or loss for the three months ended March 31, 2012, related to the interest support agreement. The Company recognized a pre-tax gain of $0.1 million and no gains or losses for the three months ended March 31, 2013 and 2012, respectively, related to the YRT premium support agreement. The Company entered into two separate portfolio maintenance agreements in October 2012. The Company recognized no pre-tax gains or losses for the three months ended March 31, 2013 related to its portfolio maintenance agreements.

· The Company uses various swaps and other types of derivatives to manage risk related to other exposures. The Company recognized pre-tax gains of $0.4 million and $0.7 million for the three months ended March 31, 2013 and 2012, respectively.

· 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 Company recognized pre-tax gains of $16.8 million and $10.7 million for the three months ended March 31, 2013 and 2012, 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 financial statements for the periods presented below:

	As of
	March 31, 2013				December 31, 2012
	Notional		Fair		Notional		Fair
	Amount		Value		Amount		Value
	(Dollars In Thousands)
Other long-term investments
Cash flow hedges:
Inflation	$	135,531	$	251	$	—	$	—
Derivatives not designated as hedging instruments:
Interest rate swaps	300,000		5,368		355,000		6,532
Volatility swaps	400		20		500		406
Derivatives with PLC(1)	1,432,876		13,287		1,404,750		17,064
Embedded derivative - Modco reinsurance treaties	30,561		1,321		30,244		1,330
Embedded derivative - GMWB	2,615,909		55,796		1,640,075		30,261
Interest rate futures	473,257		3,201		—		—
Equity futures	55,441		1,040		147,581		595
Currency futures	31,948		531		15,944		784
Interest rate caps	3,000,000		—		3,000,000		—
Equity options	840,276		64,559		573,493		61,833
Interest rate swaptions	400,000		7,268		400,000		11,370
Other	224		240		224		253
	$	9,316,423	$	152,882	$	7,567,811	$	130,428
Other liabilities
Cash flow hedges:
Inflation	$	47,434	$	65	$	182,965	$	5,027
Derivatives not designated as hedging instruments:
Interest rate swaps	1,105,000		25,057		400,000		10,025
Volatility swaps	4,075		22,245		2,675		12,198
Embedded derivative - Modco reinsurance treaties	2,636,425		395,123		2,655,134		411,907
Embedded derivative - GMWB	4,746,591		144,691		5,253,961		199,530
Interest rate futures	—		—		893,476		13,970
Equity futures	106,724		1,126		152,364		3,316
Currency futures	101,339		1,254		131,979		1,901
	$	8,747,588	$	589,561	$	9,672,554	$	657,874

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

Gain (Loss) on Derivatives in Cash Flow Relationship

				Amount and Location of
	Amount of Gains (Losses)			Gains (Losses)
	Deferred in			Reclassified from			Amount and Location of
	Accumulated Other			Accumulated Other			(Losses) Recognized in
	Comprehensive Income			Comprehensive Income			Income (Loss) on
	(Loss) on Derivatives			(Loss) into Income (Loss)			Derivatives
	(Effective Portion)			(Effective Portion)			(Ineffective Portion)
				Benefits and settlement			Realized investment
				expenses			gains (losses)
	(Dollars In Thousands)
For The Three Months Ended March 31, 2013
Interest rate	$	—		$	—		$	—
Inflation	4,409			(497		)	368
Total	$	4,409		$	(497	)	$	368

For The Three Months Ended March 31, 2012
Interest rate	$	(73	)	$	(854	)	$	—
Inflation	8,277			180			646
Total	$	8,204		$	(674	)	$	646

Based on the expected cash flows of the underlying hedged items, the Company expects to reclassify $0.6 million out of accumulated other comprehensive income (loss) into earnings during the next twelve months.

Realized investment gains (losses) - derivative financial instruments

	For The Three Months Ended March 31,
	2013			2012
	(Dollars In Thousands)
Derivatives related to variable annuity contracts:
Interest rate futures - VA	$	(16,484	)	$	(33,406	)
Equity futures - VA	(23,225		)	(25,099		)
Currency futures - VA	8,083			(984		)
Volatility futures - VA	—			(475		)
Volatility swaps - VA	(10,433		)	(1,884		)
Equity options - VA	(28,406		)	(23,872		)
Interest rate swaptions - VA	(4,102		)	(3,519		)
Interest rate swaps - VA	(16,556		)	(2,128		)
Embedded derivative - GMWB	80,375			50,167
Total derivatives related to variable annuity contracts	(10,748		)	(41,200		)
Embedded derivative - Modco reinsurance treaties	16,775			10,706
Interest rate swaps	1,003			2,037
Interest rate caps	—			(2,164		)
Derivatives with PLC(1)	(3,778		)	—
Other derivatives	355			712
Total realized gains (losses) - derivatives	$	3,607		$	(29,909	)

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

From time to time, the Company is required to post and obligated to return collateral related to derivative transactions. As of March 31, 2013, the Company had posted cash and securities (at fair value) as collateral of approximately $20.1 million and $54.6 million, respectively. As of March 31, 2013, the Company received $2.5 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 Three Months Ended March 31,
	2013			2012
	(Dollars In Thousands)
Modco trading portfolio(1)	$	(15,328	)	$	18,099

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