Derivative Instruments

3 Months Ended

Mar. 31, 2012

Derivative Instruments and Hedging Activities Disclosure [Text Block]

6. 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 Board of Directors of XL Group plc. 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, 2011.

          The following table summarizes information on the location and gross amounts of derivative fair values contained in the consolidated balance sheet at March 31, 2012 and December 31, 2011:

	March 31, 2012									December 31, 2011
(U.S. dollars in thousands, except ratios)	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 designed as hedging instruments:
Interest rate contracts (2)	$	156,271	$	106,941	$	-	$	-		$	156,271	$	109,761	$	-	$	-
Foreign exchange contracts		971,816		5,830		1,798,665		(21,415	)		2,033,428		25,387		457,892		(4,518	)
Total derivatives designed as hedging instruments	$	1,128,087	$	112,771	$	1,798,665		(21,415	)	$	2,189,699	$	135,148	$	457,892		(4,518	)
Derivatives not designed as hedging instruments:
Investment Related Derivatives:
Interest rate exposure	$	92,377	$	2,311	$	8,886	$	(26	)	$	70,978	$	1,946	$	55,033	$	(43	)
Foreign exchange exposure		78,100		384		131,658		(2,137	)		232,422		3,759		384,592		(11,737	)
Credit exposure		113,750		1,745		486,513		(14,839	)		172,500		5,271		449,513		(13,986	)
Financial market exposure		49,088		1,392		13,880		-			23,874		615		14,321		-
Financial Operations Derivatives: (3)
Credit exposure (2)		-		-		82,146		(10,288	)		-		-		81,678		(10,288	)
Other Non-Investment Derivatives:
Guaranteed minimum income benefit contract		-		-		70,352		(20,475	)		-		-		78,777		(22,490	)
Modified coinsurance funds withheld contract		76,890		-		-		-			77,200		-		-		-
Total derivatives not designed as hedging instruments	$	410,205	$	5,832	$	793,435	$	(47,765	)	$	576,974	$	11,591	$	1,063,914	$	(58,544	)

(1)	Derivative instruments in an asset or liability position are included within Other assets or Other liabilities, respectively, in the balance sheet.
(2)	At March 31, 2012 and December 31, 2011, the Company held net cash collateral related to these derivative positions of $77.5 million and $77.1 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 asset within the balance sheet as appropriate under the netting agreement.
(3)	Financial operations derivatives represent interests in variable interest entities as described in Note 10, “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 March 31, 2012 and 2011, a portion of the Company’s liabilities are 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.

          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 March 31, 2012 and 2011:

	Hedged Items - Amount of Gain/(Loss) Recognized in Income Attributable to Risk
Derivatives Designated as Fair Value Hedges: Three Months Ended March 31, 2012 (U.S. dollars in thousands)	Gain/(Loss) Recognized in Income on Derivative			Deposit Liabilities		Fixed Maturity Investments		Ineffective Portion of Hedging Relationship - Gain/(Loss)
Interest rate exposure	$	(5,457	)
Foreign exchange exposure		(15,100	)
Total	$	(20,557	)	$	3,607	$	14,511	$	(2,439	)
Three Months Ended March 31, 2011 (U.S. dollars in thousands)
Interest rate exposure	$	(874	)
Foreign exchange exposure		(20,425	)
Total	$	(21,299	)	$	2,381	$	20,139	$	1,221

          The gains (losses) recorded on both the derivatives 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 also resulted in decreases to Interest expense of $2.4 million and $2.5 million for the three months ended March 31, 2012 and 2011, respectively.

Settlement of Fair Value Hedges

          During the year ended December 31, 2010, the Company settled the interest rate contracts designated as fair value hedges of certain of the Company’s notes payable and debt and also settled three interest rate contracts designated as fair value hedges of certain of the Company’s deposit liability contracts. The cumulative increase recorded to the carrying value of the hedged notes payable and debt, and the deposit liability contracts, representing the effective portion of the hedging relationship, is amortized through interest expense over the remaining terms of the debt and deposit liability contracts. A summary of the fair value hedges that were settled in 2010 and their results during the three months ended March 31, 2012 and 2011, including the gains on settlements, is shown below:

Settlement of Fair Value Hedges - Summary	Fair Value Hedges - Notes Payable and Debt Three Months Ended March 31,				Fair Value Hedges - Deposit Liabilities Three Months Ended March 31,
(U.S. dollars in thousands, except years)	2012		2011		2012		2011
Cumulative reduction to interest expense	$	12,019	$	5,690	$	11,070	$	3,780
Remaining balance	$	9,605	$	15,933	$	138,415	$	145,705
Weighted average years remaining to maturity		P2Y5M		P3Y1M		P33Y0M		P35Y7M

(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 months ended March 31, 2012 and 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. 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 resultant gain (loss) that was recorded in the cumulative translation adjustment account within AOCI for the three months ended March 31, 2012 and 2011.

Derivative Instruments Designated as Hedges of the Net Investment in a Foreign Operation - Summary	Three Months Ended March 31,
(U.S. dollars in thousands)	2012			2011
Weighted average of U.S. dollar equivalent of foreign denominated net assets	$	1,893,401		$	1,429,874
Derivative gains (losses) (1)	$	(37,872	)	$	(41,409	)

(1) Derivative gains (losses) from derivative instruments designated as hedges of the net investment in a foreign operation are recorded in the cumulative translation adjustment account within AOCI for each period.

(c) Derivative Instruments Not Formally 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 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 months ended March 31, 2012 and 2011:

Net Realized and Unrealized Gains (Losses) on Derivative Instruments	Three Months Ended March 31,
(U.S. dollars in thousands)	2012			2011
Investment Related Derivatives:
Interest rate exposure	$	700		$	168
Foreign exchange exposure		(354	)		6,437
Credit exposure		(3,699	)		(1,253	)
Financial market exposure		3,944			1,156
Financial Operations Derivatives:
Credit exposure		143			182
Other Non-Investment Derivatives:
Contingent credit facility		-			(2,030	)
Guaranteed minimum income benefit contract		2,015			2,309
Modified coinsurance funds withheld contract		392			(4,623	)
Total derivatives not designated as hedging instruments	$	3,141		$	2,346
Amount of gain (loss) recognized in income from ineffective portion of fair value hedges		(2,439	)		1,221
Net realized and unrealized gains (losses) on derivative instruments	$	702		$	3,567

          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, 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 primarily those assets and liabilities related to certain legacy other financial lines and structured indemnity transactions. The Company uses 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 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 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.

          In addition, certain of the Company’s investment managers may, subject to investment guidelines, enter into forward contracts where potential gains may exist.

          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. 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 March 31, 2012 and December 31, 2011, the Company held two credit derivative exposures which were written as part of the Company’s previous financial lines business and are outside of the Company’s investment portfolio: one that provides credit protection on the senior tranches of a structured finance transaction; the other is a European project finance loan participation. An aggregate summary of these credit derivative exposures at March 31, 2012 and December 31, 2011 is as follows:

Financial Operations Derivatives - Credit Exposure Summary: (U.S. dollars in thousands, except term to maturity)	March 31, 2012		December 31, 2011
Principal outstanding	$	78,763	$	78,425
Interest outstanding		3,383		3,253
Aggregate outstanding exposure	$	82,146	$	81,678
Total liability recorded	$	10,288	$	10,288
Weighted average contractual term to maturity		4.5 years		5.0 years
Underlying obligations credit rating		BB		BB

          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 test. 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. In 2011, the Company’s exposure to this transaction was reduced by $147.8 million mainly due to principal pay downs. Management continues to monitor the underlying performance. The European project finance loan participation benefits from an 80% deficiency guarantee from the German state and federal governments.

          At March 31, 2012 and December 31, 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.

(d)(iii) Other Non-Investment Derivatives

          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 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.

(e) 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 a 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 liability position and the collateral posted under any of these agreements as of March 31, 2012 and December 31, 2011 were as follows:

Contingent Credit Features - Summary:	March 31, 2012		December 31, 2011
(U.S. dollars in thousands)
Aggregate fair value of derivative agreements with downgrade provisions in a net liability position	$	15,763	$	15,763
Collateral posted to counterparty	$	512	$	809