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DERIVATIVES AND HEDGE ACCOUNTING
 3 Months Ended
Mar. 31, 2020
DERIVATIVES AND HEDGE ACCOUNTING  
DERIVATIVES AND HEDGE ACCOUNTING

9. Derivatives and Hedge Accounting

We use derivatives and other financial instruments as part of our financial risk management programs and as part of our investment operations.

For a discussion of our accounting policies and procedures regarding derivatives and hedge accounting see Note 12 to the Consolidated Financial Statements in the 2019 Annual Report.

Interest rate derivatives (such as interest rate swaps) are used to manage interest rate risk associated with embedded derivatives contained in insurance contract liabilities, fixed maturity securities, outstanding medium- and long-term notes as well as other interest rate sensitive assets and liabilities. Foreign exchange derivatives (principally foreign exchange forwards and swaps) are used to economically mitigate risk associated with non-U.S. dollar denominated debt, net capital exposures, foreign currency transactions, and foreign denominated investments. Equity derivatives are used to mitigate financial risk embedded in certain insurance liabilities and economically hedge certain investments. We use credit derivatives to manage our credit exposures. The derivatives are effective economic hedges of the exposures that they are meant to offset.

In addition to hedging activities, we also enter into derivative instruments with respect to investment operations, which may include, among other things, credit default swaps (CDSs) and purchases of investments with embedded derivatives, such as equity-linked notes and convertible bonds.

The following table presents the notional amounts of our derivatives and the fair value of derivative assets and liabilities in the Condensed Consolidated Balance Sheets:

 

March 31, 2020

 

December 31, 2019

 

Gross Derivative Assets

 

Gross Derivative Liabilities

 

Gross Derivative Assets

 

Gross Derivative Liabilities

 

 

Notional

 

Fair

 

 

Notional

 

Fair

 

 

Notional

 

Fair

 

 

Notional

 

Fair

(in millions)

 

Amount

 

Value

 

 

Amount

 

Value

 

 

Amount

 

Value

 

 

Amount

 

Value

Derivatives designated as

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

hedging instruments:(a)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts

$

735

$

18

 

$

316

$

11

 

$

495

$

3

 

$

410

$

7

Foreign exchange contracts

 

7,592

 

843

 

 

1,929

 

88

 

 

4,328

 

342

 

 

5,230

 

162

Derivatives not designated

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

as hedging instruments:(a)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate contracts

 

50,409

 

6,605

 

 

36,573

 

4,215

 

 

52,437

 

3,197

 

 

35,231

 

2,742

Foreign exchange contracts

 

12,350

 

1,495

 

 

8,818

 

944

 

 

8,133

 

698

 

 

12,093

 

863

Equity contracts

 

22,291

 

1,240

 

 

4,313

 

77

 

 

18,533

 

769

 

 

7,539

 

139

Credit contracts(b)

 

7,617

 

133

 

 

923

 

81

 

 

8,457

 

3

 

 

923

 

89

Other contracts(c)

 

41,563

 

15

 

 

56

 

13

 

 

40,582

 

14

 

 

56

 

7

Total derivatives, gross

$

142,557

$

10,349

 

$

52,928

$

5,429

 

$

132,965

$

5,026

 

$

61,482

$

4,009

Counterparty netting(d)

 

 

 

(4,645)

 

 

 

 

(4,645)

 

 

 

 

(2,427)

 

 

 

 

(2,427)

Cash collateral(e)

 

 

 

(4,840)

 

 

 

 

(147)

 

 

 

 

(1,806)

 

 

 

 

(527)

Total derivatives on condensed

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

consolidated balance sheets(f)

 

 

$

864

 

 

 

$

637

 

 

 

$

793

 

 

 

$

1,055

(a)Fair value amounts are shown before the effects of counterparty netting adjustments and offsetting cash collateral.

(b)As of March 31, 2020 and December 31, 2019, included CDSs on super senior multi-sector CDOs with a net notional amount of $146 million and $152 million (fair value liability of $56 million and $48 million), respectively. The net notional amount represents the maximum exposure to loss on the portfolio.

(c)Consists primarily of stable value wraps and contracts with multiple underlying exposures.

(d)Represents netting of derivative exposures covered by a qualifying master netting agreement.

(e)Represents cash collateral posted and received that is eligible for netting.

(f)Freestanding derivatives only, excludes embedded derivatives. Derivative instrument assets and liabilities are recorded in Other assets and liabilities, respectively. Fair value of assets related to bifurcated embedded derivatives was zero at both March 31, 2020 and December 31, 2019. Fair value of liabilities related to bifurcated embedded derivatives was $8.2 billion and $6.9 billion, respectively, at March 31, 2020 and December 31, 2019. A bifurcated embedded derivative is generally presented with the host contract in the Condensed Consolidated Balance Sheets. Embedded derivatives are primarily related to guarantee features in variable annuity products, which include equity and interest rate components.

Collateral

We engage in derivative transactions that are not subject to a clearing requirement directly with unaffiliated third parties, in most cases, under International Swaps and Derivatives Association, Inc. (ISDA) Master Agreements. Many of the ISDA Master Agreements also include Credit Support Annex provisions, which provide for collateral postings that may vary at various ratings and threshold levels. We attempt to reduce our risk with certain counterparties by entering into agreements that enable collateral to be obtained from a counterparty on an upfront or contingent basis. We minimize the risk that counterparties might be unable to fulfill their contractual obligations by monitoring counterparty credit exposure and collateral value and generally requiring additional collateral to be posted upon the occurrence of certain events or circumstances. In addition, certain derivative transactions have provisions that require collateral to be posted upon a downgrade of our long-term debt ratings or give the counterparty the right to terminate the transaction. In the case of some of the derivative transactions, upon a downgrade of our long-term debt ratings, as an alternative to posting collateral and subject to certain conditions, we may assign the transaction to an obligor with higher debt ratings or arrange for a substitute guarantee of our obligations by an obligor with higher debt ratings or take other similar action. The actual amount of collateral required to be posted to counterparties in the event of such downgrades, or the aggregate amount of payments that we could be required to make, depends on market conditions, the fair value of outstanding affected transactions and other factors prevailing at and after the time of the downgrade.

Collateral posted by us to third parties for derivative transactions was $1.9 billion at March 31, 2020 and $2.2 billion at December 31, 2019. In the case of collateral posted under derivative transactions that are not subject to clearing, this collateral can generally be repledged or resold by the counterparties. Collateral provided to us from third parties for derivative transactions was $5.5 billion and $2.2 billion at March 31, 2020 and December 31, 2019, respectively. In the case of collateral provided to us under derivative transactions that are not subject to clearing, we generally can repledge or resell collateral.

Offsetting

We have elected to present all derivative receivables and derivative payables, and the related cash collateral received and paid, on a net basis on our Condensed Consolidated Balance Sheets when a legally enforceable ISDA Master Agreement exists between us and our derivative counterparty. An ISDA Master Agreement is an agreement governing multiple derivative transactions between two counterparties. The ISDA Master Agreement generally provides for the net settlement of all, or a specified group, of these derivative transactions, as well as transferred collateral, through a single payment, and in a single currency, as applicable. The net settlement provisions apply in the event of a default on, or affecting any, one derivative transaction or a termination event affecting all, or a specified group of, derivative transactions governed by the ISDA Master Agreement.

Hedge Accounting

We designated certain derivatives entered into with third parties as fair value hedges of available for sale investment securities held by our insurance subsidiaries. The fair value hedges include foreign currency forwards and cross currency swaps designated as hedges of the change in fair value of foreign currency denominated available for sale securities attributable to changes in foreign exchange rates. We also designated certain interest rate swaps entered into with third parties as fair value hedges of fixed rate GICs attributable to changes in benchmark interest rates.

We use foreign currency denominated debt and cross-currency swaps as hedging instruments in net investment hedge relationships to mitigate the foreign exchange risk associated with our non-U.S. dollar functional currency foreign subsidiaries. For net investment hedge relationships where issued debt is used as a hedging instrument, we assess the hedge effectiveness and measure the amount of ineffectiveness based on changes in spot rates. For net investment hedge relationships that use derivatives as hedging instruments, we assess hedge effectiveness and measure hedge ineffectiveness using changes in forward rates. For the three-month periods ended March 31, 2020 and 2019, we recognized gains of $99 million and $64 million, respectively, included in Change in foreign currency translation adjustment in Other comprehensive income related to the net investment hedge relationships.

A qualitative methodology is utilized to assess hedge effectiveness for net investment hedges, while regression analysis is employed for all other hedges.

The following table presents the gain (loss) recognized in earnings on our derivative instruments in fair value hedging relationships in the Condensed Consolidated Statements of Income:

 

Gains/(Losses) Recognized in Earnings for:

 

 

 

Hedging

Excluded

Hedged

 

 

(in millions)

Derivatives(a)

Components(b)

Items

Net Impact

Three Months Ended March 31, 2020

 

 

 

 

 

 

 

 

Interest rate contracts:

 

 

 

 

 

 

 

 

Interest credited to policyholder account balances

$

17

$

-

$

(17)

$

-

Net investment income

 

(3)

 

-

 

3

 

-

Foreign exchange contracts:

 

 

 

 

 

 

 

 

Realized capital gains/(losses)

 

305

 

281

 

(305)

 

281

Three Months Ended March 31, 2019

 

 

 

 

 

 

 

 

Interest rate contracts:

 

 

 

 

 

 

 

 

Interest credited to policyholder account balances

$

5

$

-

$

(5)

$

-

Net investment income

 

(1)

 

-

 

1

 

-

Foreign exchange contracts:

 

 

 

 

 

 

 

 

Realized capital gains/(losses)

 

(8)

 

(14)

 

8

 

(14)

(a)Gains and losses on derivative instruments designated and qualifying in fair value hedges that are included in the assessment of hedge effectiveness.

(b)Gains and losses on derivative instruments designated and qualifying in fair value hedges that are excluded from the assessment of hedge effectiveness and recognized in earnings on a mark-to-market basis.

Derivatives Not Designated as Hedging Instruments

The following table presents the effect of derivative instruments not designated as hedging instruments in the Condensed Consolidated Statements of Income:

 

 

 

Gains (Losses)

Three Months Ended March 31,

 

 

Recognized in Earnings

(in millions)

 

 

 

2020

 

2019

By Derivative Type:

 

 

 

 

 

 

Interest rate contracts

 

 

$

2,573

$

359

Foreign exchange contracts

 

 

 

1,025

 

(28)

Equity contracts

 

 

 

1,103

 

(208)

Credit contracts

 

 

 

122

 

(8)

Other contracts

 

 

 

10

 

16

Embedded derivatives

 

 

 

(1,052)

 

(449)

Total

 

 

$

3,781

$

(318)

By Classification:

 

 

 

 

 

 

Policy fees

 

 

$

15

$

17

Net investment income

 

 

 

(2)

 

(5)

Net realized capital gains (losses)

 

 

 

3,752

 

(334)

Policyholder benefits and claims incurred

 

 

 

16

 

4

Total

 

 

$

3,781

$

(318)

CREDIT RISK-RELATED CONTINGENT FEATURES

 

We estimate that at March 31, 2020, based on our outstanding financial derivative transactions, a downgrade of our long-term senior debt ratings to BBB or BBB– by Standard & Poor’s Financial Services LLC, a subsidiary of S&P Global Inc., and/or a downgrade to Baa2 or Baa3 by Moody’s Investors’ Service, Inc. would permit counterparties to make additional collateral calls and permit certain counterparties to elect early termination of contracts, resulting in corresponding collateral postings and termination payments in the total amount of up to approximately $44 million. The aggregate fair value of our derivatives that were in a net liability position and that contain such credit risk-related contingencies which can be triggered below our long-term senior debt ratings of BBB+ or Baa1 was approximately $257 million and $336 million at March 31, 2020 and December 31, 2019, respectively. The aggregate fair value of assets posted as collateral under these contracts at March 31, 2020 and December 31, 2019, was approximately $399 million and $381 million, respectively.

Hybrid Securities with Embedded Credit Derivatives

We invest in hybrid securities (such as credit-linked notes) with the intent of generating income, and not specifically to acquire exposure to embedded derivative risk. As is the case with our other investments in RMBS, CMBS, CDOs and ABS, our investments in these hybrid securities are exposed to losses only up to the amount of our initial investment in the hybrid security. Other than our initial investment in the hybrid securities, we have no further obligation to make payments on the embedded credit derivatives in the related hybrid securities.

We elect to account for our investments in these hybrid securities with embedded written credit derivatives at fair value, with changes in fair value recognized in Net investment income and Other income. Our investments in these hybrid securities are reported as Other bond securities in the Condensed Consolidated Balance Sheets. The fair values of these hybrid securities were $2.3 billion and $3.3 billion at March 31, 2020 and December 31, 2019, respectively. These securities have par amounts of $5.3 billion and $7.4 billion at March 31, 2020 and December 31, 2019, respectively, and have remaining stated maturity dates that extend to 2052.