Derivative Instruments

9 Months Ended

Sep. 30, 2011

Derivative Instruments and Hedging Activities Disclosure [Text Block]

7. 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. The Company recognizes all derivatives as either assets or liabilities in the balance sheet 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 and 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, 2010.

          The following table summarizes information on the location and gross amounts of derivative fair values contained in the consolidated balance sheet at September 30, 2011 and December 31, 2010:

	(Unaudited) September 30, 2011									December 31, 2010
(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:
Interest rate contracts (2)	$	159,056	$	107,707	$	—	$	—		$	161,028	$	74,368	$	—	$	—
Foreign exchange contracts		2,526,764		84,936		41,630		(1,368	)		1,850,092		43,226		244,731		(12,161	)
Total derivatives designated as hedging instruments	$	2,685,820	$	192,643	$	41,630		(1,368	)	$	2,011,120	$	117,594	$	244,731		(12,161	)
Derivatives not designated as hedging instruments:
Investment Related Derivatives:
Interest rate exposure	$	104,614	$	1,390	$	4,128	$	(49	)	$	117,689	$	281	$	41,063	$	—
Foreign exchange exposure		95,626		3,023		372,456		(14,254	)		82,395		1,377		272,724		(6,329	)
Credit exposure		212,500		6,004		419,513		(7,847	)		128,450		8,143		532,000		(5,295	)
Financial market exposure		121,107		653		22,668		(2,334	)		135,912		705		4,575		(27	)
Commodity futures		4,456		—		—		—			—		—		—		—
Financial Operations Derivatives: (3)
Credit exposure (2)		—		—		174,936		(25,887	)		—		—		246,292		(25,887	)
Other Non-Investment Derivatives:
Contingent capital facility		350,000		—		—		—			350,000		—		—		—
Guaranteed minimum income benefit contract		—		—		83,957		(22,050	)		—		—		80,025		(21,190	)
Modified coinsurance funds withheld contract		—		—		69,175		—			—		—		72,509		—
Total derivatives not designated as hedging instruments	$	888,303	$	11,070	$	1,146,833	$	(72,421	)	$	814,446	$	10,506	$	1,249,188	$	(58,728	)

(1)	Derivative instruments in an asset or liability position are included within Other Assets or Other Liabilities, respectively, in the consolidated balance sheet.
(2)	At September 30, 2011 and December 31, 2010, the Company held net cash collateral related to these derivative positions of $54.0 million and $23.0 million, respectively. The collateral balance is included within cash and cash equivalents and the corresponding liability to return the collateral has been offset against the derivative positions within the balance sheet as appropriate under the netting agreement.
(3)	Financial operations derivatives represent interests in variable interest entities as described in Note 11, “Variable Interest Entities.”

          (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.

          At September 30, 2011 and 2010, a portion of the Company’s liabilities were hedged against changes in the applicable designated benchmark interest rate. Interest rate swaps are also 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.

          On October 27, 2010, the Company settled three interest rate contracts designated as fair value hedges of certain of the Company’s deposit liability contracts. The derivative contracts were settled for a gain of $149.5 million. The cumulative increase recorded to the carrying value of the deposit liability, representing the effective portion of the hedging relationship, will be amortized through interest expense over the remaining term of the deposit liability contracts. From the date of settlement through September 30, 2011, $7.5 million of the balance was recorded as a reduction of interest expense. The remaining balance of $142.0 million will be amortized over the weighted average period of 34.3 years remaining on these deposit contracts.

          On June 7, 2010, the Company settled interest rate contracts designated as fair value hedges of certain issues of the Company’s notes payable and debt. The derivative contracts were settled for a gain of $21.6 million. The cumulative increase recorded to the carrying value of the hedged notes payable and debt, representing the effective portion of the hedging relationship, will be amortized through interest expense over the remaining term of the debt. From the date of settlement through September 30, 2011, $9.2 million of the balance was recorded as a reduction of interest expense. The remaining balance of $12.5 million will be amortized over the weighted average period of 2.8 years remaining to maturity of the debt.

          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 month periods ended September 30, 2011 and 2010:

Three Months Ended September 30, 2011 (U.S. dollars in thousands) (Unaudited)			Hedged Items – Amount of Gain/(Loss) Recognized in Income Attributable to Risk
Derivatives Designated as Fair Value Hedges:	Gain/(Loss) Recognized in Income on Derivative		Deposit Liabilities			Fixed Maturity Investments			Notes Payable and Debt		Ineffective Portion of Hedging Relationship – Gain/ (Loss)
Interest rate exposure	$	20,514
Foreign exchange exposure		18,219
Total	$	38,733	$	(21,659	)	$	(18,116	)	$	—	$	(1,042	)

Three Months Ended September 30, 2010 (U.S. dollars in thousands) (Unaudited)				Hedged Items – Amount of Gain/(Loss) Recognized in Income Attributable to Risk
Derivatives Designated as Fair Value Hedges:	Gain/(Loss) Recognized in Income on Derivative			Deposit Liabilities		Fixed Maturity Investments		Notes Payable and Debt		Ineffective Portion of Hedging Relationship – Gain/ (Loss)
Interest rate exposure	$	(43,698	)
Foreign exchange exposure		(33,124	)
Total	$	(76,822	)	$	53,417	$	23,646	$	—	$	241

Nine Months Ended September 30, 2011 (U.S. dollars in thousands) (Unaudited)				Hedged Items – Amount of Gain/(Loss) Recognized in Income Attributable to Risk
Derivatives Designated as Fair Value Hedges:	Gain/(Loss) Recognized in Income on Derivative			Deposit Liabilities			Fixed Maturity Investments		Notes Payable and Debt		Ineffective Portion of Hedging Relationship – Gain/ (Loss)
Interest rate exposure	$	25,366
Foreign exchange exposure		(3,084	)
Total	$	22,282		$	(25,950	)	$	2,890	$	—	$	(778	)

Nine Months Ended September 30, 2010 (U.S. dollars in thousands) (Unaudited)			Hedged Items – Amount of Gain/(Loss) Recognized in Income Attributable to Risk
Derivatives Designated as Fair Value Hedges:	Gain/(Loss) Recognized in Income on Derivative		Deposit Liabilities			Fixed Maturity Investments			Notes Payable and Debt			Ineffective Portion of Hedging Relationship – Gain/ (Loss)
Interest rate exposure	$	48,339
Foreign exchange exposure		15,432
Total	$	63,771	$	(33,326	)	$	(22,688	)	$	(15,940	)	$	(8,183	)

          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 are recorded through net realized and unrealized gains (losses) on derivative instruments in the income statement along with any associated ineffectiveness in the relationships. 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 and as adjustments to interest expense for the hedges of deposit liabilities and notes payable and debt.

          The periodic coupon settlements resulted in an increase to net investment income of nil for the three and nine months ended September 30, 2011 and decreases to net investment income of $0.3 million and $2.3 million for the three and nine months ended September 30, 2010, respectively.

          The periodic coupon settlements resulted in decreases to interest expense of $2.6 million and $7.7 million for the three and nine months ended September 30, 2011, respectively, and decreases to interest expense of $10.6 million and $45.1 million for the three and nine months ended September 30, 2010, respectively.

          (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 nine months ended September 30, 2011, 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.

          The U.S. dollar equivalent of foreign denominated net assets of $2.0 billion and $1.7 billion was hedged during the three and nine months ended September 30, 2011, respectively, which resulted in a derivative gain of $75.1 million and $5.9 million, respectively, being recorded in the cumulative translation adjustment account within AOCI for each period. There was no ineffectiveness resulting from these transactions.

          The U.S. dollar equivalent of foreign denominated net assets of $1.4 billion and $0.8 billion was hedged during the three and nine months ended September 30, 2010, respectively, which resulted in a derivative loss of $59.2 million and $16.6 million, respectively, being recorded in the cumulative translation adjustment account within AOCI for each period. There was no ineffectiveness resulting from these transactions.

          (c) Derivatives not designated as hedging instruments

          The following table provides the total impact on earnings relating to derivative instruments not formally designated as hedging instruments under authoritative accounting guidance. The impacts are all recorded through Net realized and unrealized gains (losses) on derivatives in the income statement:

(U.S. dollars in thousands)	Amount of Gain (Loss) Recognized in Income on Derivative
(Unaudited)	Three Months Ended September 30,						Nine Months Ended September 30,
	2011			2010			2011			2010
Derivatives not designated as hedging instruments:
Investment Related Derivatives:
Interest rate exposure	$	2,559		$	(3,500	)	$	(1,720	)	$	1,406
Foreign exchange exposure		(23,214	)		16,339			(5,763	)		(11,672	)
Credit exposure		5,207			(3,393	)		(8,452	)		(2,250	)
Financial market exposure		(6,914	)		58			(6,077	)		193
Commodity exposure		(390	)		—			(262	)		—
Financial Operations Derivatives:
Credit exposure		25			25			331			(7,317	)
Other Non-Investment Derivatives:
Contingent capital facility		(2,075	)		(2,075	)		(6,158	)		(6,158	)
Guaranteed minimum income benefit contract		(2,038	)		173			(860	)		(902	)
Modified coinsurance funds withheld contract		966			4,605			(4,560	)		6,980
Total derivatives not designated as hedging instruments		(25,874	)		12,232			(33,521	)		(19,720	)
Amount of gain (loss) recognized in income from ineffective portion of fair value hedges		(1,042	)		241			(778	)		(8,183	)
Net realized and unrealized gains (losses) on derivative instruments	$	(26,916	)	$	12,473		$	(34,299	)	$	(27,903	)

          The Company’s objectives in using these derivatives are explained in sections (d) and (e) of this note.

        (c)(i) Investment Related Derivatives

          The Company, either directly or through its investment managers, may, subject to investment guidelines, use derivative instruments within its investment portfolio, including interest rate swaps, inflation swaps, 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. The Company is exposed to credit risk in the event of non-performance by the counterparties under any swap 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 exposure to interest rate risks associated with certain of its assets and liabilities primarily in relation to certain legacy other financial lines and structured indemnity transactions. The Company may use interest rate swaps to convert certain liabilities from a fixed rate to a variable rate of interest and may also use them to convert a variable rate of interest from one basis to another.

          Investment Related Derivatives – Foreign Exchange Exposure

          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 primarily within its Life operations portfolio. 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.

          The Company has exposure to foreign currency exchange rate fluctuations through its operations and in its investment portfolio.

          Investment Related Derivatives – Credit Exposure

          Credit derivatives are 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 bond 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. The Company previously wrote a number of resettable strike swaps contracts relating to an absolute return index and diversified baskets of funds. 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.

          (c)(ii) Financial Operations Derivatives – Credit Exposure

          The Company held credit derivative exposures through a limited number of contracts written as part of the Company’s previous financial lines businesses, and through the Company’s prior reinsurance agreements with Syncora, as described below. Following the secondary sale of Syncora common shares, the Company retained some credit derivative exposures written by Syncora and certain of its subsidiaries through reinsurance agreements that had certain derivatives exposures embedded within them. The change in value of the derivative portion of the financial guarantee reinsurance agreements the Company had with Syncora was included in “Net (loss) income from operating affiliates.” Following the closing of the Master Agreement during August 2008, as described in Item 8, Note 4, “Syncora Holdings Ltd,” to the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, which terminated certain reinsurance and other agreements, these credit derivative exposures were eliminated by virtue of the commutation of the relevant reinsurance agreements.

          At September 30, 2011 and December 31, 2010, the credit derivative exposures outside of the Company’s investment portfolio consisted of two contracts written by the Company: one provides credit protection on the senior tranches of a structured finance transaction; the other is a European project finance loan participation. The two contracts have an aggregate outstanding exposure of $158.7 million ($154.4 million principal and $4.3 million interest), and $246.3 million ($226.4 million principal and $19.9 million interest), weighted average contractual term to maturity of 4.4 years and 5.3 years, a total liability recorded of $25.9 million and $25.9 million, and underlying obligations with an average credit rating of BB+ and B-, at September 30, 2011 and December 31, 2010, respectively.

          The credit protection related to the structured finance transaction is a credit default swap that was executed in 2000. The underlying collateral is predominantly securitized pools of leveraged loans and bonds. The transaction is in compliance with most of the coverage tests except the mezzanine overcollateralization tests. As a result, both interest and principal proceeds are currently redirected to amortize the most senior notes, which reduces the Company’s exposure sooner than originally anticipated. Management continues to monitor its underlying performance. The European project finance loan participation benefits from an 80% deficiency guarantee from the German state and federal governments.

          At September 30, 2011, there were no reported events of default on these obligations. Credit derivatives are recorded at fair value, which is determined using models developed by the Company and is dependent upon a number of factors, including 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 derivatives are not traded to realize this resultant value.

          (c)(iii) Other Non-Investment Derivatives

          The Company entered into derivatives as part of its contingent capital facility, including put options, interest rate swaps and asset return swaps. These derivatives are recorded at fair value with changes in fair value recognized in earnings.

          The Company also has derivatives embedded in certain reinsurance contracts. For a particular life reinsurance contract, the Company pays the ceding company a fixed amount equal to the estimated present value of the excess of guaranteed benefit GMIB 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 based on a portfolio of fixed income securities. As such, the agreements contain embedded derivatives. 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 and losses on derivative instruments.

          (d) Contingent Credit Features

          Certain derivatives 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 rating downgrade, it could potentially be in a net liability position at time of settlement. The aggregate fair value of all derivatives agreements containing such rating downgrade provisions that were in a net liability position on September 30, 2011 and December 31, 2010 was $28.5 million and $25.9 million, respectively. The Company posted collateral of $2.1 million and nil under these agreements at September 30, 2011 and December 31, 2010, respectively.