| Fair Values of Financial Instruments |
Fair Values of Financial Instruments The following sets forth a comparison of the carrying amounts and fair values of our financial instruments: | | | | | | | | | | | | | | | | | | | | | | Carrying Amount | | Fair Value | | Carrying Amount | | Fair Value | | (Dollars in thousands) | Assets | | | | | | | | Fixed maturity securities, available for sale | $ | 50,171,303 |
| | $ | 50,171,303 |
| | $ | 45,923,727 |
| | $ | 45,923,727 |
| Mortgage loans on real estate | 3,083,675 |
| | 3,128,732 |
| | 2,943,091 |
| | 2,920,612 |
| Derivative instruments | 888,208 |
| | 888,208 |
| | 205,149 |
| | 205,149 |
| Other investments | 642,219 |
| | 642,219 |
| | 355,531 |
| | 348,970 |
| Cash and cash equivalents | 1,215,967 |
| | 1,215,967 |
| | 344,396 |
| | 344,396 |
| Coinsurance deposits | 5,029,374 |
| | 4,574,116 |
| | 4,954,068 |
| | 4,553,790 |
| Interest rate caps | 59 |
| | 59 |
| | 597 |
| | 597 |
| Interest rate swap | — |
| | — |
| | 354 |
| | 354 |
| Counterparty collateral | — |
| | — |
| | 33,101 |
| | 33,101 |
| | | | | | | | | Liabilities | | | | | | | | Policy benefit reserves | 59,849,400 |
| | 50,673,721 |
| | 57,249,510 |
| | 49,180,143 |
| Single premium immediate annuity (SPIA) benefit reserves | 263,430 |
| | 271,842 |
| | 270,406 |
| | 279,077 |
| Notes payable | 494,850 |
| | 510,640 |
| | 494,591 |
| | 489,985 |
| Subordinated debentures | 243,200 |
| | 246,046 |
| | 242,982 |
| | 215,514 |
| Amounts due under repurchase agreements | — |
| | — |
| | 109,298 |
| | 109,298 |
| Interest rate swap | 881 |
| | 881 |
| | — |
| | — |
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Fair value is the price that would be received to sell an asset or paid to transfer a liability (exit price) in an orderly transaction between market participants at the measurement date. The objective of a fair value measurement is to determine that price for each financial instrument at each measurement date. We meet this objective using various methods of valuation that include market, income and cost approaches. We categorize our financial instruments into three levels of fair value hierarchy based on the priority of inputs used in determining fair value. The hierarchy defines the highest priority inputs (Level 1) as quoted prices in active markets for identical assets or liabilities. The lowest priority inputs (Level 3) are our own assumptions about what a market participant would use in determining fair value such as estimated future cash flows. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, a financial instrument's level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the financial instrument. We categorize financial assets and liabilities recorded at fair value in the consolidated balance sheets as follows: | | Level 1— | Quoted prices are available in active markets for identical financial instruments as of the reporting date. We do not adjust the quoted price for these financial instruments, even in situations where we hold a large position and a sale could reasonably impact the quoted price. |
| | Level 2— | Quoted prices in active markets for similar financial instruments, quoted prices for identical or similar financial instruments in markets that are not active; and models and other valuation methodologies using inputs other than quoted prices that are observable. |
| | Level 3— | Models and other valuation methodologies using significant inputs that are unobservable for financial instruments and include situations where there is little, if any, market activity for the financial instrument. The inputs into the determination of fair value require significant management judgment or estimation. Financial instruments that are included in Level 3 are securities for which no market activity or data exists and for which we used discounted expected future cash flows with our own assumptions about what a market participant would use in determining fair value. |
Transfers of securities among the levels occur at times and depend on the type of inputs used to determine fair value of each security. There were no transfers between levels during any period presented. Our assets and liabilities which are measured at fair value on a recurring basis as of June 30, 2019 and December 31, 2018 are presented below based on the fair value hierarchy levels: | | | | | | | | | | | | | | | | | | Total Fair Value | | Quoted Prices in Active Markets (Level 1) | | Significant Other Observable Inputs (Level 2) | | Significant Unobservable Inputs (Level 3) | | (Dollars in thousands) | | | | | | | | | Assets | | | | | | | | Fixed maturity securities, available for sale: | | | | | | | | United States Government full faith and credit | $ | 12,023 |
| | $ | 6,080 |
| | $ | 5,943 |
| | $ | — |
| United States Government sponsored agencies | 1,214,609 |
| | — |
| | 1,214,609 |
| | — |
| United States municipalities, states and territories | 4,299,962 |
| | — |
| | 4,299,962 |
| | — |
| Foreign government obligations | 233,095 |
| | — |
| | 233,095 |
| | — |
| Corporate securities | 31,312,263 |
| | 3 |
| | 31,312,260 |
| | — |
| Residential mortgage backed securities | 1,338,946 |
| | — |
| | 1,338,946 |
| | — |
| Commercial mortgage backed securities | 5,673,990 |
| | — |
| | 5,673,990 |
| | — |
| Other asset backed securities | 6,086,415 |
| | — |
| | 6,086,415 |
| | — |
| Other investments: equity securities, available for sale | 259,311 |
| | 251,870 |
| | 7,441 |
| | — |
| Derivative instruments | 888,208 |
| | — |
| | 888,208 |
| | — |
| Cash and cash equivalents | 1,215,967 |
| | 1,215,967 |
| | — |
| | — |
| Interest rate caps | 59 |
| | — |
| | 59 |
| | — |
| | $ | 52,534,848 |
| | $ | 1,473,920 |
| | $ | 51,060,928 |
| | $ | — |
| Liabilities | | | | | | | | Interest rate swap | $ | 881 |
| | $ | — |
| | $ | 881 |
| | $ | — |
| Fixed index annuities - embedded derivatives | 9,281,117 |
| | — |
| | — |
| | 9,281,117 |
| | $ | 9,281,998 |
| | $ | — |
| | $ | 881 |
| | $ | 9,281,117 |
| | | | | | | | | | | | | | | | | Assets | | | | | | | | Fixed maturity securities, available for sale: | | | | | | | | United States Government full faith and credit | $ | 11,652 |
| | $ | 5,900 |
| | $ | 5,752 |
| | $ | — |
| United States Government sponsored agencies | 1,138,529 |
| | — |
| | 1,138,529 |
| | — |
| United States municipalities, states and territories | 4,126,267 |
| | — |
| | 4,126,267 |
| | — |
| Foreign government obligations | 230,274 |
| | — |
| | 230,274 |
| | — |
| Corporate securities | 28,371,514 |
| | 7 |
| | 28,371,507 |
| | — |
| Residential mortgage backed securities | 1,202,159 |
| | — |
| | 1,202,159 |
| | — |
| Commercial mortgage backed securities | 5,379,003 |
| | — |
| | 5,379,003 |
| | — |
| Other asset backed securities | 5,464,329 |
| | — |
| | 5,464,329 |
| | — |
| Other investments: equity securities, available for sale | 7,437 |
| | — |
| | 7,437 |
| | — |
| Derivative instruments | 205,149 |
| | — |
| | 205,149 |
| | — |
| Cash and cash equivalents | 344,396 |
| | 344,396 |
| | — |
| | — |
| Interest rate caps | 597 |
| | — |
| | 597 |
| | — |
| Interest rate swap | 354 |
| | — |
| | 354 |
| | — |
| Counterparty collateral | 33,101 |
| | — |
| | 33,101 |
| | — |
| | $ | 46,514,761 |
| | $ | 350,303 |
| | $ | 46,164,458 |
| | $ | — |
| Liabilities | | | | | | | | Fixed index annuities - embedded derivatives | $ | 8,165,405 |
| | $ | — |
| | $ | — |
| | $ | 8,165,405 |
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The following methods and assumptions were used in estimating the fair values of financial instruments during the periods presented in these consolidated financial statements. Fixed maturity securities The fair values of fixed maturity securities in an active and orderly market are determined by utilizing independent pricing services. The independent pricing services incorporate a variety of observable market data in their valuation techniques, including: | | • | reported trading prices, |
| | • | relative credit information, and |
The independent pricing services also take into account perceived market movements and sector news, as well as a security's terms and conditions, including any features specific to that issue that may influence risk and marketability. Depending on the security, the priority of the use of observable market inputs may change as some observable market inputs may not be relevant or additional inputs may be necessary. The independent pricing services provide quoted market prices when available. Quoted prices are not always available due to market inactivity. When quoted market prices are not available, the third parties use yield data and other factors relating to instruments or securities with similar characteristics to determine fair value for securities that are not actively traded. We generally obtain one value from our primary external pricing service. In situations where a price is not available from this service, we may obtain quotes or prices from additional parties as needed. Market indices of similar rated asset class spreads are considered for valuations and broker indications of similar securities are compared. Inputs used by the broker include market information, such as yield data and other factors relating to instruments or securities with similar characteristics. Valuations and quotes obtained from third party commercial pricing services are non-binding and do not represent quotes on which one may execute the disposition of the assets. We validate external valuations at least quarterly through a combination of procedures that include the evaluation of methodologies used by the pricing services, comparison of the prices to a secondary pricing source, analytical reviews and performance analysis of the prices against trends, and maintenance of a securities watch list. Additionally, as needed we utilize discounted cash flow models or perform independent valuations on a case-by-case basis using inputs and assumptions similar to those used by the pricing services. Although we do identify differences from time to time as a result of these validation procedures, we did not make any significant adjustments as of June 30, 2019 and December 31, 2018. Mortgage loans on real estate Mortgage loans on real estate are not measured at fair value on a recurring basis. The fair values of mortgage loans on real estate are calculated using discounted expected cash flows using competitive market interest rates currently being offered for similar loans. The fair values of impaired mortgage loans on real estate that we have considered to be collateral dependent are based on the fair value of the real estate collateral (based on appraised values) less estimated costs to sell. The inputs utilized to determine fair value of all mortgage loans are unobservable market data (competitive market interest rates); therefore, fair value of mortgage loans falls into Level 3 in the fair value hierarchy. Derivative instruments The fair values of derivative instruments, primarily call options, are based upon the amount of cash that we will receive to settle each derivative instrument on the reporting date. These amounts are determined by our investment team using industry accepted valuation models and are adjusted for the nonperformance risk of each counterparty net of any collateral held. Inputs include market volatility and risk free interest rates and are used in income valuation techniques in arriving at a fair value for each option contract. The nonperformance risk for each counterparty is based upon its credit default swap rate. We have no performance obligations related to the call options purchased to fund our fixed index annuity policy liabilities. Other investments Equity securities are the only financial instruments included in other investments that are measured at fair value on a recurring basis (see determination of fair value above). Financial instruments included in other investments that are not measured at fair value on a recurring basis are policy loans, equity method investments and company owned life insurance ("COLI"). We have not attempted to determine the fair values associated with our policy loans, as we believe any differences between carrying values and the fair values afforded these instruments are immaterial to our consolidated financial position and, accordingly, the cost to provide such disclosure does not justify the benefit to be derived. The fair values of our equity method investments are obtained from third parties and determined by calculating the present value of future cash flows discounted by a risk free rate, a risk spread and a liquidity discount. As the risk spread and liquidity discount are unobservable market inputs, the fair value of our equity method investments falls within Level 3 of the fair value hierarchy. The fair value of our COLI approximates the cash surrender value of the policies and falls within Level 2 of the fair value hierarchy. Cash and cash equivalents Amounts reported in the consolidated balance sheets for these instruments are reported at their historical cost which approximates fair value due to the nature of the assets assigned to this category. Interest rate swap and caps The fair values of our pay fixed/receive variable interest rate swap and our interest rate caps are obtained from third parties and are determined by discounting expected future cash flows using a projected London Interbank Offered Rate ("LIBOR") for the term of the swap and caps. Counterparty collateral Amounts reported in other assets in the consolidated balance sheets for these instruments are reported at their historical cost which approximates fair value due to the nature of the assets assigned to this category. Policy benefit reserves, coinsurance deposits and SPIA benefit reserves The fair values of the liabilities under contracts not involving significant mortality or morbidity risks (principally deferred annuities), are stated at the cost we would incur to extinguish the liability (i.e., the cash surrender value) as these contracts are generally issued without an annuitization date. The coinsurance deposits related to the annuity benefit reserves have fair values determined in a similar fashion. For period-certain annuity benefit contracts, the fair value is determined by discounting the benefits at the interest rates currently in effect for newly issued immediate annuity contracts. We are not required to and have not estimated the fair value of the liabilities under contracts that involve significant mortality or morbidity risks, as these liabilities fall within the definition of insurance contracts that are exceptions from financial instruments that require disclosures of fair value. Policy benefit reserves, coinsurance deposits and SPIA benefit reserves are not measured at fair value on a recurring basis. All of the fair values presented within these categories fall within Level 3 of the fair value hierarchy as most of the inputs are unobservable market data. Notes payable The fair values of our senior unsecured notes are based upon pricing matrices developed by a third party pricing service when quoted market prices are not available and are categorized as Level 2 within the fair value hierarchy. Notes payable are not remeasured at fair value on a recurring basis. Subordinated debentures Fair values for subordinated debentures are estimated using discounted cash flow calculations based principally on observable inputs including our incremental borrowing rates, which reflect our credit rating, for similar types of borrowings with maturities consistent with those remaining for the debt being valued. These fair values are categorized as Level 2 within the fair value hierarchy. Subordinated debentures are not measured at fair value on a recurring basis. Amounts due under repurchase agreements The amounts reported in the consolidated balance sheets for short term indebtedness under repurchase agreements with variable interest rates approximate their fair values. Fixed index annuities - embedded derivatives We estimate the fair value of the embedded derivative component of our fixed index annuity policy benefit reserves at each valuation date by (i) projecting policy contract values and minimum guaranteed contract values over the expected lives of the contracts and (ii) discounting the excess of the projected contract value amounts at the applicable risk free interest rates adjusted for our nonperformance risk related to those liabilities. The projections of policy contract values are based on our best estimate assumptions for future policy growth and future policy decrements. Our best estimate assumptions for future policy growth include assumptions for the expected index credit on the next policy anniversary date which are derived from the fair values of the underlying call options purchased to fund such index credits and the expected costs of annual call options we will purchase in the future to fund index credits beyond the next policy anniversary. The projections of minimum guaranteed contract values include the same best estimate assumptions for policy decrements as were used to project policy contract values. Within this determination we have the following significant unobservable inputs: 1) the expected cost of annual call options we will purchase in the future to fund index credits beyond the next policy anniversary and 2) our best estimates for future policy decrements, primarily lapse, partial withdrawal and mortality rates. As of June 30, 2019 and December 31, 2018, we utilized an estimate of 3.10% for the expected cost of annual call options, which are based on estimated long-term account value growth and a historical review of our actual option costs. Our best estimate assumptions for lapse, partial withdrawal and mortality rates are based on our actual experience and our outlook as to future expectations for such assumptions. These assumptions, which are consistent with the assumptions used in calculating deferred policy acquisition costs and deferred sales inducements, are reviewed on a quarterly basis and are revised as our experience develops and/or as future expectations change. Our mortality rate assumptions are based on 65% of the 1983 Basic Annuity Mortality Tables. The following table presents average lapse rate and partial withdrawal rate assumptions, by contract duration, used in estimating the fair value of the embedded derivative component of our fixed index annuity policy benefit reserves at each reporting date: | | | | | | | | | | | | Average Lapse Rates | | Average Partial Withdrawal Rates | | | | | | | | | | 1 - 5 | | 2.31% | | 2.05% | | 3.34% | | 3.33% | 6 - 10 | | 7.53% | | 7.28% | | 3.34% | | 3.33% | 11 - 15 | | 11.38% | | 11.35% | | 3.36% | | 3.35% | 16 - 20 | | 11.86% | | 11.90% | | 3.23% | | 3.22% | 20+ | | 11.55% | | 11.57% | | 3.23% | | 3.22% |
Lapse rates are generally expected to increase as surrender charge percentages decrease. Lapse expectations reflect a significant increase in the year in which the surrender charge period on a contract ends. The following table provides a reconciliation of the beginning and ending balances for our Level 3 liabilities, which are measured at fair value on a recurring basis using significant unobservable inputs for the three and six months ended June 30, 2019 and 2018: | | | | | | | | | | | | | | | | | | Three Months Ended
June 30, | | | | 2019 | | 2018 | | 2019 | | 2018 | | (Dollars in thousands) | Fixed index annuities - embedded derivatives | | | | | | | | Beginning balance | $ | 8,876,055 |
| | $ | 8,233,557 |
| | $ | 8,165,405 |
| | $ | 8,790,427 |
| Premiums less benefits | 200,472 |
| | 406,494 |
| | 258,480 |
| | 955,647 |
| Change in fair value, net | 204,590 |
| | (288,900 | ) | | 857,232 |
| | (1,394,923 | ) | Ending balance | $ | 9,281,117 |
| | $ | 8,351,151 |
| | $ | 9,281,117 |
| | $ | 8,351,151 |
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The fair value of our fixed index annuities embedded derivatives is net of coinsurance ceded of $617.8 million and $538.8 million as of June 30, 2019 and December 31, 2018, respectively. Change in fair value, net for each period in our embedded derivatives is included in change in fair value of embedded derivatives in the unaudited consolidated statements of operations. Certain derivatives embedded in our fixed index annuity contracts are our most significant financial instrument measured at fair value that are categorized as Level 3 in the fair value hierarchy. The contractual obligations for future annual index credits within our fixed index annuity contracts are treated as a "series of embedded derivatives" over the expected life of the applicable contracts. We estimate the fair value of these embedded derivatives at each valuation date by the method described above under fixed index annuities - embedded derivatives. The projections of minimum guaranteed contract values include the same best estimate assumptions for policy decrements as were used to project policy contract values. The most sensitive assumption in determining policy liabilities for fixed index annuities is the rates used to discount the excess projected contract values. As indicated above, the discount rate reflects our nonperformance risk. If the discount rates used to discount the excess projected contract values at June 30, 2019, were to increase by 100 basis points, the fair value of the embedded derivatives would decrease by $572.7 million recorded through operations as a decrease in the change in fair value of embedded derivatives and there would be a corresponding decrease of $323.0 million to our combined balance for deferred policy acquisition costs and deferred sales inducements recorded through operations as an increase in amortization of deferred policy acquisition costs and deferred sales inducements. A decrease by 100 basis points in the discount rate used to discount the excess projected contract values would increase the fair value of the embedded derivatives by $635.9 million recorded through operations as an increase in the change in fair value of embedded derivatives and there would be a corresponding increase of $355.8 million to our combined balance for deferred policy acquisition costs and deferred sales inducements recorded through operations as a decrease in amortization of deferred policy acquisition costs and deferred sales inducements.
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