5. FAIR VALUE MEASUREMENTS

We determine the fair values of our debt, derivative, perpetual and privately issued equity securities primarily using four pricing approaches or techniques: quoted market prices readily available from public exchange markets, price quotes and valuations from third party pricing vendors, a discounted cash flow (DCF) pricing model, and non-binding price quotes we obtain from outside brokers.

Our DCF pricing model incorporates an option adjusted spread and utilizes various market inputs we obtain from both active and inactive markets. The estimated fair values developed by the DCF pricing model is most sensitive to prevailing credit spreads, the level of interest rates (yields) and interest rate volatility. Prior to March 31, 2010, credit spreads were derived based on pricing data obtained from investment brokers and took into account the current yield curve, time to maturity and subordination levels for similar securities or classes of securities. Subsequent to March 31, 2010, credit spreads were derived from using a bond index to create a credit spread matrix which takes into account the current credit spread, ratings and remaining time to maturity, and subordination levels for securities that are included in the bond index. Our DCF pricing model is based on a widely used global bond index that is comprised of investments in active markets. The index provides a broad-based measure of the global fixed-income bond market. This bond index covers bonds issued by European and American issuers, which account for the majority of bonds that we hold. We validate the reliability of the DCF pricing model periodically by using the model to price investments for which there are quoted market prices from active and inactive markets or, in the alternative, are quoted by our custodian for the same or similar securities.

The pricing data and market quotes we obtain from outside sources are reviewed internally for reasonableness. If a fair value appears unreasonable, we will re-examine the inputs and assess the reasonableness of the pricing data with the vendor. Additionally, we may compare the inputs to relevant market indices and other performance measurements. Based on that analysis, the valuation is confirmed or revised.

Fair Value Hierarchy

GAAP specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. These two types of inputs create three valuation hierarchy levels. Level 1 valuations reflect quoted market prices for identical assets or liabilities in active markets. Level 2 valuations reflect quoted market prices for similar assets or liabilities in an active market, quoted market prices for identical or similar assets or liabilities in non-active markets or model-derived valuations in which all significant valuation inputs are observable in active markets. Level 3 valuations reflect valuations in which one or more of the significant inputs are not observable in an active market. The vast majority of our financial instruments subject to the classification provisions of GAAP relate to our investment securities classified as securities available for sale in our investment portfolio. We determine the fair value of our securities available for sale using several sources or techniques based on the type and nature of the investment securities.

The following tables present the fair value hierarchy levels of the Company’s assets and liabilities that are measured at fair value on a recurring basis as of December 31.


	2011
(In millions)	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total Fair Value
Assets:
Fixed maturities:
Government and agencies	$	11,092	$	721	$	0	$	11,813
Municipalities		0		1,159		0		1,159
Mortgage- and asset-backed securities		0		944		394		1,338
Public utilities		0		6,803		422		7,225
Collateralized debt obligations		0		0		0		0
Sovereign and supranational		0		1,874		434		2,308
Banks/financial institutions		0		6,379		1,074		7,453
Other corporate		0		15,171		1,105		16,276
Total fixed maturities		11,092		33,051		3,429		47,572
Perpetual securities:
Banks/financial institutions		0		5,552		526		6,078
Other corporate		0		361		0		361
Total perpetual securities		0		5,913		526		6,439
Equity securities		15		6		4		25
Other assets:
Interest rate swaps		0		0		34		34
Foreign currency swaps		0		0		341		341
Total other assets		0		0		375		375
Total assets	$	11,107	$	38,970	$	4,334	$	54,411

Liabilities:
Interest rate swaps	$	0	$	0	$	4	$	4
Foreign currency swaps		0		0		397		397
Credit default swaps		0		0		130		130
Total liabilities	$	0	$	0	$	531	$	531

Assets:
Fixed maturities:
Government and agencies	$	16,534	$	679	$	0	$	17,213
Municipalities		0		973		0		973
Mortgage- and asset-backed securities		0		1,539		267		1,806
Public utilities		0		5,369		0		5,369
Collateralized debt obligations		0		0		5		5
Sovereign and supranational		0		1,394		0		1,394
Banks/financial institutions		0		8,047		386		8,433
Other corporate		0		13,162		0		13,162
Total fixed maturities		16,534		31,163		658		48,355
Perpetual securities:
Banks/financial institutions		0		7,169		0		7,169
Other corporate		0		343		0		343
Total perpetual securities		0		7,512		0		7,512
Equity securities		14		5		4		23
Other assets:
Interest rate swaps		0		124		0		124
Foreign currency swaps		0		151		289		440
Total other assets		0		275		289		564
Total assets	$	16,548	$	38,955	$	951	$	56,454

Liabilities:
Interest rate swaps	$	0	$	70	$	0	$	70
Foreign currency swaps		0		280		48		328
Credit default swaps		0		0		343		343
Total liabilities	$	0	$	350	$	391	$	741

As of December 31, 2011, approximately 49% of the fair value, or 77% of the number of holdings, of our fixed income and perpetual investments classified as Level 2 are valued by obtaining quoted market prices from our investment custodian. The custodian obtains price quotes from various third party pricing services that estimate fair values based on observable market transactions for similar investments in active markets, market transactions for the same investments in inactive markets, or other observable market data where available. The fair value of approximately 45% of our Level 2 fixed income and perpetual investments, or 11% of the number of Level 2 holdings, are determined using our DCF pricing model. The significant valuation inputs to the DCF model are obtained from, or corroborated by, observable market sources from both active and inactive markets. For the remaining 6% of Level 2 investment valuations, or 12% of the number of Level 2 holdings, that are not provided by our custodian and are not priced using the DCF pricing model, we obtain quotes from other pricing services that estimate fair values based on observable market transactions for similar investments in active markets, market transactions for the same investments in inactive markets, or other observable market data where available.

Due to our reliance on third-party pricing services to provide valuations on 49% of our Level 2 portfolio, we regularly discuss and review pricing methodologies with the investment custodian. We also review the custodians’ Service Organization Control (SOC 1) report for the period covering the current year to gain satisfaction with the controls and control environment of the custodian.

For securities in Level 2 that are below investment grade or have split ratings where the valuation calculated by our DCF model does not conform to current market conditions, a CDS spread is used in lieu of the index spread discussed above. The CDS is chosen based on an average of spreads of issues with the same issuer, rating and subordination.

We use derivative instruments to manage the risk associated with certain assets. However, the derivative instrument may not be classified with the same fair value hierarchy as the associated asset. Inputs used to value derivatives include, but are not limited to, interest rates, credit spreads, foreign currency forward and spot rates, and interest volatility. For derivatives associated with VIEs where we are the primary beneficiary, we are not the direct counterparty to the swap contracts. As a result, the fair value measurements incorporate the credit risk of the collateral associated with the VIE and counterparty credit risk.

Prior to the third quarter of 2011, our derivative instruments were reported in Level 2 of the fair value hierarchy, except CDSs and certain foreign currency swaps which were classified as Level 3. The interest rate and certain foreign currency derivative instruments previously classified as Level 2 were priced by broker quotations. In the third quarter of 2011, we changed from receiving valuations from brokers to receiving valuations from a third party pricing vendor for our derivatives. Based on an analysis of these derivatives and a review of the methodology employed by the pricing vendor, we determined that due to the long duration of these swaps and the need to extrapolate from short-term observable data to derive and measure long-term inputs, certain inputs, assumptions and judgments are required to value future cash flows that cannot be corroborated by current inputs or current observable market data. As a result, our derivatives are classified as Level 3 of the fair value hierarchy as of December 31, 2011.

The fixed maturities classified as Level 3 consist of securities for which there are limited or no observable valuation inputs. We estimate the fair value of these securities by obtaining non-binding broker quotes from a limited number of brokers. These brokers base their quotes on a combination of their knowledge of the current pricing environment and market conditions. We consider these inputs unobservable. The significant valuation inputs that are used in the valuation process for the below-investment-grade and private placement investments classified as Level 3 include forward exchange rates, yen swap rates, dollar swap rates, interest rate volatilities, credit spread data on specific issuers, assumed default and default recovery rates, and certain probability assumptions. In obtaining these valuation inputs, we have determined that certain pricing assumptions and data used by our pricing sources are difficult to validate or corroborate by the market and/or appear to be internally developed rather than observed in or corroborated by the market. The use of these unobservable valuation inputs causes more subjectivity in the valuation process for these securities.

The equity securities classified in Level 3 are related to investments in Japanese businesses, each of which are insignificant and in the aggregate are immaterial. Because fair values for these investments are not readily available, we carry them at their original cost. We review each of these investments periodically and, in the event we determine that any are other-than-temporarily impaired, we write them down to their estimated fair value at that time.

Historically, we have not adjusted the quotes or prices we obtain from the brokers and pricing services we use.

The following tables present the changes in our available-for-sale investments and derivatives classified as Level 3 for the years ended December 31.


	2011
		Fixed Maturities															Perpetual Securities		Equities		Derivatives
(In millions)	Mortgage- and Asset- Backed Securities			Public Utilities		Collateralized Debt Obligations			Sovereign and Supranational		Banks/ Financial Institutions			Other Corporate		Banks/ Financial Institutions				Interest Rate Swaps			Foreign Currency Swaps			Credit Default Swaps			Total
Balance, beginning of period	$	267		$	0	$	5		$	0	$	386		$	0	$	0	$	4	$	0		$	241		$	(343	)	$	560
Realized gains or losses included in earnings		(16	)		0		(2	)		0		1			0		0		0		(33	)		(160	)		(64	)		(274	)
Unrealized gains or losses included in other comprehensive income		18			0		0			0		15			0		0		0		0			(33	)		0			0
Purchases, issuances, sales and settlements: Purchases		0			0		0			0		0			0		0		0		0			(6	)		0			(6	)
Sales		0			0		(3	)		0		0			0		0		0		0			0			15			12
Settlements		(10	)		0		0			0		0			0		0		0		4			(8	)		262			248
Transfers into Level 3⁽¹⁾		139			422		0			434		1,048			1,105		526		0		59			(90	)		0			3,643
Transfers out of Level 3⁽²⁾		(4	)		0		0			0		(376	)		0		0		0		0			0			0			(380	)

Balance, end of period	$	394		$	422	$	0		$	434	$	1,074		$	1,105	$	526	$	4	$	30		$	(56	)	$	(130	)	$	3,803

Change in unrealized gains (losses) still held⁽³⁾	$	(16	)	$	0	$	0		$	0	$	1		$	0	$	0	$	0	$	(33	)	$	(160	)	$	(64	)	$	(272	)

⁽¹⁾

Due to a lack of visibility to observe significant inputs to price

⁽²⁾

A result of changing our pricing methodology to using a third party pricing vendor for estimating fair value instead of obtaining pricing of the securities from brokers or arrangers

⁽³⁾

Represents the amount of total gains or losses for the period, included in earnings, attributable to the change in unrealized gains (losses) relating to assets classified as Level 3 that were still held at December 31, 2011


	2010
		Fixed Maturities																		Perpetual Securities			Equities			Derivatives
(In millions)	Mortgage- and Asset- Backed Securities			Public Utilities			Collateralized Debt Obligations			Sovereign and Supranational			Banks/ Financial Institutions			Other Corporate			Banks/ Financial Institutions						Foreign Currency Swaps		Credit Default Swaps			Total
Balance, beginning of period	$	62		$	497		$	267		$	293		$	1,240		$	1,248		$	1,441		$	9		$	0	$	0		$	5,057
Effect of change in accounting principle⁽¹⁾		0			0			(263	)		0			0			0			0			0			0		(312	)		(575	)
Revised balance, beginning of period		62			497			4			293			1,240			1,248			1,441			9			0		(312	)		4,482
Realized gains or losses included in earnings		(1	)		0			1			0			6			0			108			0			1		(31	)		84
Unrealized gains or losses included in other comprehensive income		20			(9	)		0			5			69			6			51			0			0		0			142
Purchases, issuances, sales and settlements:
Purchases		0			0			0			0			0			0			0			0			0		0			0
Sales		(3	)		(2	)		0			0			(175	)		0			(585	)		0			0		0			(765	)
Settlements		(4	)		0			0			0			(2	)		0			0			0			0		0			(6	)
Transfers into Level 3⁽²⁾		237			0			0			0			330			0			149			0			240		0			956
Transfers out of Level 3⁽³⁾		(44	)		(486	)		0			(298	)		(1,082	)		(1,254	)		(1,164	)		(5	)		0		0			(4,333	)

Balance, end of period	$	267		$	0		$	5		$	0		$	386		$	0		$	0		$	4		$	241	$	(343	)	$	560

Change in unrealized gains (losses) still held⁽⁴⁾	$	0		$	0		$	0		$	0		$	0		$	0		$	0		$	0		$	1	$	(31	)	$	(30	)

⁽¹⁾

Change in accounting for VIEs effective January 1, 2010. See Notes 1, 3, and 4 for additional information.

⁽²⁾

Due to a lack of visibility to observe significant inputs to price and credit events of respective issuers of securities

⁽³⁾

A result of changing our pricing methodology to using a pricing index for estimating fair value instead of obtaining pricing of the securities from brokers or arrangers

⁽⁴⁾

Transfers into and/or out of Level 3 are attributable to a change in the observability of inputs. Transfers into and/or out of any fair value hierarchy level are assumed to occur at the balance sheet date.

In 2011 and 2010, transfers into Level 3 from Level 2 resulted primarily from current market conditions characterized by a lack of trading activity, decreased liquidity, and credit ratings downgrades on certain of our fixed income securities which have resulted in decreased transparency of valuations and an increased use of broker quotations or management estimates and unobservable inputs to determine estimated fair value.

The most significant transfer into Level 3 in 2011 related to our reverse dual-currency (RDC) holdings. These securities are valued using a 60-day historical volatility to produce a binomial tree of possible foreign exchange scenarios over a specified time interval. The market standard approach is to use implied volatility to value options or instruments with optionality. Due to the use of historical volatility as a significant input to the valuation and due to it not being previously identified as being a significant unobservable input, these holdings were transferred from Level 2 to Level 3 of the fair value hierarchy effective December 31, 2011. These RDC securities had a fair value of $2.3 billion and $2.7 billion at December 31, 2011 and 2010, respectively. The remaining transfers of fixed maturity securities into Level 3 from Level 2 in 2011 were a result of using broker quotes for valuation instead of using custodian or DCF valuations.

In 2011, we transferred securities out of Level 3 into Level 2 as a result of changing our pricing methodology from obtaining pricing from brokers or arrangers to using a third party pricing vendor that estimates fair values based on observable market transactions for similar investments in active markets, market transactions for the same investments in inactive markets, or other observable market data where available. In 2010, we transferred securities out of Level 3 into Level 2 as a result of changing our pricing methodology from obtaining pricing from brokers or arrangers to using our DCF pricing model for estimating fair value.

As discussed in Notes 1 and 3, we adopted new accounting guidance on VIEs effective January 1, 2010, and as a result have consolidated certain VIE investments. Upon consolidation, the beneficial interest was derecognized and the underlying securities and derivatives were recognized. In many cases, the fair value hierarchy level differed between the original beneficial interest asset and the underlying securities that are now being recognized. In the Level 3 rollforward, we have separately disclosed the impact of consolidating these VIE investments that were previously categorized as Level 3 and now the underlying securities are Level 2. As noted in the Level 3 rollforward above, the CDSs which are separately recognized as a result of this change in accounting are reported as Level 3 investments. In addition, approximately $1.0 billion of Level 2 investments were reclassified upon the adoption of this guidance, and their underlying securities are being reported as Level 1 as of January 1, 2010.

Fair Value of Financial Instruments

The carrying values and estimated fair values of the Company’s financial instruments as of December 31 were as follows:


	2011				2010
(In millions)	Carrying Value		Fair Value		Carrying Value		Fair Value
Assets:
Fixed-maturity securities	$	88,588	$	88,039	$	72,570	$	72,999
Fixed-maturity securities - consolidated variable interest entities		5,993		5,916		5,869		5,825
Perpetual securities		5,149		5,149		5,974		5,974
Perpetual securities - consolidated variable interest entities		1,290		1,290		1,538		1,538
Equity securities		25		25		23		23
Interest rate, foreign currency, and credit default swaps		375		375		564		564
Liabilities:
Notes payable (excluding capitalized leases)		3,275		3,536		3,032		3,248
Interest rate, foreign currency, and credit default swaps		531		531		741		741
Obligation to Japanese policyholder protection corporation		71		71		108		108

As mentioned previously, we determine the fair values of our fixed maturity securities, perpetual securities, privately issued equity securities and our derivatives using four basic pricing approaches or techniques: quoted market prices readily available from public exchange markets, price quotes and valuations from third party pricing vendors, pricing models, and price quotes we obtain from outside brokers.

The fair values of our publicly issued notes payable were obtained from a limited number of independent brokers, and the fair values of our yen-denominated loans approximate their carrying values. The fair value of the obligation to the Japanese policyholder protection corporation is our estimated share of the industry’s obligation calculated on a pro rata basis by projecting our percentage of the industry’s premiums and reserves and applying that percentage to the total industry obligation payable in future years.

The carrying amounts for cash and cash equivalents, receivables, accrued investment income, accounts payable, cash collateral and payables for security transactions approximated their fair values due to the short-term nature of these instruments. Consequently, such instruments are not included in the above table. The preceding table also excludes liabilities for future policy benefits and unpaid policy claims as these liabilities are not financial instruments as defined by GAAP.

DCF Sensitivity

Our DCF pricing model utilizes various market inputs we obtain from both active and inactive markets. The estimated fair values developed by the DCF pricing models are most sensitive to prevailing credit spreads, the level of interest rates (yields), and, for our callable securities, interest rate volatility. Management believes that under normal market conditions, a movement of 50 basis points (bps) in interest rates and credit spreads and 50 percent in interest rate volatility would be sufficiently reasonable stresses to illustrate the sensitivity of valuations to these risk factors. Therefore, we selected these magnitudes of movements and provided both upward and downward movements in these key assumptions used to estimate fair value. Since the changes in fair value are relatively linear, readers of these financial statements can make their own judgments as to the movement in interest rates and the change in fair value based upon this data. The following scenarios provide a view of the sensitivity of our securities priced by our DCF pricing model.

The fair values of our available-for-sale fixed-maturity and perpetual securities valued by our DCF pricing model totaled $19.7 billion at December 31, 2011. The estimated effect of potential changes in interest rates, credit spreads and interest rate volatility on these fair values as of such date is as follows:


Interest Rates				Credit Spreads					Interest Rate Volatility
Factor change	Change in fair value (in millions)			Factor change		Change in fair value (in millions)			Factor change			Change in fair value (in millions)
+50 bps	$	(1,035	)		+50 bps	$	(1,027	)		+50	%	$	(125	)
-50 bps		1,095			-50 bps		1,090			-50	%		6

The fair values of our held-to-maturity fixed-maturity securities valued by our DCF pricing model totaled $25.8 billion at December 31, 2011. The estimated effect of potential changes in interest rates, credit spreads and interest rate volatility on these fair values as of such date is as follows:


Interest Rates				Credit Spreads					Interest Rate Volatility
Factor change	Change in fair value (in millions)			Factor change		Change in fair value (in millions)			Factor change			Change in fair value (in millions)
+50 bps	$	(1,596	)		+50 bps	$	(1,485	)		+50	%	$	(126	)
-50 bps		1,631			-50 bps		1,489			-50	%		165

For additional information on our investments and financial instruments, see the accompanying Notes 1, 3 and 4.