Note 12 — Derivative Financial Instruments
The Company uses derivative financial instruments to manage the characteristics of investment assets to meet the varying demands of the related insurance and contractholder liabilities. The Company has written and purchased reinsurance contracts under its Run-off Reinsurance segment that are accounted for as freestanding derivatives. The Company also used derivative financial instruments to manage the equity, foreign currency, and certain interest rate risk exposures of its Run-off Reinsurance segment until February 4, 2013 (for further information, see Note 7). For information on the Company's accounting policy for derivative financial instruments, see Note 2. Derivatives in the Company's separate accounts are excluded from the following discussion because associated gains and losses generally accrue directly to separate account policyholders.
Collateral and termination features. The Company routinely monitors exposure to credit risk associated with derivatives and diversifies the portfolio among approved dealers of high credit quality to minimize this risk. Certain of the Company's over-the-counter derivative instruments contain provisions requiring either the Company or the counterparty to post collateral or demand immediate payment depending on the amount of the net liability position and predefined financial strength or credit rating thresholds. Collateral posting requirements vary by counterparty. The net liability positions of these derivatives were not material as of December 31, 2013 or 2012.
Derivative instruments used in the Company's investment risk management.
The Company uses derivative financial instruments as a part of its investment strategy to manage the characteristics of investment assets (such as duration, yield, currency and liquidity) to meet the varying demands of the related insurance and contractholder liabilities (such as paying claims, investment returns, and withdrawals). Derivatives are typically used in this strategy to reduce interest rate and foreign currency risks.
Investment Cash Flow Hedges.
Purpose. The Company uses interest rate, foreign currency, and combination (interest rate and foreign currency) swap contracts to hedge the interest and foreign currency cash flows of its fixed maturity bonds to match associated insurance liabilities.
Accounting policy. Using cash flow hedge accounting, fair values are reported in other long-term investments or other liabilities. Changes in fair value are reported in accumulated other comprehensive income and amortized into net investment income or reported in other realized investment gains and losses as interest or principal payments are received.
Cash flows. Under the terms of these various contracts, the Company periodically exchanges cash flows between variable and fixed interest rates and/or between two currencies for both principal and interest. Foreign currency swaps are primarily Euros, Australian dollars, Canadian dollars, Japanese yen, and British pounds, and have terms for periods of up to eight years. Net interest cash flows are reported in operating activities.
Volume of activity. The following table provides the notional values of these derivative instruments as of December 31:
| Notional Amount (In millions) | ||||||||
| Instrument | 2013 | 2012 | ||||||
| Interest rate swaps | $ | 45 | $ | 58 | ||||
| Foreign currency swaps | 118 | 133 | ||||||
| Combination interest rate and foreign currency swaps | 40 | 64 | ||||||
| Total | $ | 203 | $ | 255 | ||||
The following table provides the effect of these derivative instruments on the financial statements for the indicated periods:
| Fair Value Effect on the Financial Statements (In millions) | ||||||||||||||||
| Other Long-Term Investments | Accounts Payable, Accrued Expenses and Other Liabilities | Gain (Loss) Recognized in Other Comprehensive Income (1) | ||||||||||||||
| As of December 31, | As of December 31, | For the years ended December 31, | ||||||||||||||
| Instrument | 2013 | 2012 | 2013 | 2012 | 2013 | 2012 | ||||||||||
| Interest rate swaps | $ | 2 | $ | 4 | $ | - | $ | - | $ | (2) | $ | (3) | ||||
| Foreign currency swaps | 1 | 1 | 13 | 18 | 1 | (3) | ||||||||||
| Combination interest rate and foreign currency swaps | - | - | 2 | 13 | 10 | (2) | ||||||||||
| Total | $ | 3 | $ | 5 | $ | 15 | $ | 31 | $ | 9 | $ | (8) | ||||
| (1) Other comprehensive income for foreign currency swaps excludes amounts required to adjust future policy benefits for the run-off settlement annuity business. | ||||||||||||||||
For the years ended December 31, 2013 and 2012, the amount of gains (losses) reclassified from accumulated other comprehensive income into shareholders' net income was not material. No amounts were excluded from the assessment of hedge effectiveness and no gains (losses) were recognized due to hedge ineffectiveness.
Derivative instruments associated with the Company's Run-off Reinsurance segment.
As explained in Note 7, the Company entered into an agreement to effectively exit the GMIB and GMDB business on February 4, 2013. As a result, the following disclosures related to derivative instruments associated with the GMIB and GMDB business are provided for context, including a description of the derivative accounting for the GMIB contracts. Cash flows on derivative instruments associated with the GMIB and GMDB business are reported in operating activities.
Guaranteed Minimum Income Benefits (GMIB).
As described further in Note 7, the Company effectively exited the GMIB business by purchasing additional reinsurance coverage for these contracts in 2013. The fair value effects on the financial statements are included in Note 10 and the volume of activity is included in Note 23.
Purpose. The Company has written reinsurance contracts with issuers of variable annuity contracts that provide annuitants with certain guarantees of minimum income benefits resulting from the level of variable annuity account values compared with a contractually guaranteed amount (“GMIB liabilities”). According to the contractual terms of the written reinsurance contracts, payment by the Company depends on the actual account value in the underlying mutual funds and the level of interest rates when the contractholders elect to receive minimum income payments.
GMDB and GMIB Hedge Programs.
As a result of the reinsurance agreement with Berkshire to effectively exit the GMDB and GMIB business, the GMDB and GMIB hedge programs were terminated beginning February 4, 2013. See Note 7 for further details regarding this business.