7. Derivative Financial Instruments

The Company uses derivatives to manage 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, and for asset replication. The Company does not use derivatives for speculative purposes.

Property-Liability uses interest rate swaps, swaptions, futures and options to manage the interest rate risks of existing investments. Portfolio duration management is a risk management strategy that is principally employed by Property-Liability wherein financial futures and interest rate swaps 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. Equity index futures and options are used by Property-Liability to offset valuation losses in the equity portfolio during periods of declining equity market values. Credit default swaps are typically used to mitigate the credit risk within the Property-Liability fixed income portfolio. Property-Liability uses equity futures to hedge the market risk related to deferred compensation liability contracts and forward contracts 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 Financial 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. Allstate Financial uses financial futures and interest rate swaps to hedge anticipated asset purchases and liability issuances and futures and options for hedging the equity exposure contained in its equity indexed life and annuity product contracts that offer equity returns to contractholders. In addition, Allstate Financial uses interest rate swaps to hedge interest rate risk inherent in funding agreements. Allstate Financial uses foreign currency swaps and forwards primarily to reduce the foreign currency risk associated with issuing foreign currency denominated funding agreements and holding foreign currency denominated investments. Credit default swaps are typically used to mitigate the credit risk within the Allstate Financial fixed income portfolio.

Asset replication refers to the “synthetic” creation of assets through the use of derivatives and primarily investment grade host bonds to replicate securities that are either unavailable in the cash markets or more economical to acquire in synthetic form. The Company replicates fixed income securities using a combination of a credit default swap and one or more highly rated fixed income securities to synthetically replicate the economic characteristics of one or more cash market securities.

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 equity returns to contractholders; equity-indexed notes containing equity call options, which provide a coupon payout that is determined using one or more equity-based indices; credit default swaps in synthetic collateralized debt obligations, which provide enhanced coupon rates as a result of selling credit protection; and conversion options in fixed income securities, which provide the Company with the right to convert the instrument into a predetermined number of shares of common stock.

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. Allstate Financial designates certain of its interest rate and foreign currency swap contracts and 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. Allstate Financial designates certain of its foreign currency swap contracts as cash flow hedges when the hedging instrument is highly effective in offsetting the exposure of variations in cash flows for the hedged risk that could affect net income. Amounts are reclassified to net investment income or realized capital gains and losses as the hedged item affects net income.

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 certain exchange traded and cleared derivatives, margin deposits are required as well as daily cash settlements of margin accounts. As of September 30, 2013, the Company pledged $15 million of cash and securities in the form of margin deposits.

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. For cash flow hedges, gains and losses are amortized from accumulated other comprehensive income and are reported in net income in the same period the forecasted transactions being hedged impact net income.

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 following table provides a summary of the volume and fair value positions of derivative instruments as well as their reporting location in the Condensed Consolidated Statement of Financial Position as of September 30, 2013.

($ 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 accounting hedging instruments
Foreign currency swap agreements	Other investments	$	16	n/a	$	2	$	2	$	--

Derivatives not designated as accounting hedging instruments
Interest rate contracts
Interest rate swap agreements	Other investments		700	n/a		3		4		(1)
Interest rate cap agreements	Other investments		122	n/a		2		2		--
Equity and index contracts
Options and warrants (2)	Other investments		3	10,570		208		208		--
Foreign currency contracts
Foreign currency forwards	Other investments		355	n/a		11		12		(1)
Embedded derivative financial instruments
Conversion options	Fixed income securities		5	n/a		--		--		--
Credit default swaps	Fixed income securities		12	n/a		(12)		--		(12)
Other embedded derivative financial instruments	Other investments		1,000	n/a		--		--		--
Credit default contracts
Credit default swaps - buying protection	Other investments		101	n/a		(1)		1		(2)
Credit default swaps - selling protection	Other investments		155	n/a		2		2		--
Other contracts
Other contracts	Other assets		3	n/a		1		1		--
Subtotal			2,456	10,570		214		230		(16)
Total asset derivatives		$	2,472	10,570	$	216	$	232	$	(16)

Liability derivatives
Derivatives designated as accounting hedging instruments
Foreign currency swap agreements	Other liabilities & accrued expenses	$	132	n/a	$	(16)	$	--	$	(16)

Derivatives not designated as accounting hedging instruments
Interest rate contracts
Interest rate swap agreements	Other liabilities & accrued expenses		685	n/a		8		8		--
Interest rate cap agreements	Other liabilities & accrued expenses		234	n/a		3		3		--
Financial futures contracts	Other liabilities & accrued expenses		--	400		--		--		--
Equity and index contracts
Options and futures	Other liabilities & accrued expenses		81	11,723		(126)		1		(127)
Embedded derivative financial instruments
Guaranteed accumulation benefits	Contractholder funds		734	n/a		(54)		--		(54)
Guaranteed withdrawal benefits	Contractholder funds		505	n/a		(19)		--		(19)
Equity-indexed and forward starting options in life and annuity product contracts	Contractholder funds		1,463	n/a		(205)		--		(205)
	Liabilities held for sale		2,493	n/a		(249)		--		(249)
Other embedded derivative financial instruments	Contractholder funds		85	n/a		(5)		--		(5)
Credit default contracts
Credit default swaps – buying protection	Other liabilities & accrued expenses		355	n/a		(7)		--		(7)
Credit default swaps – selling protection	Other liabilities & accrued expenses		140	n/a		(15)		--		(15)
Subtotal			6,775	12,123		(669)		12		(681)
Total liability derivatives		$	6,907	12,123	$	(685)	$	12	$	(697)

Total derivatives		$	9,379	22,693	$	(469)

_______________

(1) Volume for OTC 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)

(2) In addition to the number of contracts presented in the table, the Company held 2,860 stock rights and 887,964 stock warrants. Stock rights and warrants can be converted to cash upon sale of those instruments or exercised for shares of common stock.

The following table provides a summary of the volume and fair value positions of derivative instruments as well as their reporting location in the Consolidated Statement of Financial Position as of December 31, 2012.

($ 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 accounting hedging instruments
Foreign currency swap agreements	Other investments	$	16	n/a	$	2	$	2	$	--

Derivatives not designated as accounting hedging instruments
Interest rate contracts
Interest rate swap agreements	Other investments		5,541	n/a		19		28		(9)
Interest rate cap agreements	Other investments		372	n/a		1		1		--
Financial futures contracts	Other assets		n/a	2		--		--		--
Equity and index contracts
Options and warrants (2)	Other investments		146	12,400		125		125		--
Financial futures contracts	Other assets		n/a	1,087		5		5		--
Foreign currency contracts
Foreign currency forwards and options	Other investments		258	n/a		6		6		--
Embedded derivative financial instruments
Conversion options	Fixed income securities		5	n/a		--		--		--
Equity-indexed call options	Fixed income securities		90	n/a		9		9		--
Credit default swaps	Fixed income securities		12	n/a		(12)		--		(12)
Other embedded derivative financial instruments	Other investments		1,000	n/a		--		--		--
Credit default contracts
Credit default swaps - buying protection	Other investments		209	n/a		--		2		(2)
Credit default swaps - selling protection	Other investments		308	n/a		2		3		(1)
Other contracts
Other contracts	Other assets		4	n/a		1		1		--
Subtotal			7,945	13,489		156		180		(24)
Total asset derivatives		$	7,961	13,489	$	158	$	182	$	(24)

Liability derivatives
Derivatives designated as accounting hedging instruments
Foreign currency swap agreements	Other liabilities & accrued expenses	$	135	n/a	$	(19)	$	--	$	(19)

Derivatives not designated as accounting hedging instruments
Interest rate contracts
Interest rate swap agreements	Other liabilities & accrued expenses		1,185	n/a		16		18		(2)
Interest rate swaption agreements	Other liabilities & accrued expenses		250	n/a		--		--		--
Interest rate cap agreements	Other liabilities & accrued expenses		429	n/a		1		1		--
Financial futures contracts	Other liabilities & accrued expenses		--	357		--		--		--
Equity and index contracts
Options and futures	Other liabilities & accrued expenses		--	12,262		(58)		--		(58)
Foreign currency contracts
Foreign currency forwards and options	Other liabilities & accrued expenses		139	n/a		(1)		1		(2)
Embedded derivative financial instruments
Guaranteed accumulation benefits	Contractholder funds		820	n/a		(86)		--		(86)
Guaranteed withdrawal benefits	Contractholder funds		554	n/a		(39)		--		(39)
Equity-indexed and forward starting options in life and annuity product contracts	Contractholder funds		3,916	n/a		(419)		--		(419)
Other embedded derivative financial instruments	Contractholder funds		85	n/a		(9)		--		(9)
Credit default contracts
Credit default swaps – buying protection	Other liabilities & accrued expenses		420	n/a		(3)		2		(5)
Credit default swaps – selling protection	Other liabilities & accrued expenses		285	n/a		(29)		1		(30)
Subtotal			8,083	12,619		(627)		23		(650)
Total liability derivatives		$	8,218	12,619	$	(646)	$	23	$	(669)

Total derivatives		$	16,179	26,108	$	(488)

_______________

(2) In addition to the number of contracts presented in the table, the Company held 34,634 stock rights and 879,158 stock warrants. Stock rights and warrants can be converted to cash upon sale of those instruments or exercised for shares of common stock.

The following table provides gross and net amounts for the Company’s OTC derivatives, all of which are subject to enforceable master netting agreements.

($ in millions)				Offsets
		Gross amount		Counter- party netting		Cash collateral (received) pledged		Net amount on balance sheet		Securities collateral (received) pledged		Net amount
September 30, 2013
Asset derivatives	$	34	$	(16)	$	(10)	$	8	$	(2)	$	6
Liability derivatives		(40)		16		(2)		(26)		24		(2)

December 31, 2012
Asset derivatives	$	66	$	(35)	$	(22)	$	9	$	(4)	$	5
Liability derivatives		(70)		35		(2)		(37)		25		(12)

The following table provides a summary of the impacts of the Company’s foreign currency contracts in cash flow hedging relationships. Amortization of net losses from accumulated other comprehensive income related to cash flow hedges is expected to be $3 million during the next twelve months. There was no hedge ineffectiveness reported in realized gains and losses for the three months and nine months ended September 30, 2013 or 2012.

($ in millions)		Three months ended September 30,				Nine months ended September 30,
		2013		2012		2013		2012
(Loss) gain recognized in OCI on derivatives during the period	$	(7)	$	(3)	$	2	$	(3)
Loss recognized in OCI on derivatives during the term of the hedging relationship		(19)		(19)		(19)		(19)
Loss reclassified from AOCI into income (net investment income)		--		--		(1)		--
Loss reclassified from AOCI into income (realized capital gains and losses)		--		--		--		(1)

The following tables present gains and losses from valuation, settlements and hedge ineffectiveness reported on derivatives used in fair value hedging relationships and derivatives not designated as accounting hedging instruments in the Condensed Consolidated Statements of Operations. For the three months and nine months ended September 30, 2013, the Company had no derivatives used in fair value hedging relationships.

($ in millions)		Realized capital gains and losses		Life and annuity contract benefits		Interest credited to contractholder funds		Operating costs and expenses		Total gain (loss) recognized in net income on derivatives
Three months ended September 30, 2013
Interest rate contracts	$	(1)	$	--	$	--	$	--	$	(1)
Equity and index contracts		(4)		--		16		10		22
Embedded derivative financial instruments		--		10		(9)		--		1
Foreign currency contracts		--		--		--		11		11
Credit default contracts		(7)		--		--		--		(7)
Other contracts		--		--		--		--		--
Total	$	(12)	$	10	$	7	$	21	$	26

Nine months ended September 30, 2013
Interest rate contracts	$	2	$	--	$	--	$	--	$	2
Equity and index contracts		(9)		--		63		23		77
Embedded derivative financial instruments		(1)		56		(35)		--		20
Foreign currency contracts		(4)		--		--		4		--
Credit default contracts		10		--		--		--		10
Other contracts		--		--		(3)		--		(3)
Total	$	(2)	$	56	$	25	$	27	$	106

($ in millions)		Net investment income		Realized capital gains and losses		Life and annuity contract benefits		Interest credited to contractholder funds		Operating costs and expenses		Total gain (loss) recognized in net income on derivatives
Three months ended September 30, 2012
Derivatives in fair value accounting hedging relationships
Interest rate contracts	$	--	$	--	$	--	$	--	$	--	$	--

Derivatives not designated as accounting hedging instruments
Interest rate contracts		--		(2)		--		--		--		(2)
Equity and index contracts		--		(6)		--		19		6		19
Embedded derivative financial instruments		--		2		18		138		--		158
Foreign currency contracts		--		1		--		--		5		6
Credit default contracts		--		3		--		--		--		3
Other contracts		--		--		--		1		--		1
Total	$	--	$	(2)	$	18	$	158	$	11	$	185

Nine months ended September 30, 2012
Derivatives in fair value accounting hedging relationships
Interest rate contracts	$	(1)	$	--	$	--	$	--	$	--	$	(1)

Derivatives not designated as accounting hedging instruments
Interest rate contracts		--		(1)		--		--		--		(1)
Equity and index contracts		--		(5)		--		56		15		66
Embedded derivative financial instruments		--		21		32		140		--		193
Foreign currency contracts		--		1		--		--		7		8
Credit default contracts		--		11		--		--		--		11
Other contracts		--		--		--		3		--		3
Subtotal		--		27		32		199		22		280
Total	$	(1)	$	27	$	32	$	199	$	22	$	279

The following table provides a summary of the changes in fair value of the Company’s fair value hedging relationships in the Condensed Consolidated Statements of Operations.

($ in millions)		Gain (loss) on derivatives		Gain (loss) on hedged risk
Location of gain or (loss) recognized in net income on derivatives		Interest rate contracts		Investments

Three months ended September 30, 2012
Net investment income	$	1	$	(1)

Nine months ended September 30, 2012
Net investment income	$	3	$	(3)

The Company manages its exposure to credit risk by utilizing highly rated counterparties, establishing risk control limits, executing 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 September 30, 2013, counterparties pledged $14 million in cash and securities to the Company, and the Company pledged $24 million in securities to counterparties which includes $13 million of collateral posted under MNAs for contracts containing credit-risk-contingent provisions that are in a liability position and $11 million of collateral posted under MNAs for contracts without credit-risk-contingent liabilities. 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 enforceable master netting agreements.

The following table summarizes the counterparty credit exposure by counterparty credit rating as it relates to the Company’s OTC derivatives.

($ in millions)	September 30, 2013							December 31, 2012

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+	2	$	101	$	1	$	1	2	$	29	$	1	$	1
A	3		32		2		--	4		2,450		13		2
A-	4		514		11		4	3		797		8		2
BBB+	1		776		4		1	1		3,617		11		--
Total	10	$	1,423	$	18	$	6	10	$	6,893	$	33	$	5

______________

(1) Rating is the lower of S&P or Moody’s 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 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 or in the event AIC, ALIC or ALNY are no longer rated by either Moody’s or S&P. Credit-risk-contingent cross-default provisions allow the counterparties to terminate the derivative instruments 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 enforceable MNAs.

($ in millions)		September 30, 2013		December 31, 2012
Gross liability fair value of contracts containing credit-risk-contingent features	$	29	$	65
Gross asset fair value of contracts containing credit-risk-contingent features and subject to MNAs		(14)		(31)
Collateral posted under MNAs for contracts containing credit-risk-contingent features		(13)		(25)
Maximum amount of additional exposure for contracts with credit-risk-contingent features if all features were triggered concurrently	$	2	$	9

Credit derivatives - selling protection

Free-standing credit default swaps (“CDS”) are utilized for selling credit protection against a specified credit event. A credit default swap is a derivative instrument, representing an agreement between two parties to exchange the credit risk of a specified entity (or a group of entities), or an index based on the credit risk of a group of entities (all commonly referred to as the “reference entity” or a portfolio of “reference entities”), in return for a periodic premium. In selling protection, CDS are used to replicate fixed income securities and to complement the cash market when credit exposure to certain issuers is not available or when the derivative alternative is less expensive than the cash market alternative. CDS typically have a five-year term.

The following table shows the CDS notional amounts by credit rating and fair value of protection sold.

($ in millions)		Notional amount
		AAA		AA		A		BBB		BB and lower		Total		Fair value
September 30, 2013
Single name
Investment grade corporate debt (1)	$	--	$	20	$	30	$	65	$	--	$	115	$	2
Baskets
First-to-default
Municipal		--		--		100		--		--		100		(16)
Index
Investment grade corporate debt (1)		--		1		20		55		4		80		1
Total	$	--	$	21	$	150	$	120	$	4	$	295	$	(13)

December 31, 2012
Single name
Investment grade corporate debt (1)	$	5	$	20	$	53	$	80	$	10	$	168	$	--
Municipal		--		25		--		--		--		25		(3)
Subtotal		5		45		53		80		10		193		(3)
Baskets
First-to-default
Municipal		--		--		100		--		--		100		(26)
Index
Investment grade corporate debt (1)		--		3		79		204		14		300		2
Total	$	5	$	48	$	232	$	284	$	24	$	593	$	(27)

______________

(1) Investment grade corporate debt categorization is based on the rating of the underlying name(s) at initial purchase.

In selling protection with CDS, the Company sells credit protection on an identified single name, a basket of names in a first-to-default (“FTD”) structure or a specific tranche of a basket, or credit derivative index (“CDX”) that is generally investment grade, and in return receives periodic premiums through expiration or termination of the agreement. With single name CDS, this premium or credit spread generally corresponds to the difference between the yield on the reference entity’s public fixed maturity cash instruments and swap rates at the time the agreement is executed. With a FTD basket or a tranche of a basket, because of the additional credit risk inherent in a basket of named reference entities, the premium generally corresponds to a high proportion of the sum of the credit spreads of the names in the basket and the correlation between the names. CDX is utilized to take a position on multiple (generally 125) reference entities. Credit events are typically defined as bankruptcy, failure to pay, or restructuring, depending on the nature of the reference entities. If a credit event occurs, the Company settles with the counterparty, either through physical settlement or cash settlement. In a physical settlement, a reference asset is delivered by the buyer of protection to the Company, in exchange for cash payment at par, whereas in a cash settlement, the Company pays the difference between par and the prescribed value of the reference asset. When a credit event occurs in a single name or FTD basket (for FTD, the first credit event occurring for any one name in the basket), the contract terminates at the time of settlement. When a credit event occurs in a tranche of a basket, there is no immediate impact to the Company until cumulative losses in the basket exceed the contractual subordination. To date, realized losses have not exceeded the subordination. For CDX, the reference entity’s name incurring the credit event is removed from the index while the contract continues until expiration. The maximum payout on a CDS is the contract notional amount. A physical settlement may afford the Company with recovery rights as the new owner of the asset.

The Company monitors risk associated with credit derivatives through individual name credit limits at both a credit derivative and a combined cash instrument/credit derivative level. The ratings of individual names for which protection has been sold are also monitored.

In addition to the CDS described above, the Company’s synthetic collateralized debt obligations contain embedded credit default swaps which sell protection on a basket of reference entities. The synthetic collateralized debt obligations are fully funded; therefore, the Company is not obligated to contribute additional funds when credit events occur related to the reference entities named in the embedded credit default swaps. The Company’s maximum amount at risk equals the amount of its aggregate initial investment in the synthetic collateralized debt obligations.