R QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2011
OR
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from _____ to _____
Commission File Number 1-5823
CNA FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Delaware
(State or other jurisdiction of
incorporation or organization)
36-6169860
(I.R.S. Employer
Identification No.)
333 S. Wabash
Chicago, Illinois
(Address of principal executive offices)
60604
(Zip Code)
(312) 822-5000
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes R No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes R No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer £
Accelerated filer R
Non-accelerated filer o
(Do not check if a smaller reporting company)
Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No R
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Notes to Condensed Consolidated Financial Statements (Unaudited)
Note A. General
Basis of Presentation
The Condensed Consolidated Financial Statements (Unaudited) include the accounts of CNA Financial Corporation (CNAF) and its controlled subsidiaries. Collectively, CNAF and its controlled subsidiaries are referred to as CNA or the Company. CNA’s property and casualty and remaining life and group insurance operations are primarily conducted by Continental Casualty Company (CCC), The Continental Insurance Company (CIC), Continental Assurance Company (CAC) and CNA Surety Corporation (CNA Surety). Loews Corporation (Loews) owned approximately 90% of the outstanding common stock of CNAF as of June 30, 2011.
The accompanying Condensed Consolidated Financial Statements have been prepared in conformity with accounting principles generally accepted in the United States of America (GAAP). Certain financial information that is normally included in annual financial statements, including certain financial statement notes, prepared in accordance with GAAP, is not required for interim reporting purposes and has been condensed or omitted. These statements should be read in conjunction with the Consolidated Financial Statements and notes thereto included in CNAF’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (SEC) for the year ended December 31, 2010, including the summary of significant accounting policies in Note A. The preparation of Condensed Consolidated Financial Statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the Condensed Consolidated Financial Statements and the reported amounts of revenues and expenses during the reporting periods. Actual results may differ from those estimates.
The interim financial data as of June 30, 2011 and for the three and six months ended June 30, 2011 and 2010 is unaudited. However, in the opinion of management, the interim data includes all adjustments, consisting of normal recurring accruals, necessary for a fair statement of the Company’s results for the interim periods. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year. Intercompany amounts have been eliminated.
CNA Surety
On June 10, 2011, CNA completed its previously announced acquisition of the noncontrolling interest of CNA Surety. Previously the Company owned approximately 61% of the outstanding publicly-traded common stock of CNA Surety. CNA Surety is now a wholly-owned subsidiary of CCC, and, effective after the close of the stock market on June 10, 2011, trading in CNA Surety common stock ceased.
The aggregate purchase price was approximately $475 million, based on the offer price of $26.55 per share and inclusive of the retirement of CNA Surety employee stock options. The amount paid to acquire the common stock of CNA Surety not owned by the Company in excess of the closing date noncontrolling interest included in the Company's equity of $434 million was reflected as an adjustment to Additional Paid-in Capital and Accumulated Other Comprehensive Income on the Condensed Consolidated Statement of Equity. For the three and six months ended June 30, 2011, net income attributable to the noncontrolling interest in CNA Surety through the acquisition date of June 10, 2011 was $4 million and $12 million and is reflected on the Condensed Consolidated Statement of Operations. For the three and six months ended June 30, 2010, net income attributable to the noncontrolling interest in CNA Surety was $11 million and $19 million.
Reinsurance Receivables
The Company has established an allowance for uncollectible reinsurance receivables which relates to both amounts already billed on ceded paid losses as well as ceded reserves that will be billed when losses are paid in the future. The allowance for uncollectible reinsurance receivables is estimated on the basis of periodic evaluations of balances due from reinsurers, reinsurer creditworthiness, management’s experience and current economic conditions. Financial strength ratings are updated and reviewed on an annual basis or sooner if the Company becomes aware of significant changes related to a reinsurer. Because billed receivables are less than 5% of total reinsurance receivables the age of the reinsurance receivables related to paid losses is not a significant input into the allowance analysis. For the six months ended June 30, 2011, there was no significant change in the Company’s allowance for uncollectible reinsurance receivables.
Earnings per share attributable to the Company's common stockholders is based on the weighted average number of outstanding common shares. Basic earnings per share excludes the impact of dilutive securities and is computed by dividing net income attributable to CNA by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock.
For the three and six months ended June 30, 2011, approximately 352 thousand and 329 thousand potential shares attributable to exercises under stock-based employee compensation plans were included in the calculation of diluted earnings per share. For those same periods, approximately 931 thousand and 1.0 million potential shares attributable to exercises under stock-based employee compensation plans were not included in the calculation of diluted earnings per share because the effect would have been antidilutive.
For the three and six months ended June 30, 2010, approximately 245 thousand and 193 thousand potential shares attributable to exercises under stock-based employee compensation plans were included in the calculation of diluted earnings per share. For those same periods, approximately 1.2 million and 1.4 million potential shares attributable to exercises under stock-based employee compensation plans were not included in the calculation of diluted earnings per share because the effect would have been antidilutive.
The significant components of net investment income are presented in the following table.
Net Investment Income
Periods ended June 30
Three Months
Six Months
(In millions)
2011
2010
2011
2010
Fixed maturity securities
$
505
$
519
$
1,011
$
1,029
Short term investments
2
5
4
11
Limited partnership investments
11
(4
)
125
68
Equity securities
6
9
12
19
Mortgage loans
2
—
4
—
Trading portfolio (a)
3
2
6
6
Other
3
3
5
5
Gross investment income
532
534
1,167
1,138
Investment expense
(15
)
(13
)
(30
)
(27
)
Net investment income
$
517
$
521
$
1,137
$
1,111
____________________
(a)
There were no net unrealized gains (losses) related to changes in fair value of trading securities still held included in net investment income for the three and six months ended June 30, 2011 and 2010.
Net realized investment gains are presented in the following table.
Net Realized Investment Gains
Periods ended June 30
Three Months
Six Months
(In millions)
2011
2010
2011
2010
Net realized investment gains:
Fixed maturity securities:
Gross realized gains
$
89
$
133
$
177
$
231
Gross realized losses
(69
)
(67
)
(137
)
(138
)
Net realized investment gains on fixed maturity securities
20
66
40
93
Equity securities:
Gross realized gains
1
—
6
4
Gross realized losses
(3
)
(28
)
(8
)
(29
)
Net realized investment losses on equity securities
(2
)
(28
)
(2
)
(25
)
Derivatives
—
—
(1
)
—
Short term investments and other (a) (b)
(3
)
(9
)
(9
)
(5
)
Net realized investment gains, net of participating policyholders’ interests
$
15
$
29
$
28
$
63
____________________
(a)
The six months ended June 30, 2011 includes a $9 million loss related to the early extinguishment of $400 million of senior notes originally due August 15, 2011.
(b)
There were no net unrealized gains (losses) included in the three months ended June 30, 2011 and $1 million of net unrealized gains included in the six months ended June 30, 2011 related to changes in fair value of securities for which the fair value option has been elected.
The components of net other-than-temporary impairment (OTTI) losses recognized in earnings by asset type are summarized in the following table.
Periods ended June 30
Three Months
Six Months
(In millions)
2011
2010
2011
2010
Fixed maturity securities available-for-sale:
Corporate and other bonds
$
15
$
24
$
24
$
42
States, municipalities and political subdivisions
—
6
—
20
Asset-backed:
Residential mortgage-backed
46
11
74
37
Commercial mortgage-backed
—
—
—
2
Other asset-backed
—
2
—
2
Total asset-backed
46
13
74
41
Total fixed maturity securities available-for-sale
61
43
98
103
Equity securities available-for-sale:
Common stock
1
5
4
5
Preferred stock
—
9
1
9
Total equity securities available-for-sale
1
14
5
14
Net OTTI losses recognized in earnings
$
62
$
57
$
103
$
117
A security is impaired if the fair value of the security is less than its cost adjusted for accretion, amortization and previously recorded OTTI losses, otherwise defined as an unrealized loss. When a security is impaired, the impairment is evaluated to determine whether it is temporary or other-than-temporary.
Significant judgment is required in the determination of whether an OTTI loss has occurred for a security. The Company follows a consistent and systematic process for determining and recording an OTTI loss. The Company has established a committee responsible for the OTTI process. This committee, referred to as the Impairment Committee, is made up of three officers appointed by the Company’s Chief Financial Officer. The Impairment Committee is responsible for evaluating all securities in an unrealized loss position on at least a quarterly basis.
The Impairment Committee’s assessment of whether an OTTI loss has occurred incorporates both quantitative and qualitative information. Fixed maturity securities that the Company intends to sell, or it more likely than not will be required to sell before recovery of amortized cost, are considered to be other-than-temporarily impaired and the entire difference between the amortized cost basis and fair value of the security is recognized as an OTTI loss in earnings. The remaining fixed maturity securities in an unrealized loss position are evaluated to determine if a credit loss exists. The factors considered by the Impairment Committee include (a) the financial condition and near term prospects of the issuer, (b) whether the debtor is current on interest and principal payments, (c) credit ratings of the securities and (d) general market conditions and industry or sector specific outlook. The Company also considers results and analysis of cash flow modeling for asset-backed securities, and when appropriate, other fixed maturity securities. The focus of the analysis for asset-backed securities is on assessing the sufficiency and quality of underlying collateral and timing of cash flows based on scenario tests. If the present value of the modeled expected cash flows equals or exceeds the amortized cost of a security, no credit loss is judged to exist and the asset-backed security is deemed to be temporarily impaired. If the present value of the expected cash flows is less than amortized cost, the security is judged to be other-than-temporarily impaired for credit reasons and that shortfall, referred to as the credit component, is recognized as an OTTI loss in earnings. The difference between the adjusted amortized cost basis and fair value, referred to as the non-credit component, is recognized as OTTI in Other comprehensive income. In subsequent reporting periods, a change in intent to sell or further credit impairment on a security whose fair value has not deteriorated will cause the non-credit component originally recorded as OTTI in Other comprehensive income to be recognized as an OTTI loss in earnings.
The Company performs the discounted cash flow analysis using stressed scenarios to determine future expectations regarding recoverability. For asset-backed securities, significant assumptions enter into these cash flow projections including delinquency rates, probable risk of default, loss severity upon a default, over collateralization and interest coverage triggers, credit support from lower level tranches and impacts of rating agency downgrades.
The Company applies the same impairment model as described above for the majority of non-redeemable preferred stock securities on the basis that these securities possess characteristics similar to debt securities and that the issuers maintain their ability to pay dividends. For all other equity securities, in determining whether the security is other-than-temporarily impaired, the Impairment Committee considers a number of factors including, but not limited to: (a) the length of time and the extent to which the fair value has been less than amortized cost, (b) the financial condition and near term prospects of the issuer, (c) the intent and ability of the Company to retain its investment for a period of time sufficient to allow for an anticipated recovery in value and (d) general market conditions and industry or sector specific outlook.
The following tables provide a summary of fixed maturity and equity securities.
Summary of Fixed Maturity and Equity Securities
June 30, 2011
Cost or
Amortized
Cost
Gross
Unrealized
Gains
Gross
Unrealized
Losses
Estimated
Fair
Value
Unrealized
OTTI
Losses (Gains)
(In millions)
Fixed maturity securities available-for-sale:
Corporate and other bonds
$
19,213
$
1,705
$
39
$
20,879
$
—
States, municipalities and political subdivisions
8,628
357
268
8,717
—
Asset-backed:
Residential mortgage-backed
6,076
103
166
6,013
61
Commercial mortgage-backed
1,011
62
36
1,037
(9
)
Other asset-backed
925
17
9
933
—
Total asset-backed
8,012
182
211
7,983
52
U.S. Treasury and obligations of government-sponsored enterprises
231
14
1
244
—
Foreign government
659
18
—
677
—
Redeemable preferred stock
48
6
—
54
—
Total fixed maturity securities available-for-sale
U.S. Treasury and obligations of government-sponsored enterprises
122
16
1
137
—
Foreign government
602
18
—
620
—
Redeemable preferred stock
47
7
—
54
—
Total fixed maturity securities available-for-sale
36,421
1,945
795
37,571
$
112
Total fixed maturity securities trading
6
—
—
6
Equity securities available-for-sale:
Common stock
90
25
—
115
Preferred stock
332
2
9
325
Total equity securities available-for-sale
422
27
9
440
Total
$
36,849
$
1,972
$
804
$
38,017
The following tables summarize the estimated fair value and gross unrealized losses of available-for-sale fixed maturity and equity securities in a gross unrealized loss position by the length of time in which the securities have continuously been in that position.
Securities in a Gross Unrealized Loss Position
Less than 12 Months
Greater than 12 Months
Total
June 30, 2011
Estimated
Fair Value
Gross
Unrealized
Losses
Estimated
Fair Value
Gross
Unrealized
Losses
Estimated
Fair Value
Gross
Unrealized
Losses
(In millions)
Fixed maturity securities available-for-sale:
Corporate and other bonds
$
1,321
$
23
$
197
$
16
$
1,518
$
39
States, municipalities and political subdivisions
1,331
62
663
206
1,994
268
Asset-backed:
Residential mortgage-backed
2,131
42
1,016
124
3,147
166
Commercial mortgage-backed
317
15
194
21
511
36
Other asset-backed
168
4
61
5
229
9
Total asset-backed
2,616
61
1,271
150
3,887
211
U.S. Treasury and obligations of government-sponsored enterprises
118
1
—
—
118
1
Total fixed maturity securities available-for-sale
U.S. Treasury and obligations of government-sponsored enterprises
8
1
—
—
8
1
Total fixed maturity securities available-for-sale
7,152
255
3,344
540
10,496
795
Equity securities available-for-sale:
Preferred stock
175
5
70
4
245
9
Total equity securities available-for-sale
175
5
70
4
245
9
Total
$
7,327
$
260
$
3,414
$
544
$
10,741
$
804
The amount of pretax net unrealized gains on available-for-sale securities reclassified out of accumulated other comprehensive income (AOCI) into earnings was $20 million and $41 million for the three and six months ended June 30, 2011 and $39 million and $71 million for the three and six months ended June 30, 2010.
The following table summarizes the activity for the three and six months ended June 30, 2011 and 2010 related to the pretax credit loss component reflected in Retained earnings on fixed maturity securities still held at June 30, 2011 and 2010 for which a portion of an OTTI loss was recognized in Other comprehensive income.
Periods ended June 30
Three Months
Six Months
(In millions)
2011
2010
2011
2010
Beginning balance of credit losses on fixed maturity securities
$
113
$
171
$
141
$
164
Additional credit losses for which an OTTI loss was previously recognized
8
11
18
22
Credit losses for which an OTTI loss was not previously recognized
—
3
1
8
Reductions for securities sold during the period
(21
)
(14
)
(46
)
(23
)
Reductions for securities the Company intends to sell or more likely than not will be required to sell
(18
)
—
(32
)
—
Ending balance of credit losses on fixed maturity securities
$
82
$
171
$
82
$
171
Based on current facts and circumstances, the Company has determined that no additional OTTI losses related to the securities in an unrealized loss position presented in the June 30, 2011 Securities in a Gross Unrealized Loss Position table above are required to be recorded. A discussion of some of the factors reviewed in making that determination is presented below.
The classification between investment grade and non-investment grade presented in the discussion below is based on a ratings methodology that takes into account ratings from two major providers, Standard & Poor’s (S&P) and Moody’s Investors Service, Inc. (Moody’s) in that order of preference. If a security is not rated by these providers, the Company formulates an internal rating. For securities with credit support from third party guarantees, the rating reflects the greater of the underlying rating of the issuer or the insured rating.
States, Municipalities and Political Subdivisions
The fair value of total states, municipalities and political subdivisions holdings at June 30, 2011 was $8,717 million. These holdings consist of both tax-exempt and taxable bonds, 72% of which are special revenue and assessment bonds, followed by general obligation political subdivision bonds at 19% and state general obligation bonds at 9%.
The unrealized losses on the Company's investments in this category are primarily due to market conditions for zero coupon bonds, particularly for those with maturity dates that exceed 20 years. Yields for these securities continue to be higher than historical norms relative to after-tax returns on similar fixed income securities. The holdings for all securities in this category include 304 securities that have at least one trade lot in a gross unrealized loss position. The aggregate severity of the total gross unrealized losses was approximately 12% of amortized cost.
The following table summarizes the ratings distribution of states, municipalities and political subdivisions securities in a gross unrealized loss position at June 30, 2011.
Gross Unrealized Losses by Ratings Distribution
June 30, 2011
Amortized
Cost
Estimated
Fair Value
Gross
Unrealized
Losses
(In millions)
AAA
$
412
$
387
$
25
AA
1,050
877
173
A
713
650
63
BBB
71
65
6
Non-investment grade
16
15
1
Total
$
2,262
$
1,994
$
268
The largest exposures at June 30, 2011 as measured by gross unrealized losses were several separate issues of Puerto Rico sales tax revenue bonds with gross unrealized losses of $102 million and several separate issues of New Jersey transit revenue bonds with gross unrealized losses of $41 million. All of these securities are rated investment grade.
The Company has no current intent to sell these securities, nor is it more likely than not that it will be required to sell prior to recovery of amortized cost. Additionally, the Company believes that the unrealized losses on these securities were not due to factors regarding the ultimate collection of principal and interest; accordingly, the Company has determined that there are no additional OTTI losses to be recorded at June 30, 2011.
Asset-Backed Securities
The fair value of total asset-backed holdings at June 30, 2011 was $7,983 million which was comprised of 2,057 different securities. The fair value of these securities tends to be influenced by the characteristics and projected cash flows of the underlying collateral rather than the credit of the issuer. Each security has deal-specific tranche structures, credit support that results from the unique deal structure, particular collateral characteristics and other distinct security terms. As a result, seemingly common factors such as delinquency rates and collateral performance affect each security differently. Of these securities, 138 have underlying collateral that is either considered sub-prime or Alt-A in nature. The exposure to sub-prime residential mortgage (sub-prime) collateral and Alternative A residential mortgages that have lower than normal standards of loan documentation (Alt-A) collateral is measured by the original deal structure.
Residential mortgage-backed securities include 137 non-agency structured securities that have at least one trade lot in a gross unrealized loss position. In addition, there were 95 mortgage-backed securities guaranteed by agencies or sponsored enterprises of the U.S. Government that have at least one trade lot in a gross unrealized loss position. The aggregate severity of the gross unrealized loss for residential mortgage-backed securities was approximately 5% of amortized cost.
Commercial mortgage-backed securities include 50 securities that have at least one trade lot in a gross unrealized loss position. The aggregate severity of the gross unrealized loss was approximately 7% of amortized cost.
Other asset-backed securities include 21 securities that have at least one trade lot in a gross unrealized loss position. The aggregate severity of the gross unrealized loss was approximately 4% of amortized cost.
The following table summarizes asset-backed securities in a gross unrealized loss position by ratings distribution at June 30, 2011.
Gross Unrealized Losses by Ratings Distribution
June 30, 2011
Amortized
Cost
Estimated
Fair Value
Gross
Unrealized
Losses
(In millions)
U.S. Government, Government Agencies, and Government-Sponsored Enterprises
$
1,881
$
1,852
$
29
AAA
688
660
28
AA
318
295
23
A
173
164
9
BBB
296
256
40
Non-investment grade and equity tranches
742
660
82
Total
$
4,098
$
3,887
$
211
The Company believes the unrealized losses are primarily attributable to broader economic conditions, changes in interest rates, wider than historical bid/ask spreads, and uncertainty with regard to the timing and amount of ultimate collateral realization, but are not indicative of the ultimate collectibility of the current carrying values of securities. The Company has no current intent to sell these securities, nor is it more likely than not that it will be required to sell prior to recovery of amortized cost. Generally, non-investment grade asset-backed securities consist of investments which were investment grade at the time of purchase but have subsequently been downgraded and primarily consist of holdings senior to the equity tranche. Additionally, the Company believes that the unrealized losses on these securities were not due to factors regarding the ultimate collection of principal and interest, collateral shortfalls, or substantial changes in future cash flow expectations; accordingly, the Company has determined that there are no additional OTTI losses to be recorded at June 30, 2011.
The following table summarizes available-for-sale fixed maturity securities by contractual maturity at June 30, 2011 and December 31, 2010. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid with or without call or prepayment penalties. Securities not due at a single date are allocated based on weighted average life.
Contractual Maturity
June 30, 2011
December 31, 2010
(In millions)
Cost or
Amortized
Cost
Estimated
Fair
Value
Cost or
Amortized
Cost
Estimated
Fair
Value
Due in one year or less
$
1,641
$
1,649
$
1,515
$
1,506
Due after one year through five years
11,352
11,882
11,198
11,653
Due after five years through ten years
9,778
10,274
10,022
10,425
Due after ten years
14,020
14,749
13,686
13,987
Total
$
36,791
$
38,554
$
36,421
$
37,571
Commercial Mortgage Loans
Mortgage loans are commercial in nature and are carried at unpaid principal balance, net of unamortized fees and any valuation allowance. Mortgage loans are considered to be impaired loans when it is probable that contractual principal and interest payments will not be collected. A valuation allowance is established for impaired loans to the extent that the present value of expected future cash flows discounted at the loan's original effective interest rate is less than the carrying value of the loan. Interest income from mortgage loans is recognized on an accrual basis using the effective yield method. Accrual of income is generally suspended for mortgage loans that are impaired and collection of principal and interest payment is unlikely. Mortgage loans are considered past due when full principal or interest payments have not been received according to contractual terms.
Risks related to the recoverability of loan balances include declines in the estimated cash flows from underlying property leases, declines in the fair value of collateral, and creditworthiness of tenants of credit tenant loan properties, where lease payments directly service the loan. As of June 30, 2011, 17% of the carrying value of mortgage loans related to credit tenant loans. The Company identifies loans for evaluation of impairment primarily based on the collection experience of each loan. As of June 30, 2011, there were no loans past due or in non-accrual status, and no valuation allowance was recorded.
Investment Commitments
As of June 30, 2011, the Company had committed approximately $154 million to future capital calls from various third-party limited partnership investments in exchange for an ownership interest in the related partnerships.
The Company invests in various privately placed debt securities, including bank loans, as part of its overall investment strategy and has committed to additional future purchases and sales. The purchase and sale of these investments are recorded on the date that the legal agreements are finalized and cash settlements are made. As of June 30, 2011, the Company had commitments to purchase $104 million and sell $96 million of such investments.
The Company uses derivatives in the normal course of business, primarily in an attempt to reduce its exposure to market risk (principally interest rate risk, equity price risk and foreign currency risk) stemming from various assets and liabilities and credit risk (the ability of an obligor to make timely payment of principal and/or interest). The Company's principal objective under such risk strategies is to achieve the desired reduction in economic risk, even if the position does not receive hedge accounting treatment.
The Company's use of derivatives is limited by statutes and regulations promulgated by the various regulatory bodies to which it is subject, and by its own derivative policy. The derivative policy limits the authorization to initiate derivative transactions to certain personnel. Derivatives entered into for hedging, regardless of the choice to designate hedge accounting, shall have a maturity that effectively correlates to the underlying hedged asset or liability. The policy prohibits the use of derivatives containing greater than one-to-one leverage with respect to changes in the underlying price, rate or index. The policy also prohibits the use of borrowed funds, including funds obtained through securities lending, to engage in derivative transactions.
The Company has exposure to economic losses due to interest rate risk arising from changes in the level of, or volatility of, interest rates. The Company attempts to mitigate its exposure to interest rate risk in the normal course of portfolio management which includes rebalancing its existing portfolios of assets and liabilities. In addition, various derivative financial instruments are used to modify the interest rate risk exposures of certain assets and liabilities. These strategies include the use of interest rate swaps, interest rate caps and floors, options, futures, forwards and commitments to purchase securities. These instruments are generally used to lock interest rates or market values, to shorten or lengthen durations of fixed maturity securities or to hedge (on an economic basis) interest rate risks associated with investments and variable rate debt.
The Company has exposure to equity price risk as a result of its investment in equity securities and equity derivatives. Equity price risk results from changes in the level or volatility of equity prices, which affect the value of equity securities, or instruments that derive their value from such securities. The Company attempts to mitigate its exposure to such risks by limiting its investment in any one security or index. The Company may also manage this risk by utilizing instruments such as options, swaps, futures and collars to protect appreciation in securities held.
The Company has exposure to credit risk arising from the uncertainty associated with a financial instrument obligor's ability to make timely principal and/or interest payments. The Company attempts to mitigate this risk by limiting credit concentrations, practicing diversification and frequently monitoring the credit quality of issuers and counterparties. In addition, the Company may utilize credit derivatives such as credit default swaps (CDS) to modify the credit risk inherent in certain investments. CDS involve a transfer of credit risk from one party to another in exchange for periodic payments.
Foreign currency risk arises from the possibility that changes in foreign currency exchange rates will impact the fair value of financial instruments denominated in a foreign currency. The Company's foreign transactions are primarily denominated in British pounds, Euros and Canadian dollars. The Company typically manages this risk via asset/liability currency matching and through the use of foreign currency forwards.
In addition to the derivatives used for risk management purposes described above, the Company may also use derivatives for purposes of income enhancement. Income enhancement transactions are entered into with the intention of providing additional income or yield to a particular portfolio segment or instrument. Income enhancement transactions are limited in scope and primarily involve the sale of covered options in which the Company receives a premium in exchange for selling a call or put option.
The Company will also use CDS to sell credit protection against a specified credit event. In selling credit protection, CDS are used to replicate fixed income securities when credit exposure to certain issuers is not available or when it is economically beneficial to transact in the derivative market compared to the cash market alternative. Credit risk includes both the default event risk and market value exposure due to fluctuations in credit spreads. In selling CDS protection, the Company receives a periodic premium in exchange for providing credit protection on a single name reference obligation or a credit derivative index. If there is an event of default as defined by the CDS agreement, the Company is required to pay the counterparty the referenced notional amount of the CDS contract and in exchange, the Company is entitled to receive the referenced defaulted security or the cash equivalent.
The tables below summarize open CDS contracts where the Company sold credit protection as of June 30, 2011 and December 31, 2010. The fair value of the contracts represents the amounts that the Company would receive or pay at those dates to exit the derivative positions. The maximum amount of future payments assumes no residual value in the defaulted securities that the Company would receive as part of the contract terminations and is equal to the notional value of the CDS contracts.
Credit Ratings of Underlying Reference Obligations
