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Derivative Financial Instruments
 6 Months Ended
Jun. 30, 2019
Derivative Instruments and Hedging Activities Disclosure [Abstract]  
Derivative Financial Instruments
Note 7
Derivative Financial Instruments
The Company uses derivatives for risk reduction and to increase investment portfolio returns through asset replication. Risk reduction activity is focused on managing the risks with certain assets and liabilities arising from the potential adverse impacts from changes in risk-free interest rates, changes in equity market valuations, increases in credit spreads and foreign currency fluctuations.
Asset replication refers to the “synthetic” creation of assets through the use of derivatives. The Company replicates fixed income securities using a combination of a credit default swap, index total return swap, or a foreign currency forward contract and one or more highly rated fixed income securities, primarily investment grade host bonds, to synthetically replicate the economic characteristics of one or more cash market securities. The Company replicates equity securities using futures, index total return swaps, and options to increase equity exposure.
Property-Liability may use interest rate swaps, swaptions, futures and options to manage the interest rate risks of existing investments. These instruments are utilized to change the duration of the portfolio in order to offset the economic effect that interest rates would otherwise have on the fair value of its fixed income securities. Fixed income index total return swaps are used to offset valuation losses in the fixed income portfolio during periods of declining market values. Credit default swaps are typically used to mitigate the credit risk within the Property-Liability fixed income portfolio. Equity index total return swaps, futures and options are used by Property-Liability to offset valuation losses in the equity portfolio during periods of declining equity market values. In addition, equity futures are used to hedge the market risk related to deferred compensation liability contracts. Forward contracts are primarily used by Property-Liability to hedge foreign currency risk associated with holding foreign currency denominated investments and foreign operations.
Asset-liability management is a risk management strategy that is principally employed by Allstate Life and Allstate Annuities to balance the respective interest-rate sensitivities of its assets and liabilities. Depending upon the attributes of the assets acquired and liabilities issued, derivative instruments such as interest rate swaps, caps, swaptions and futures are utilized to change the interest rate characteristics of existing assets and liabilities to ensure the relationship is maintained within specified ranges and to reduce exposure to rising or falling interest rates. Fixed income index total return swaps are used to offset valuation losses in the portfolio during periods of declining market values. Credit default swaps are typically used to mitigate the credit risk within the Allstate Life and Allstate Annuities fixed income portfolios. Futures and options are used for hedging the equity exposure contained in equity indexed life and annuity product contracts that offer equity returns to contractholders. In addition, the Company uses equity index total return swaps, options and futures to
offset valuation losses in the equity portfolio during periods of declining equity market values. Foreign currency swaps and forwards are primarily used to reduce the foreign currency risk associated with holding foreign currency denominated investments.
The Company also has derivatives embedded in non-derivative host contracts that are required to be separated from the host contracts and accounted for at fair value with changes in fair value of embedded derivatives reported in net income. The Company’s primary embedded derivatives are equity options in life and annuity product contracts, which provide returns linked to equity indices to contractholders.
When derivatives meet specific criteria, they may be designated as accounting hedges and accounted for as fair value, cash flow, foreign currency fair value or foreign currency cash flow hedges. The Company designates certain investment risk transfer reinsurance agreements as fair value hedges when the hedging instrument is highly effective in offsetting the risk of changes in the fair value of the hedged item. The fair value of hedged liability is reported in contractholder funds in the Condensed Consolidated Statements of Financial Position. The impact from results of the fair value hedge is reported in interest credited to contractholder funds in the Condensed Consolidated Statements of Operations.
The notional amounts specified in the contracts are used to calculate the exchange of contractual payments under the agreements and are generally not representative of the potential for gain or loss on these agreements. However, the notional amounts specified in credit default swaps where the Company has sold credit protection represent the maximum amount of potential loss, assuming no recoveries.
Fair value, which is equal to the carrying value, is the estimated amount that the Company would receive or pay to terminate the derivative contracts at the reporting date. The carrying value amounts for OTC derivatives are further adjusted for the effects, if any, of enforceable master netting agreements and are presented on a net basis, by counterparty agreement, in the Condensed Consolidated Statements of Financial Position.
For those derivatives which qualify for fair value hedge accounting, net income includes the changes in the fair value of both the derivative instrument and the hedged risk, and therefore reflects any hedging ineffectiveness. Non-hedge accounting is generally used for “portfolio” level hedging strategies where the terms of the individual hedged items do not meet the strict homogeneity requirements to permit the application of hedge accounting. For non-hedge derivatives, net income includes changes in fair value and accrued periodic settlements, when applicable. With the exception of non-hedge derivatives used for asset replication and non-hedge embedded derivatives, all of the Company’s derivatives are evaluated for their ongoing effectiveness as either
accounting hedge or non-hedge derivative financial instruments on at least a quarterly basis.
The Company had one derivative used in fair value hedging relationships for the three and six months ended June 30, 2019 and 2018. The Company had no
derivatives used in cash flow hedging relationships for the three and six months ended June 30, 2019 and had one foreign currency contract designated as a cash flow hedge during the three and six months ended June 30, 2018.
Summary of the volume and fair value positions of derivative instruments as of June 30, 2019
($ in millions, except number of contracts)
 
 
Volume (1)
 
 
 
 
 
 
Balance sheet location
 
Notional amount
 
Number of contracts
 
Fair value, net
 
Gross asset
 
Gross liability
Asset derivatives
 
 
 

 
 

 
 

 
 

 
 

Derivatives designated as fair value accounting hedging instruments
 
 

 
 

 
 

 
 

 
 

Other
Other assets
 
$
2

 
n/a

 
$
—

 
$
—

 
$
—

Derivatives not designated as accounting hedging instruments
 
 

 
 

 
 

 
 

 
 

Interest rate contracts
 
 
 

 
 

 
 

 
 

 
 

Interest rate swap agreements
Other investments
 
1

 
n/a

 
—

 
—

 
—

Futures
Other assets
 
—

 
561

 
—

 
—

 
—

Equity and index contracts
 
 
 

 
 

 
 

 
 

 
 

Options
Other investments
 
—

 
9,362

 
122

 
122

 
—

Futures
Other assets
 
—

 
1,710

 
2

 
2

 
—

Total return index contracts
 
 
 
 
 
 
 
 
 
 
 
Total return swap agreements – fixed income
Other investments
 
235

 
n/a

 
8

 
8

 
—

Total return swap agreements – equity index
Other investments
 
172

 
n/a

 
6

 
6

 
—

Foreign currency contracts
 
 
 

 
 

 
 

 
 

 
 

Foreign currency forwards
Other investments
 
257

 
n/a

 
14

 
14

 
—

Credit default contracts
 
 
 

 
 

 
 

 
 

 
 

Credit default swaps – buying protection
Other investments
 
138

 
n/a

 
(4
)
 
—

 
(4
)
Total asset derivatives
 
 
$
805

 
11,633

 
$
148

 
$
152

 
$
(4
)
 
 
 
 
 
 
 
 
 
 
 
 
Liability derivatives
 
 
 

 
 

 
 

 
 

 
 

Derivatives not designated as accounting hedging instruments
 
 

 
 

 
 

 
 

 
 

Interest rate contracts
 
 
 

 
 

 
 

 
 

 
 

Interest rate cap agreements
Other liabilities & accrued expenses
 
$
35

 
n/a

 
$
—

 
$
—

 
$
—

Futures
Other liabilities & accrued expenses
 
—

 
3,050

 
—

 
—

 
—

Equity and index contracts
 
 
 

 
 

 
 

 
 

 
 

Options
Other liabilities & accrued expenses
 
—

 
9,214

 
(47
)
 
—

 
(47
)
Futures
Other liabilities & accrued expenses
 
—

 
1,001

 
(1
)
 
—

 
(1
)
Total return index contracts
 
 
 
 
 
 
 
 
 
 
 
Total return swap agreements – fixed income
Other liabilities & accrued expenses
 
95

 
n/a

 
2

 
2

 
—

Foreign currency contracts
 
 
 

 
 

 
 

 
 

 
 

Foreign currency forwards
Other liabilities & accrued expenses
 
279

 
n/a

 
7

 
8

 
(1
)
Embedded derivative financial instruments
 
 

 
 

 
 

 
 

 
 

Guaranteed accumulation benefits
Contractholder funds
 
172

 
n/a

 
(22
)
 
—

 
(22
)
Guaranteed withdrawal benefits
Contractholder funds
 
209

 
n/a

 
(14
)
 
—

 
(14
)
Equity-indexed and forward starting options in life and annuity product contracts
Contractholder funds
 
1,782

 
n/a

 
(401
)
 
—

 
(401
)
Credit default contracts
 
 
 

 
 

 
 

 
 

 
 

Credit default swaps – buying protection
Other liabilities & accrued expenses
 
49

 
n/a

 
(1
)
 
1

 
(2
)
Credit default swaps – selling protection
Other liabilities & accrued expenses
 
9

 
n/a

 
—

 
—

 
—

Total liability derivatives
 
 
2,630

 
13,265

 
(477
)
 
$
11

 
$
(488
)
Total derivatives
 
 
$
3,435

 
24,898

 
$
(329
)
 
 

 
 

(1) 
Volume for OTC and cleared derivative contracts is represented by their notional amounts. Volume for exchange traded derivatives is represented by the number of contracts, which is the basis on which they are traded. (n/a = not applicable)
Summary of the volume and fair value positions of derivative instruments as of December 31, 2018
($ in millions, except number of contracts)
 
 
Volume (1)
 
 
 
 
 
 
Balance sheet location
 
Notional amount
 
Number of contracts
 
Fair value, net
 
Gross asset
 
Gross liability
Asset derivatives
 
 
 

 
 

 
 

 
 

 
 

Derivatives not designated as accounting hedging instruments
 
 

 
 

 
 

 
 

 
 

Interest rate contracts
 
 
 

 
 

 
 

 
 

 
 

Interest rate cap agreements
Other investments
 
$
6

 
n/a

 
$
—

 
$
—

 
$
—

Futures
Other assets
 
—

 
1,330

 
1

 
1

 
—

Equity and index contracts
 
 
 

 
 

 
 

 
 

 
 

Options
Other investments
 
—

 
11,131

 
115

 
115

 
—

Futures
Other assets
 
—

 
1,453

 
1

 
1

 
—

Total return index contracts
 
 
 
 
 
 
 
 
 
 
 
Total return swap agreements – fixed income
Other investments
 
7

 
n/a

 
—

 
—

 
—

Total return swap agreements – equity index
Other investments
 
61

 
n/a

 
(2
)
 
—

 
(2
)
Foreign currency contracts
 
 
 

 
 

 
 

 
 

 
 

Foreign currency forwards
Other investments
 
258

 
n/a

 
10

 
11

 
(1
)
Credit default contracts
 
 
 

 
 

 
 

 
 

 
 

Credit default swaps – buying protection
Other investments
 
136

 
n/a

 
(1
)
 
2

 
(3
)
Other contracts
 
 
 

 
 

 
 

 
 

 
 

Other
Other assets
 
2

 
n/a

 
—

 
—

 
—

Total asset derivatives
 
 
$
470

 
13,914

 
$
124

 
$
130

 
$
(6
)
 
 
 
 
 
 
 
 
 
 
 
 
Liability derivatives
 
 
 

 
 

 
 

 
 

 
 

Derivatives not designated as accounting hedging instruments
 
 

 
 

 
 

 
 

 
 

Interest rate contracts
 
 
 

 
 

 
 

 
 

 
 

Interest rate cap agreements
Other liabilities & accrued expenses
 
$
31

 
n/a

 
$
1

 
$
1

 
$
—

Futures
Other liabilities & accrued expenses
 
—

 
1,300

 
(1
)
 
—

 
(1
)
Equity and index contracts
 
 
 

 
 

 
 

 
 

 
 

Options and futures
Other liabilities & accrued expenses
 
—

 
10,956

 
(50
)
 
—

 
(50
)
Total return index contracts
 
 
 
 
 
 
 
 
 
 
 
Total return swap agreements – fixed income
Other liabilities & accrued expenses
 
38

 
n/a

 
(1
)
 
—

 
(1
)
Total return swap agreements – equity index
Other liabilities & accrued expenses
 
71

 
n/a

 
(4
)
 
—

 
(4
)
Foreign currency contracts
 
 
 

 
 

 
 

 
 

 
 

Foreign currency forwards
Other liabilities & accrued expenses
 
341

 
n/a

 
10

 
11

 
(1
)
Embedded derivative financial instruments
 
 

 
 

 
 

 
 

 
 

Guaranteed accumulation benefits
Contractholder funds
 
169

 
n/a

 
(25
)
 
—

 
(25
)
Guaranteed withdrawal benefits
Contractholder funds
 
210

 
n/a

 
(14
)
 
—

 
(14
)
Equity-indexed and forward starting options in life and annuity product contracts
Contractholder funds
 
1,770

 
n/a

 
(185
)
 
—

 
(185
)
Credit default contracts
 
 
 

 
 

 
 

 
 

 
 

Credit default swaps – buying protection
Other liabilities & accrued expenses
 
40

 
n/a

 
—

 
—

 
—

Credit default swaps – selling protection
Other liabilities & accrued expenses
 
5

 
n/a

 
—

 
—

 
—

Total liability derivatives
 
 
2,675

 
12,256

 
(269
)
 
$
12

 
$
(281
)
Total derivatives
 
 
$
3,145

 
26,170

 
$
(145
)
 
 

 
 

(1) 
Volume for OTC and cleared derivative contracts is represented by their notional amounts. Volume for exchange traded derivatives is represented by the number of contracts, which is the basis on which they are traded. (n/a = not applicable)
Gross and net amounts for OTC derivatives (1)
($ in millions)
 
 
 
Offsets
 
 
 
 
 
 
 
Gross amount
 
Counter-party netting
 
Cash collateral (received) pledged
 
Net amount on balance sheet
 
Securities collateral (received) pledged
 
Net amount
June 30, 2019
 
 

 
 

 
 

 
 

 
 

 
 

Asset derivatives
 
$
39

 
$
(15
)
 
$
(20
)
 
$
4

 
$
—

 
$
4

Liability derivatives
 
(7
)
 
15

 
(10
)
 
(2
)
 
—

 
(2
)
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2018
 
 

 
 

 
 

 
 

 
 

 
 

Asset derivatives
 
$
25

 
$
(18
)
 
$
(5
)
 
$
2

 
$
—

 
$
2

Liability derivatives
 
(12
)
 
18

 
(12
)
 
(6
)
 
—

 
(6
)

(1) 
All OTC derivatives are subject to enforceable master netting agreements.
Gains (losses) from valuation and settlements reported on derivatives not designated as accounting hedges
($ in millions)
 
Realized capital gains (losses)
 
Life contract benefits
 
Interest credited to contractholder funds
 
Operating costs and expenses
 
Total gain (loss) recognized in net income on derivatives
Three months ended June 30, 2019
 
 

 
 

 
 

 
 

 
 

Interest rate contracts
 
$
19

 
$
—

 
$
—

 
$
—

 
$
19

Equity and index contracts
 
(17
)
 
—

 
11

 
5

 
(1
)
Embedded derivative financial instruments
 
—

 
(5
)
 
(6
)
 
—

 
(11
)
Foreign currency contracts
 
5

 
—

 
—

 
—

 
5

Credit default contracts
 
(1
)
 
—

 
—

 
—

 
(1
)
Total return swaps - fixed income
 
8

 
—

 
—

 
—

 
8

Total return swaps - equity index
 
8

 
—

 
—

 
—

 
8

Total
 
$
22

 
$
(5
)
 
$
5

 
$
5

 
$
27

 
 
 
 
 
 
 
 
 
 
 
Six months ended June 30, 2019
 
 

 
 

 
 

 
 

 
 

Interest rate contracts
 
$
26

 
$
—

 
$
—

 
$
—

 
$
26

Equity and index contracts
 
(88
)
 
—

 
42

 
26

 
(20
)
Embedded derivative financial instruments
 
—

 
3

 
(41
)
 
—

 
(38
)
Foreign currency contracts
 
10

 
—

 
—

 
—

 
10

Credit default contracts
 
(5
)
 
—

 
—

 
—

 
(5
)
Total return swaps - fixed income
 
10

 
—

 
—

 
—

 
10

Total return swaps - equity index
 
23

 
—

 
—

 
—

 
23

Total
 
$
(24
)
 
$
3

 
$
1

 
$
26

 
$
6

 
 
 
 
 
 
 
 
 
 
 
Three months ended June 30, 2018
 
 

 
 

 
 

 
 

 
 

Interest rate contracts
 
$
1

 
$
—

 
$
—

 
$
—

 
$
1

Equity and index contracts
 
(1
)
 
—

 
10

 
6

 
15

Embedded derivative financial instruments
 
—

 
1

 
1

 
—

 
2

Foreign currency contracts
 
19

 
—

 
—

 
(2
)
 
17

Total return swaps
 
1

 
—

 
—

 
—

 
1

Total
 
$
20

 
$
1

 
$
11

 
$
4

 
$
36

 
 
 
 
 
 
 
 
 
 
 
Six months ended June 30, 2018
 
 

 
 

 
 

 
 

 
 

Interest rate contracts
 
$
1

 
$
—

 
$
—

 
$
—

 
$
1

Equity and index contracts
 
(3
)
 
—

 
6

 
3

 
6

Embedded derivative financial instruments
 
—

 
5

 
21

 
—

 
26

Foreign currency contracts
 
12

 
—

 
—

 
(1
)
 
11

Total return swaps
 
1

 
—

 
—

 
—

 
1

Credit default contracts
 
1

 
—

 
—

 
—

 
1

Total
 
$
12

 
$
5

 
$
27

 
$
2

 
$
46


The Company manages its exposure to credit risk by utilizing highly rated counterparties, establishing risk control limits, executing legally enforceable master netting agreements (“MNAs”) and obtaining collateral where appropriate. The Company uses MNAs for OTC derivative transactions that permit either party to net payments due for transactions and collateral is either pledged or obtained when certain predetermined exposure limits are exceeded. As of June 30, 2019, counterparties pledged $32 million in collateral to the Company, and the Company pledged $2 million in collateral to counterparties under MNAs for contracts containing credit-risk-contingent provisions that are in a liability position. The Company has not incurred any losses on derivative financial instruments due to counterparty nonperformance. Other derivatives, including futures and certain option contracts, are traded on organized exchanges which require margin
deposits and guarantee the execution of trades, thereby mitigating any potential credit risk.
Counterparty credit exposure represents the Company’s potential loss if all of the counterparties concurrently fail to perform under the contractual terms of the contracts and all collateral, if any, becomes worthless. This exposure is measured by the fair value of OTC derivative contracts with a positive fair value at the reporting date reduced by the effect, if any, of legally enforceable master netting agreements.
For certain exchange traded and cleared derivatives, margin deposits are required as well as daily cash settlements of margin accounts. As of June 30, 2019, the Company pledged $46 million in the form of margin deposits.
OTC derivatives counterparty credit exposure by counterparty credit rating
($ in millions)
 
June 30, 2019
 
December 31, 2018
Rating (1)
 
Number of
counter-
parties
 
Notional
amount (2)
 
Credit
exposure (2)
 
Exposure, net of collateral (2)
 
Number of
counter-
parties
 
Notional
amount (2)
 
Credit
exposure (2)
 
Exposure, net of collateral (2)
A+
 
6

 
$
1,121

 
$
32

 
$
4

 
3

 
$
643

 
$
19

 
$
1

A
 
1

 
81

 
2

 
—

 
2

 
121

 
1

 
—

Total
 
7

 
$
1,202

 
$
34

 
$
4

 
5

 
$
764

 
$
20

 
$
1

(1) 
Allstate uses the lower of S&P’s or Moody’s long-term debt issuer ratings.
(2) 
Only OTC derivatives with a net positive fair value are included for each counterparty.
Market risk is the risk that the Company will incur losses due to adverse changes in market rates and prices. Market risk exists for all of the derivative financial instruments the Company currently holds, as these instruments may become less valuable due to adverse changes in market conditions. To limit this risk, the Company’s senior management has established risk control limits. In addition, changes in fair value of the derivative financial instruments that the Company uses for risk management purposes are generally offset by the change in the fair value or cash flows of the hedged risk component of the related assets, liabilities or forecasted transactions.
Certain of the Company’s derivative instruments contain credit-risk-contingent termination events, cross-default provisions and credit support annex agreements. Credit-risk-contingent termination events allow the counterparties to terminate the derivative agreement or a specific trade on certain dates if AIC’s, ALIC’s or Allstate Life Insurance
Company of New York’s (“ALNY”) financial strength credit ratings by Moody’s or S&P fall below a certain level. Credit-risk-contingent cross-default provisions allow the counterparties to terminate the derivative agreement if the Company defaults by pre-determined threshold amounts on certain debt instruments. Credit-risk-contingent credit support annex agreements specify the amount of collateral the Company must post to counterparties based on AIC’s, ALIC’s or ALNY’s financial strength credit ratings by Moody’s or S&P, or in the event AIC, ALIC or ALNY are no longer rated by either Moody’s or S&P.
The following summarizes the fair value of derivative instruments with termination, cross-default or collateral credit-risk-contingent features that are in a liability position, as well as the fair value of assets and collateral that are netted against the liability in accordance with provisions within legally enforceable MNAs.
($ in millions)
 
As of June 30, 2019
 
As of December 31, 2018
Gross liability fair value of contracts containing credit-risk-contingent features
 
$
6

 
$
11

Gross asset fair value of contracts containing credit-risk-contingent features and subject to MNAs
 
(6
)
 
(5
)
Collateral posted under MNAs for contracts containing credit-risk-contingent features
 
—

 
(2
)
Maximum amount of additional exposure for contracts with credit-risk-contingent features if all features were triggered concurrently
 
$
—

 
$
4