Derivative Financial Instruments

Purpose of Derivatives

We are exposed to certain risks relating to our ongoing business operations. The primary risks managed by using derivative instruments are interest rate risk, risk related to matching duration for our assets and liabilities, foreign currency risk, and credit risk. Historically, we have utilized current and forward interest rate swaps, current and forward currency swaps, forward treasury locks, currency forward contracts, forward contracts on specific fixed income securities, and credit default swaps. Transactions hedging interest rate risk are primarily associated with our individual and group long-term care and individual and group disability products. All other product portfolios are periodically reviewed to determine if hedging strategies would be appropriate for risk management purposes. We do not use derivative financial instruments for speculative purposes.

Derivatives designated as cash flow hedges and used to reduce our exposure to interest rate and duration risk are as follows:

•

Interest rate swaps are used to hedge interest rate risks and to improve the matching of assets and liabilities. An interest rate swap is an agreement in which we agree with other parties to exchange, at specified intervals, the difference between fixed rate and variable rate interest amounts. We use interest rate swaps to hedge the anticipated purchase of fixed maturity securities thereby protecting us from the potential adverse impact of declining interest rates on the associated policy reserves. We also use interest rate swaps to hedge the potential adverse impact of rising interest rates in anticipation of issuing fixed rate long-term debt.


•	Forward treasury locks are used to minimize interest rate risk associated with the anticipated purchase or disposal of fixed maturity securities. A forward treasury lock is a derivative contract without an initial investment where we and the counterparty agree to purchase or sell a specific U.S. Treasury bond at a future date at a pre-determined price.

Derivatives designated as fair value hedges and used to reduce our exposure to interest rate and duration risk are as follows:

•

Interest rate swaps are used to effectively convert certain of our fixed rate securities into floating rate securities which are used to fund our floating rate long-term debt. Under these swap agreements, we receive a variable rate of interest and pay a fixed rate of interest. Additionally, we use interest rate swaps to effectively convert certain fixed rate, long-term debt into floating rate long-term debt. Under these swap agreements, we receive a fixed rate of interest and pay a variable rate of interest.

Derivatives designated as cash flow hedges and used to reduce our exposure to foreign currency risk are as follows:

•

Foreign currency interest rate swaps have historically been used to hedge the currency risk of certain foreign currency-denominated fixed maturity securities owned for portfolio diversification and to hedge the currency risk associated with certain of the principal and interest payments of the U.S. dollar-denominated debt issued by one of our U.K. subsidiaries. For hedges of fixed maturity securities, we agree to pay, at specified intervals, fixed rate foreign currency-denominated principal and interest payments in exchange for fixed rate payments in the functional currency of the operating segment. For hedges of debt issued, we paid, at specified intervals, fixed rate foreign currency-denominated principal and interest payments to the counterparty in exchange for fixed rate U.S. dollar-denominated principal and interest payments.

Derivatives not designated as hedging instruments and used to reduce our exposure to foreign currency risk, credit losses on securities owned, and interest rate risk are as follows:

•

Foreign currency interest rate swaps previously designated as hedges were used to hedge the currency risk of certain foreign currency-denominated fixed maturity securities owned for portfolio diversification. These derivatives were effective hedges prior to novation to a new counterparty. In conjunction with the novation, these derivatives were de-designated as hedges. We agree to pay, at specified intervals, fixed rate foreign currency-denominated principal and interest payments in exchange for fixed rate payments in the functional currency of the operating segment. We hold offsetting swaps wherein we agree to pay fixed rate principal and interest payments in the functional currency of the operating segment in exchange for fixed rate foreign currency-denominated payments.

•

Credit default swaps are used as economic hedges against credit risk but do not qualify for hedge accounting. A credit default swap is an agreement in which we agree with another party to pay, at specified intervals, a fixed-rate fee in exchange for insurance against a credit event on a specific investment. If a defined credit event occurs, our counterparty may either pay us a net cash settlement or we may surrender the specific investment to them in exchange for cash equal to the full notional amount of the swap. Credit events typically include events such as bankruptcy, failure to pay, or certain types of debt restructuring.


•	Interest rate swap is used to effectively convert certain of our floating rate, long-term debt into fixed rate long-term debt. Under this swap agreement, we receive a variable rate of interest and pay a fixed rate of interest.

Derivative Risks

The basic types of risks associated with derivatives are market risk (that the value of the derivative will be adversely impacted by changes in the market, primarily the change in interest and exchange rates) and credit risk (that the counterparty will not perform according to the terms of the contract). The market risk of the derivatives should generally offset the market risk associated with the hedged financial instrument or liability. To help limit the credit exposure of the derivatives, we enter into master netting agreements with our counterparties whereby contracts in a gain position can be offset against contracts in a loss position. We also typically enter into bilateral, cross-collateralization agreements with our counterparties to help limit the credit exposure of the derivatives. These agreements require the counterparty in a loss position to submit acceptable collateral with the other counterparty in the event the net loss position meets or exceeds an agreed upon amount. Credit exposure on derivatives is limited to the value of those contracts in a net gain position, including accrued interest receivable less collateral held. Our current credit exposure on derivatives, which is limited to the value of those contracts in a net gain position, including accrued interest receivable less collateral held, was $1.1 million at June 30, 2017. We held $21.4 million and $26.1 million cash collateral from our counterparties at June 30, 2017 and December 31, 2016, respectively. We post either fixed maturity securities or cash as collateral to our counterparties. The carrying value of fixed maturity securities posted as collateral to our counterparties was $40.2 million and $35.2 million at June 30, 2017 and December 31, 2016, respectively. We had no cash posted as collateral to our counterparties at June 30, 2017 or December 31, 2016. See Note 4 for further discussion of our master netting agreements.

The majority of our derivative instruments contain provisions that require us to maintain specified issuer credit ratings and financial strength ratings. Should our ratings fall below these specified levels, we would be in violation of the provisions, and our derivatives counterparties could terminate our contracts and request immediate payment. The aggregate fair value of all derivative instruments with credit risk-related contingent features that were in a liability position was $52.6 million and $52.8 million at June 30, 2017 and December 31, 2016, respectively.

Derivative Transactions

The table below summarizes, by notional amounts, the activity for each category of derivatives. The notional amounts represent the basis upon which our counterparty pay and receive amounts are calculated.



	Swaps
	Receive Variable/Pay Fixed		Receive Fixed/Pay Fixed		Receive Fixed/Pay Variable		Credit Default		Forwards		Total
	(in millions of dollars)
Balance at March 31, 2016	$	126.0	$	650.3	$	600.0	$	70.0	$	—	$	1,446.3
Additions	—		—		—		—		—		—
Terminations	—		5.8		—		—		—		5.8
Balance at June 30, 2016	$	126.0	$	644.5	$	600.0	$	70.0	$	—	$	1,440.5

Balance at December 31, 2015	$	150.0	$	650.3	$	600.0	$	70.0	$	—	$	1,470.3
Additions	—		—		—		—		—		—
Terminations	24.0		5.8		—		—		—		29.8
Balance at June 30, 2016	$	126.0	$	644.5	$	600.0	$	70.0	$	—	$	1,440.5

Balance at March 31, 2017	$	105.4	$	596.2	$	250.0	$	70.0	$	—	$	1,021.6
Additions	—		—		—		—		16.0		16.0
Terminations	3.4		4.5		—		—		16.0		23.9
Balance at June 30, 2017	$	102.0	$	591.7	$	250.0	$	70.0	$	—	$	1,013.7

Balance at December 31, 2016	$	105.5	$	616.5	$	250.0	$	70.0	$	10.0	$	1,052.0
Additions	—		—		—		—		16.0		16.0
Terminations	3.5		24.8		—		—		26.0		54.3
Balance at June 30, 2017	$	102.0	$	591.7	$	250.0	$	70.0	$	—	$	1,013.7

Cash Flow Hedges

As of June 30, 2017 and December 31, 2016, we had $369.3 million and $394.1 million, respectively, notional amount of receive fixed, pay fixed, open current and forward foreign currency interest rate swaps to hedge fixed income foreign currency-denominated securities.

For the three and six months ended June 30, 2017 and 2016, there was no material ineffectiveness related to our cash flow hedges, and no component of the derivative instruments' gain or loss was excluded from the assessment of hedge effectiveness.

As of June 30, 2017, we expect to amortize approximately $60.6 million of net deferred gains on derivative instruments during the next twelve months. This amount will be reclassified from accumulated other comprehensive income into earnings and reported on the same income statement line item as the hedged item. The income statement line items that will be affected by this amortization are net investment income and interest and debt expense. Additional amounts that may be reclassified from accumulated other comprehensive income into earnings to offset the earnings impact of foreign currency translation of hedged items are not estimable.

As of June 30, 2017, we are hedging the variability of future cash flows associated with forecasted transactions through the year 2038.

Fair Value Hedges

As of June 30, 2017 and December 31, 2016, we had $102.0 million notional amount of receive variable, pay fixed interest rate swaps to hedge the changes in fair value of certain fixed rate securities held. These swaps effectively convert the associated fixed rate securities into floating rate securities, which are used to fund our floating rate long-term debt. The change in fair value of the hedged fixed maturity securities attributable to the hedged benchmark interest rate resulted in a loss of $0.9 million and $2.0 million for the three and six months ended June 30, 2017, and $1.1 million and $2.9 million for the three and six months ended June 30, 2016, respectively, with an offsetting gain on the related interest rate swaps. During the first quarter of 2016, we terminated $24.0 million notional amount of receive variable, pay fixed interest rate swaps in connection with the sale of the hedged securities and recorded a loss on the swap terminations of $1.2 million in our consolidated statements of income as a component of net realized investment gains and losses.

As of June 30, 2017 and December 31, 2016, we had $250.0 million notional amount of receive fixed, pay variable interest rate swaps to hedge the changes in the fair value of certain fixed rate long-term debt. These swaps effectively convert the associated fixed rate long-term debt into floating rate debt and provide for a better matching of interest rates with our short-term investments, which have frequent interest rate resets similar to a floating rate security. The change in fair value of the hedged debt attributable to the hedged benchmark interest rate resulted in a loss of $1.1 million and $0.6 million for the three and six months ended June 30, 2017, and $1.0 million and $6.6 million for the three and six months ended June 30, 2016 respectively, with an offsetting gain on the related interest rate swaps.

For the three and six months ended June 30, 2017 and 2016, there was no material ineffectiveness related to our fair value hedges, and no component of the derivative instruments' gain or loss was excluded from the assessment of hedge effectiveness. There were no instances wherein we discontinued fair value hedge accounting due to a hedged firm commitment no longer qualifying as a fair value hedge.

Derivatives not Designated as Hedging Instruments

As of June 30, 2017 and December 31, 2016, we held $222.4 million notional amount of receive fixed, pay fixed, foreign currency interest rate swaps. These derivatives were not designated as hedges, and as such, changes in fair value related to these derivatives will be reported in earnings as a component of net realized investment gain or loss.

As of June 30, 2017 and December 31, 2016, we held $70.0 million notional amount of single name credit default swaps. We entered into these swaps in order to mitigate the credit risk associated with specific securities owned.

As of December 31, 2016, we held $3.5 million notional amount of a receive variable, pay fixed interest rate swap acquired through our purchase of Starmount in the third quarter of 2016. This swap effectively converted Starmount's floating rate long-term debt into fixed rate debt. During the second quarter of 2017, we purchased and retired the debt and terminated the interest rate swap. We recorded a loss of $0.1 million on the swap termination in our consolidated statements of income as a component of net realized investment gains and losses. See Note 12.

We have an embedded derivative in a modified coinsurance arrangement for which we include in our realized investment gains and losses a calculation intended to estimate the value of the option of our reinsurance counterparty to cancel the reinsurance contract with us. However, neither party can unilaterally terminate the reinsurance agreement except in extreme circumstances resulting from regulatory supervision, delinquency proceedings, or other direct regulatory action. Cash settlements or collateral related to this embedded derivative are not required at any time during the reinsurance contract or at termination of the reinsurance contract. There are no credit-related counterparty triggers, and any accumulated embedded derivative gain or loss reduces to zero over time as the reinsured business winds down.

Locations and Amounts of Derivative Financial Instruments

The following tables summarize the location and fair values of derivative financial instruments, as reported in our consolidated balance sheets.



	June 30, 2017
	Asset Derivatives			Liability Derivatives
	Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
	(in millions of dollars)
Designated as Hedging Instruments
Interest Rate Swaps	Other L-T Investments	$	—	Other Liabilities	$	4.3
Foreign Exchange Contracts	Other L-T Investments	27.0		Other Liabilities	16.4
Total		$	27.0		$	20.7

Not Designated as Hedging Instruments
Credit Default Swaps				Other Liabilities	$	0.5
Foreign Exchange Contracts				Other Liabilities	31.4
Embedded Derivative in Modified Coinsurance Arrangement				Other Liabilities	31.9
Total					$	63.8



	December 31, 2016
	Asset Derivatives			Liability Derivatives
	Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
	(in millions of dollars)
Designated as Hedging Instruments
Interest Rate Swaps and Forwards	Other L-T Investments	$	—	Other Liabilities	$	6.9
Foreign Exchange Contracts	Other L-T Investments	32.7		Other Liabilities	13.4
Total		$	32.7		$	20.3

Not Designated as Hedging Instruments
Credit Default Swaps				Other Liabilities	$	0.4
Interest Rate Swaps				Other Liabilities	0.7
Foreign Exchange Contracts				Other Liabilities	31.4
Embedded Derivative in Modified Coinsurance Arrangement				Other Liabilities	46.7
Total					$	79.2

The following table summarizes the location of gains and losses on the effective portion of derivative financial instruments designated as cash flow hedging instruments, as reported in our consolidated statements of income and consolidated statements of comprehensive income.



		Three Months Ended June 30						Six Months Ended June 30
		2017			2016			2017			2016
		(in millions of dollars)
Gain (Loss) Recognized in Other Comprehensive Income (Loss) on Derivatives
Foreign Exchange Contracts		$	(4.7	)	$	(0.2	)	$	(9.2	)	$	(24.5	)

Gain (Loss) Reclassified from Accumulated Other Comprehensive Income into Income
Net Investment Income
	Interest Rate Swaps and Forwards	$	14.8		$	13.6		$	29.1		$	26.8
	Foreign Exchange Contracts	(0.2		)	(0.4		)	(0.5		)	(0.5		)
Net Realized Investment Gain (Loss)
	Interest Rate Swaps	—			—			—			3.2
	Foreign Exchange Contracts	(0.3		)	(0.5		)	(1.5		)	(0.5		)
Interest and Debt Expense
	Interest Rate Swaps	(0.5		)	(0.4		)	(1.0		)	(0.9		)
	Total	$	13.8		$	12.3		$	26.1		$	28.1

The following table summarizes the location of gains and losses on our derivatives not designated as hedging instruments, as reported in our consolidated statements of income.



		Three Months Ended June 30						Six Months Ended June 30
		2017			2016			2017			2016
		(in millions of dollars)
Net Realized Investment Gain (Loss)
	Credit Default Swaps	$	(0.1	)	$	(0.4	)	$	(0.4	)	$	(0.4	)
	Interest Rate Swaps	(0.1		)	—			(0.1		)	—
	Foreign Exchange Contracts	(0.2		)	(0.7		)	—			(2.0		)
	Embedded Derivative in Modified Coinsurance Arrangement	6.2			10.2			14.8			4.6
	Total	$	5.8		$	9.1		$	14.3		$	2.2