Derivative Instruments

The Company enters into derivative instruments for both risk management and investment purposes. The Company is exposed to potential loss from various market risks, and manages its market risks based on guidelines established by management and the Risk and Finance Committee of the Company's Board of Directors. The Company recognizes all derivatives as either assets or liabilities in the balance sheets and measures those instruments at fair value, with the changes in fair value of derivatives shown in the consolidated statement of income as “Net realized and unrealized gains (losses) on derivative instruments” unless the derivatives are designated as hedging instruments. The accounting for derivatives that are designated as hedging instruments is described in Item 8, Note 2(h), “Significant Accounting Policies - Derivative Instruments,” to the Consolidated Financial Statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2013.

The following table summarizes information on the location and gross amounts of derivative fair values contained in the consolidated balance sheets at June 30, 2014 and December 31, 2013:



	June 30, 2014								December 31, 2013
(U.S. dollars in thousands)	Asset Derivative Notional Amount		Asset Derivative Fair Value (1)		Liability Derivative Notional Amount		Liability Derivative Fair Value (1)		Asset Derivative Notional Amount		Asset Derivative Fair Value (1)		Liability Derivative Notional Amount		Liability Derivative Fair Value (1)
Derivatives designated as hedging instruments:
Foreign exchange contracts	$	891,217	$	45,597	$	1,315,385	$	35,265	$	1,005,610	$	26,098	$	2,572,227	$	70,462
Derivatives not designated as hedging instruments:
Investment Related Derivatives:
Interest rate exposure	$	1,295,267	$	259	$	28,090	$	—	$	30,702	$	266	$	10,259	$	8
Foreign exchange exposure	190,870		1,914		105,797		3,004		17,497		12		50,614		680
Credit exposure	4,566		3		14,270		9,988		—		—		340,020		15,128
Financial market exposure	46,645		344		43,468		—		58,232		1,111		14,821		77
Financial Operations Derivatives: (2)
Credit exposure	—		—		41,346		8,930		—		—		44,234		4,190
Other Non-Investment Derivatives:
Guaranteed minimum income benefit contract	50,802		12,453		50,802		12,453		—		—		53,564		14,940
Modified coinsurance funds withheld contracts (3)	65,721		—		5,659,644		—		66,369		—		—		—
Total derivatives not designated as hedging instruments	$	1,653,871	$	14,973	$	5,943,417	$	34,375	$	172,800	$	1,389	$	513,512	$	35,023

____________


(1)	Derivative instruments in an asset or liability position are included within Other assets or Other liabilities, respectively, in the balance sheets on a net basis where the Company has both a legal right of offset and the intentions to settle the contracts on a net basis.


(2)	Financial operations derivatives represent interests in variable interest entities as described in Note 12, “Variable Interest Entities".

(3)

The fair value movements in derivative assets and liabilities relating to modified coinsurance funds withheld contracts are included within the the associated asset or liability at each period end on the face of the balance sheets. Notional amounts associated with reinsurance agreements under which the Company assumes reinsurance risk are recorded as asset derivative notional amounts. Notional amounts associated with the Life Retro Arrangements under which the Company cedes reinsurance risk are recorded as liability derivative notional amounts. Included in the liability derivative notional amount at June 30, 2014 is the current period net realized and unrealized loss on life retrocession embedded derivative of $17.5 million.

The following table summarizes information on the gross and net amounts of derivative fair values and associated collateral received related to derivative assets or paid relating to derivative liabilities contained in the consolidated balance sheets at June 30, 2014 and December 31, 2013:



							Gross Amounts Not Offset in the Balance Sheets
June 30, 2014 (U.S. dollars in thousands)	Gross Amounts Recognized in the Balance Sheets		Gross Amounts Offset in the Balance Sheets		Net Amounts in the Balance Sheets		Financial Instruments		Cash Collateral		Net Amounts
Derivative Assets	$	60,570	$	1,240	$	59,330	$	—	$	3,160	$	56,170
Derivative Liabilities	$	69,640	$	1,240	$	68,400	$	—	$	—	$	68,400

December 31, 2013 (U.S. dollars in thousands)
Derivative Assets	$	27,487	$	1,342	$	26,145	$	—	$	—	$	26,145
Derivative Liabilities	$	105,485	$	1,342	$	104,143	$	—	$	19,847	$	84,296

Derivative instruments in an asset or liability position are included within Other assets or Other liabilities, respectively, in the balance sheets on a net basis where the Company has both a legal right of offset and the intention to settle the contracts on a net basis. The Company often enters into different types of derivative contracts with a single counterparty and these contracts are covered under netting agreements. At June 30, 2014 the Company held cash collateral related to foreign currency derivative positions and certain other derivative positions of $3.2 million and at December 31, 2013, the Company paid cash collateral related to foreign currency derivative positions and certain other derivative positions of $19.8 million. The assets related to the net collateral paid were recorded as Other assets within the balance sheets as the collateral and derivative positions are not intended to be settled on a net basis.

(a) Derivative Instruments Designated as Fair Value Hedges

The Company designates certain of its derivative instruments as fair value hedges or cash flow hedges and formally and contemporaneously documents all relationships between the hedging instruments and hedged items and links the hedging derivative to specific assets and liabilities. The Company assesses the effectiveness of the hedge both at inception and on an on-going basis, and determines whether the hedge is highly effective in offsetting changes in fair value or cash flows of the linked hedged item.

The Company may hedge portions of its liabilities against changes in the applicable designated benchmark interest rate. Interest rate swaps may also be used to hedge the changes in fair value of certain fixed rate liabilities and fixed income securities due to changes in the designated benchmark interest rate. In addition, the Company utilizes foreign exchange contracts to hedge the fair value of certain fixed income securities as well as to hedge certain net investments in foreign operations.

The following table provides the total impact on earnings relating to derivative instruments formally designated as fair value hedges along with the impacts of the related hedged items for the three and six months ended June 30, 2014 and 2013:



				Hedged Items - Amount of Gain/(Loss) Recognized in Income Attributable to Risk
Derivatives Designated as Fair Value Hedges: Three Months Ended June 30, 2014 (U.S. dollars in thousands)	Gain/(Loss) Recognized in Income on Derivative				Fixed Maturity Investments			Ineffective Portion of Hedging Relationship - Gain/(Loss)
Interest rate exposure	$	—
Foreign exchange exposure	(9,132		)
Total	$	(9,132	)		$	7,082		$	(2,050	)

Three Months Ended June 30, 2013
(U.S. dollars in thousands)
Interest rate exposure	$	—
Foreign exchange exposure	(5,002		)
Total	$	(5,002	)		$	4,496		$	(506	)

Six Months Ended June 30, 2014
(U.S. dollars in thousands)
Interest rate exposure	$	—
Foreign exchange exposure	(15,663		)
Total	$	(15,663	)		$	15,407		$	(256	)

Six Months Ended June 30, 2013
(U.S. dollars in thousands)
Interest rate exposure	$	—
Foreign exchange exposure	25,243
Total	$	25,243			$	(24,274	)	$	969

The gains (losses) recorded on both the derivative instruments and specific items designated as being hedged as part of the fair value hedging relationships outlined above along with any associated ineffectiveness in the relationships are recorded through Net realized and unrealized gains (losses) on derivative instruments in the income statement. In addition, the periodic coupon settlements relating to the interest rate swaps are recorded as adjustments to net investment income for the hedges of fixed maturity investments.

Settlement of Fair Value Hedges

A summary of the fair value hedges that have been settled and their impact on results during the three and six months ended June 30, 2014 and 2013, as well as the remaining balance of fair value hedges and average years remaining to maturity are shown below:



Settlement of Fair Value Hedges - Summary	Fair Value Hedges - Notes Payable and Debt June 30,				Fair Value Hedges - Deposit Liabilities June 30,
(U.S. dollars in thousands, except years)	2014		2013		2014		2013
Cumulative reduction to interest expense	$	20,810	$	16,903	$	90,615	$	29,257
Remaining balance	$	814	$	4,721	$	142,580	$	203,938
Weighted average years remaining to maturity	0.2		1.2		24.0		24.2

During the second quarter of 2014, the Company negotiated the termination of one of its larger structured indemnity contracts. This contract had previously been designated as a fair value hedge that was settled as noted above. The remaining fair value adjustment of $47.0 million that was being amortized as a reduction of interest expense over the remaining term of the contract was recorded as an adjustment to interest expense at the termination date. As a result of the termination, a net decrease of $28.7 million was recorded to interest expense reflecting the realization of the remaining balance of the fair value hedge adjustment, partially offset by an accretion rate adjustment due to changes in cash flows.

(b) Derivative Instruments Designated as Hedges of the Net Investment in a Foreign Operation

The Company utilizes foreign exchange contracts to hedge the fair value of certain net investments in foreign operations. During the three and six months ended June 30, 2014 and 2013, the Company entered into foreign exchange contracts that were formally designated as hedges of investments in foreign subsidiaries, the majority of which have functional currencies of either U.K. sterling or the Euro. There was no ineffectiveness in these transactions.

The following table provides the weighted average U.S. dollar equivalent of foreign denominated net assets that were hedged and the resulting derivative gain (loss) that was recorded in the Foreign currency translation adjustment, net of tax, account within AOCI for the three and six months ended June 30, 2014 and 2013:



Derivative Instruments Designated as Hedges of the Net Investment in a Foreign Operation - Summary	Three months ended June 30,						Six months ended June 30,
(U.S. dollars in thousands)	2014			2013			2014			2013
Weighted average of U.S. dollar equivalent of foreign denominated net assets	$	2,270,090		$	2,588,385		$	2,478,772		$	2,556,103
Derivative gains (losses)	$	(2,170	)	$	(6,135	)	$	(1,210	)	$	54,479

The following table provides the total impact on earnings relating to derivative instruments not formally designated as hedging instruments under authoritative accounting guidance and from the ineffective portion of fair value hedges. The impacts are all recorded through Net realized and unrealized gains (losses) on derivatives in the income statement for the three and six months ended June 30, 2014 and 2013:



Net Realized and Unrealized Gains (Losses) on Derivative Instruments	Three months ended June 30,						Six months ended June 30,
(U.S. dollars in thousands)	2014			2013			2014			2013
Investment Related Derivatives:
Interest rate exposure	$	8,978		$	288		$	9,326		$	489
Foreign exchange exposure	(1,490		)	(2,690		)	1,798			(4,288		)
Credit exposure	411			(1,178		)	7			(1,994		)
Financial market exposure	2,508			(2,736		)	3,378			2,616
Financial Operations Derivatives:
Credit exposure	447			1,087			(4,353		)	1,329
Other Non-Investment Derivatives:
Guaranteed minimum income benefit contract	633			2,306			2,257			6,002
Modified coinsurance funds withheld contract	2,162			(1,676		)	1,252			(2,343		)
Total gain (loss) recognized in income from derivatives not designated as hedging instruments	$	13,649		$	(4,599	)	$	13,665		$	1,811
Amount of gain (loss) recognized in income from ineffective portion of fair value hedges	(2,050		)	(506		)	(256		)	969
Net realized and unrealized gains (losses) on derivative instruments	$	11,599		$	(5,105	)	$	13,409		$	2,780

Net realized and unrealized gains (losses) on life retrocession embedded derivative	$	(17,546	)	$	—		$	(17,546	)	$	—

The Company’s objectives in using these derivatives are explained below.

(d)(i) Investment Related Derivatives

The Company, either directly or through its investment managers, may use derivative instruments within its investment portfolio, including interest rate swaps, inflation swaps, commodity contracts, credit derivatives (single name and index credit default swaps), options, forward contracts and financial futures (foreign exchange, bond and stock index futures), primarily as a means of economically hedging exposures to interest rate, credit spread, equity price changes and foreign currency risk or, in limited instances, for investment purposes. When using cleared (exchange-traded) derivatives, the Company is exposed to the credit risk of the applicable clearing house and of the Company's future commissions merchant. When using uncleared (over-the-counter) derivatives, the Company is exposed to credit risk in the event of non-performance by the counterparties under any derivative contracts, although the Company generally seeks to use credit support arrangements with counterparties to help manage this risk.

Investment Related Derivatives – Interest Rate Exposure

The Company utilizes risk management and overlay strategies that incorporate the use of derivative financial instruments, primarily to manage its fixed income portfolio duration and net economic exposure to interest rate risks. The Company may also use interest rate swaps to convert certain liabilities from a fixed rate to a variable rate of interest or use them to convert a variable rate of interest from one basis to another.

Investment Related Derivatives – Foreign Exchange Exposure

The Company has exposure to foreign currency exchange rate fluctuations through its operations and in its investment portfolio. The Company uses foreign exchange contracts to manage its exposure to the effects of fluctuating foreign currencies on the value of certain of its foreign currency fixed maturities. These contracts are not designated as specific hedges for financial reporting purposes and, therefore, realized and unrealized gains and losses on these contracts are recorded in income in the period in which they occur. These contracts generally have maturities of twelve months or less.

In addition, certain of the Company's investment managers may, subject to investment guidelines, enter into forward contracts.

Investment Related Derivatives – Credit Exposure

Credit derivatives may be purchased within the Company's investment portfolio in the form of single name and basket credit default swaps, which are used to mitigate credit exposure through a reduction in credit spread duration (i.e., macro credit strategies rather than single-name credit hedging) or exposure to selected issuers, including issuers that are not held in the underlying fixed income portfolio.

Investment Related Derivatives - Financial Market Exposure

Stock index futures may be purchased within the Company's investment portfolio in order to create synthetic equity exposure and to add value to the portfolio with overlay strategies where market inefficiencies are believed to exist. From time to time, the Company may enter into other financial market exposure derivative contracts on various indices including, but not limited to, inflation and commodity contracts.

(d)(ii) Financial Operations Derivatives - Credit Exposure

At June 30, 2014 and December 31, 2013, the Company held one credit derivative exposure, which was written as part of the Company's previous financial lines business and is outside of the Company's investment portfolio. This is a European project finance loan participation that benefits from a deficiency guarantee from the German state and federal governments, in the current amount of 68% of the outstanding exposure at June 30, 2014, following the scheduled expiry of a portion of this guarantee. An aggregate summary of the credit derivative exposure at June 30, 2014 and December 31, 2013 is as follows:



Financial Operations Derivatives - Credit Exposure Summary: (U.S. dollars in thousands)	June 30, 2014		December 31, 2013
Principal outstanding	$	39,748	$	42,080
Interest outstanding	1,598		2,154
Aggregate outstanding exposure	$	41,346	$	44,234
Total liability recorded	$	8,930	$	4,190
Weighted average contractual term to maturity	3.3 years		3.7 years
Underlying obligations credit rating	CC		CC

At June 30, 2014 and December 31, 2013, there was no reported event of default on this obligation. However, the liability shown in the above table has been recorded due to the combination of the reduction in the deficiency guarantee percentage and a deterioration of the credit quality of the underlying obligations. Credit derivatives are recorded at fair value based upon prices received from the investment bank counterparty, or by using models developed by the Company. Although the Company does not have access to the specific unobservable inputs that may be used in the determination of fair value, it expects that the significant inputs considered would include changes in interest rates, future default rates, credit spreads, changes in credit quality, future expected recovery rates and other market factors. The change resulting from movements in credit and credit quality spreads is unrealized as the credit derivative is not traded to realize this resultant value.

(d)(iii) Other Non-Investment Derivatives

The Company also has derivatives embedded in certain reinsurance contracts. For a certain life reinsurance contract, the Company pays the ceding company a fixed amount equal to the estimated present value of the excess of the guaranteed benefit over the account balance upon the policyholder's election to take the income benefit. The fair value of this derivative is determined based on the present value of expected cash flows. In addition, the Company has modified coinsurance and funds withheld reinsurance agreements that provide for a return to be paid to the Company based on a portfolio of fixed income securities. As such, the agreements contain an embedded derivative. The embedded derivative is bifurcated from the funds withheld balance and recorded at fair value with changes in fair value recognized in earnings through Net realized and unrealized gains (losses) on derivative instruments.

In addition, the Company has entered into Life Retro Arrangements as described in Notes 2, "Significant Accounting Policies - (a) Investments Related to Life Retrocession Agreements written on a Funds Withheld Basis" and " - (b) Reinsurance" and Note 3, "Sale of Life Reinsurance Subsidiary." The embedded derivative related to the Life Retro Arrangements is recorded at fair value with changes in fair value recognized in earnings through net realized and unrealized gains (losses) on life retrocession embedded derivative.

The value of the life retrocession embedded derivative includes the interest income, realized and unrealized gains and losses on Life Funds Withheld Assets and certain related expenses subsequent to May 30, 2014 as follows:



Components of Life Retrocession Embedded Derivative:	May 30 to June 30
(U.S. dollars in thousands)	2014
Interest income	$	(19,944	)
Realized and unrealized gains (losses) on Life Funds Withheld Assets	1,893
Other	505
Net realized and unrealized gains (losses) on life retrocession embedded derivative	$	(17,546	)

(e) Contingent Credit Features

Certain derivative agreements entered into by the Company or its subsidiaries contain rating downgrade provisions that permit early termination of the agreement by the counterparty if collateral is not posted following failure to maintain certain credit ratings from one or more of the principal credit rating agencies. If the Company were required to early terminate such agreements due to a rating downgrade, it could potentially be in a net liability position at the time of settlement of such agreements. The aggregate fair value of all derivative agreements containing such rating downgrade provisions that were in a liability position and any collateral posted under these agreements as of June 30, 2014 and December 31, 2013 were as follows:



Contingent Credit Features - Summary: (U.S. dollars in thousands)	June 30, 2014		December 31, 2013
Aggregate fair value of derivative agreements with downgrade provisions in a net liability position	$	6,728	$	47,703
Collateral posted to counterparty	$	—	$	13,260