Derivative Instruments

3 Months Ended

Mar. 31, 2018

Derivative Instruments and Hedging Activities Disclosure [Abstract]

The Company enters into derivative instruments for both risk management and investment purposes. The Company is exposed to potential loss from various market risks, and manages its market risks based on a comprehensive framework of investment decision authorities ("Authorities Framework") adopted by the Risk and Finance Committee of XL Group's Board of Directors ("RFC"). The Authorities Framework is intended to align the risk profile of our investment portfolio to be consistent with the Company's risk tolerance and other guidelines established by the RFC. The following table summarizes information on the notional amounts and gross amounts of derivative fair values contained in the Unaudited Consolidated Balance Sheets at March 31, 2018 and December 31, 2017:



	March 31, 2018										December 31, 2017
(U.S. dollars in thousands)	Asset Derivative Notional Amount		Asset Derivative Fair Value			Liability Derivative Notional Amount		Liability Derivative Fair Value			Asset Derivative Notional Amount		Asset Derivative Fair Value			Liability Derivative Notional Amount		Liability Derivative Fair Value
Derivatives designated as hedging instruments:
Foreign currency exposure	$	585,573	$	15,155		$	534,856	$	15,025		$	580,194	$	5,655		$	339,221	$	3,968
Total derivatives designated as hedging instruments	$	585,573	$	15,155		$	534,856	$	15,025		$	580,194	$	5,655		$	339,221	$	3,968
Derivatives not designated as hedging instruments:
Investment Related Derivatives:
Interest rate exposure	$	—	$	—		$	238,215	$	726		$	181,975	$	423		$	—	$	—
Foreign currency exposure	33,070		313			336,055		3,674			263,722		6,931			141,300		2,256
Credit exposure	5,000		128			45,000		6,262			5,000		187			45,000		6,784
Financial market exposure	—		—			40,823		3,873			30,001		1,271			6,998		42
Other Non-Investment Derivatives:
Credit exposure	20,242		334			—		—			—		—			25,526		169
Guaranteed minimum income benefit contract	35,288		17,841			35,288		17,841			36,171		18,136			36,171		18,136
Modified coinsurance and funds withheld contracts, including life retrocession embedded derivative (1)	917,921		2,132			4,230,047		—			51,653		—			5,014,284		31,541
Other	—		—			—		—			16,000		191			—		—
Total derivatives not designated as hedging instruments	$	1,011,521	$	20,748		$	4,925,428	$	32,376		$	584,522	$	27,139		$	5,269,279	$	58,928
Total derivatives			$	35,903				$	47,401				$	32,794				$	62,896
Counterparty netting			(7,239		)			(7,239		)			(3,579		)			(3,579		)
Total derivatives net of counterparty netting			28,664					40,162					29,215					59,317
Cash collateral held/paid (2)			(6,060		)			(17,338		)			(3,920		)			(1,312		)
Total derivatives as recorded in the Unaudited Consolidated Balance Sheets			$	22,604				$	22,824				$	25,295				$	58,005

____________

(1)

The fair value movements in derivative assets and liabilities relating to modified coinsurance and funds withheld contracts are included within the associated asset or liability at each period end on the face of the Unaudited Consolidated Balance Sheets. Notional amounts associated with reinsurance agreements under which the Company assumes reinsurance risk are recorded as asset derivative notional amounts. Notional amounts associated with the GreyCastle Life Retro Arrangements and other outward reinsurance contracts under which the Company cedes risk are recorded as liability derivative notional amounts. Included in the liability derivative notional amount at March 31, 2018 is the cumulative net realized and unrealized loss on the life retrocession embedded derivative of $1.1 billion.

(2)

At March 31, 2018, the Company held cash collateral related to foreign currency derivative positions and certain other derivative positions of $6.1 million for derivatives in an asset position and paid cash collateral of $17.3 million for derivatives in a liability position. At December 31, 2017, the Company held cash collateral related to a foreign currency derivative position and certain other derivative positions of $3.9 million for derivatives in an asset position and paid cash collateral of $1.3 million for derivatives in a liability position. The assets and liabilities related to the net collateral paid or held were recorded as Other assets and Other liabilities within the Unaudited Consolidated Balance Sheets as the collateral and derivative positions are not intended to be settled on a net basis.

Derivative instruments in an asset or liability position are included within "Other assets" or "Other liabilities," respectively, at fair value in the Unaudited Consolidated Balance Sheets on a net basis where the Company has both a legal right of offset and the intention to settle the contracts on a net basis. Certain embedded derivatives within reinsurance contracts are included in "Reinsurance balances payable." The Company often enters into different types of derivative contracts with a single counterparty and these contracts are covered under netting agreements. Changes in the fair values of derivatives are shown in the Unaudited Consolidated Statements of Income as "Net realized and unrealized gains (losses) on derivative instruments," unless the derivatives are designated as hedging instruments. The accounting for derivatives that are designated as hedging instruments is described in Item 8, Note 1(h), "Significant Accounting Policies - Derivative Instruments," to the Consolidated Financial Statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2017.

(a) Derivative Instruments Designated as Hedges of a Net Investment in a Foreign Operation

The Company utilizes foreign currency contracts to hedge the fair value of certain net investments in foreign operations. During the three months ended March 31, 2018 and 2017, the Company entered into foreign currency contracts that were formally designated as hedges of investments in foreign subsidiaries, the majority of which have functional currencies of either the British pound or Canadian dollars. There was no ineffectiveness in these transactions.

The following table provides the weighted average U.S. dollar equivalent of foreign denominated net assets that were hedged and the resulting derivative gain (loss) that was recorded in the foreign currency translation adjustment, net of tax, account within AOCI for the three months ended March 31, 2018 and 2017:



Derivative Instruments Designated as Hedges of a Net Investment in a Foreign Operation - Summary	Three months ended March 31,
(U.S. dollars in thousands)	2018			2017
Weighted average of U.S. dollar equivalent of foreign denominated net assets	$	1,094,210		$	1,677,145
Derivative gains (losses) (1)	$	(2,323	)	$	29,398

____________


(1)	Derivative gains (losses) from derivative instruments designated as hedges of the net investment in a foreign operation are recorded in the cumulative translation adjustment account within AOCI for each period.

As described in Note 9, "Notes Payable and Debt and Financing Arrangements," the Company has issued debt denominated in Euros that is designated and qualifies as a non-derivative hedging instrument against an equal amount of the Company's currency exposure to the Euro resulting from net investments in foreign operations. Accordingly, the foreign currency revaluation of this debt is recorded in AOCI, offsetting the foreign currency translation adjustment of the related net investments that is also recorded in AOCI.

(b) Derivative Instruments Not Formally Designated As Hedging Instruments

The following table provides the total impact on earnings relating to derivative instruments not formally designated as hedging instruments. The impacts are all recorded through "Net realized and unrealized gains (losses) on derivative instruments" in the Unaudited Consolidated Statements of Income for the three months ended March 31, 2018 and 2017:



Net Realized and Unrealized Gains (Losses) on Derivative Instruments	Three months ended March 31,
(U.S. dollars in thousands)	2018			2017
Investment Related Derivatives:
Interest rate exposure	$	997		$	(214	)
Foreign currency exposure	(3,318		)	(745		)
Credit exposure	(41		)	(854		)
Financial market exposure	(1,348		)	185
Other Non-Investment Derivatives:
Foreign currency exposure	—			(1,210		)
Credit exposure	615			632
Modified coinsurance and funds withheld contracts, including life retrocession embedded derivative	2,492			(3,925		)
Other	4,824			(938		)
Net realized and unrealized gains (losses) on derivative instruments	$	4,221		$	(7,069	)

Net realized and unrealized gains (losses) on life retrocession embedded derivative and derivative instruments - Life Funds Withheld Assets	$	22,921		$	(50,101	)

The Company's objectives in using these derivatives are explained below.

Investment Related Derivatives

The Company, either directly or through third-party investment managers, may use derivative instruments within its investment portfolio, including interest rate swaps and options on interest rate swaps, total return swaps, credit derivatives (including single name and index credit default swaps and options on credit default swaps), equity options, forward contracts and futures (including foreign exchange, bond and stock index, interest rate and commodity futures), primarily as a means of reducing investment risk by economically hedging exposures to interest rate, credit spread, equity price changes and foreign currency risk or, in limited instances, for efficient portfolio management. When using exchange-traded or cleared over-the-counter derivatives, the Company is exposed to the credit risk of the applicable clearing house and of the Company's futures commission merchant. When using uncleared over-the-counter derivatives, the Company is exposed to credit risk in the event of non-performance by the counterparties to such derivative contracts. To manage this risk, the Company requires appropriate legal documentation with counterparties that has been reviewed and negotiated by legal counsel on behalf of the Company and complies with the Company's documentation standards, investment guidelines and policies.

Investment Related Derivatives – Interest Rate Exposure

The Company utilizes risk management and overlay strategies that incorporate the use of derivative financial instruments, primarily to manage its fixed income portfolio duration and net economic exposure to interest rate risks. The Company may also use interest rate swaps to convert certain liabilities from a fixed rate to a variable rate of interest or use them to convert a variable rate of interest from one basis to another.

Investment Related Derivatives – Foreign Currency Exposure

The Company has exposure to foreign currency exchange rate fluctuations through its operations and in its investment portfolio. The Company uses foreign currency contracts to manage its exposure to the effects of fluctuating foreign currencies on the value of certain of its foreign currency fixed maturities and equities. These contracts are not designated as specific hedges for financial reporting purposes and, therefore, realized and unrealized gains and losses on these contracts are recorded in income in the period in which they occur. These contracts generally have maturities of twelve months or less.

In addition, certain of the Company's investment managers may, subject to investment guidelines, enter into forward contracts.

Investment Related Derivatives – Credit Exposure

Credit derivatives may be purchased within the Company's investment portfolio in the form of single name and basket credit default swaps and swaptions, which are used to mitigate credit exposure through a reduction in credit spread duration (i.e., macro credit strategies rather than single-name credit hedging) or exposure to securities of selected issuers. Credit derivatives may also be used to efficiently gain exposure to credit markets, subject to guidelines that prohibit the introduction of effective leverage.

Investment Related Derivatives – Financial Market Exposure

Stock index futures may be purchased within the Company's investment portfolio to create synthetic equity exposure and to add value to the portfolio with overlay strategies where market inefficiencies are believed to exist. Stock index futures may be sold to facilitate the timely and efficient reduction of equity exposure. Equity option strategies, including both purchases and sales of options, may be used to add value or reduce exposure with overlay or other strategies. From time to time, the Company may enter into other financial market exposure derivative contracts on various indices and other underlying financial instruments including, but not limited to, equity options, total return swaps, and commodity contracts.

Other Non-Investment Derivatives

Credit Exposure

During the year ended December 31, 2017, the Company entered into a non-investment related credit derivative relating to a number of reference pool mortgage tranches associated with actual mortgage loans that were securitized into agency mortgage-backed securities and sold as Structured Agency Credit Risk Notes. At March 31, 2018, there was no reported event of default on this obligation. The credit derivative is recorded at fair value based upon models developed by the Company. Significant unobservable inputs considered in the valuation include the impact of changes in interest rates, future defaults, delinquency and prepayment rates, credit spreads, changes in credit quality, and other market factors.

Guaranteed Minimum Income Benefit Contract

The Company has derivatives embedded in certain reinsurance contracts. For a certain life reinsurance contract, the Company pays the ceding company a fixed amount equal to the estimated present value of the excess of the guaranteed benefit over the account balance upon the policyholder's election to take the income benefit. The fair value of this derivative is determined based on the present value of expected cash flows.

Modified Coinsurance and Funds Withheld Contracts, including Life Retrocession Embedded Derivative

The Company has modified coinsurance and funds withheld reinsurance agreements that provide for a return to be paid based on a portfolio of fixed income securities. As such, the agreements contain an embedded derivative. The embedded derivative is bifurcated from the funds withheld balance and recorded at fair value, with changes in fair value recognized in earnings through "Net realized and unrealized gains (losses) on derivative instruments."

In addition, the Company entered into the GreyCastle Life Retro Arrangements, as described in Note 1(a), "Significant Accounting Policies - Basis of Preparation and Consolidation." The embedded derivative related to the GreyCastle Life Retro Arrangements is recorded at fair value with changes in fair value recognized in earnings through "Net realized and unrealized gains (losses) on life retrocession embedded derivative and derivative instruments - Life Funds Withheld Assets."

The impact of the GreyCastle Life Retro Arrangements on the Company's results was as follows:



Impact of GreyCastle Life Retro Arrangements	Three months ended March 31,
(U.S. dollars in thousands)	2018			2017
Underwriting profit (loss)	$	—		$	—
Net investment income - Life Funds Withheld Assets	30,398			33,364
Net realized gains (losses) on investments, trading - Life Funds Withheld Assets	10,358			34,474
Net unrealized gains (losses) on investments, trading - Life Funds Withheld Assets	(31,667		)	(1,406		)
OTTI - Life Funds Withheld Assets	(1,203		)	—
Foreign exchange gains (losses)	10,719			3,294
Other income and expenses	(36		)	(70		)
Net realized and unrealized gains (losses) on life retrocession embedded derivative and derivative instruments - Life Funds Withheld Assets	22,921			(50,101		)
Net income (loss)	$	41,490		$	19,555
Change in net unrealized gains (losses) on investments AFS - Life Funds Withheld Assets	(35,754		)	(20,108		)
Change in adjustments related to future policy benefit reserves	4,164			5,132
Change in cumulative translation adjustment - Life Funds Withheld Assets	(9,900		)	(4,579		)
Total changes to other comprehensive income as a result of GreyCastle Life Retro Arrangements	$	(41,490	)	$	(19,555	)
Comprehensive income (loss)	$	—		$	—

As shown in the table above, although the Company's net income (loss) is subject to variability related to the GreyCastle Life Retro Arrangements, there is no net impact on the Company's comprehensive income in any period. The life retrocession embedded derivative value includes the interest income, unrealized gains and losses, and realized gains and losses from sale of the Life Funds Withheld Assets.

Other

The Company has entered into short-term weather derivative swap agreements as the fixed rate payer which provide for a return to be paid to the Company based on the occurrence of certain industry weather events. The derivatives are recorded at fair value with changes in fair value recognized in earnings through "Net realized and unrealized gains (losses) on derivative instruments."

The Company may designate certain of its derivative instruments as fair value hedges or cash flow hedges, in which case it formally and contemporaneously documents all relationships between the hedging instruments and hedged items and links the hedging derivatives to specific assets and liabilities. The Company assesses the effectiveness of the hedge both at inception and on an on-going basis, and determines whether the hedge is highly effective in offsetting changes in fair value or cash flows of the linked hedged item.

Settlement of Fair Value Hedges

During the fourth quarter of 2010 and the third quarter of 2012, the Company settled five interest rate contracts designated as fair value hedges of certain of the Company's structured indemnity contracts. The gain on settlement of these contracts, which represented the effective portion of the hedging relationship, was recorded as an increase in the carrying value of the deposit liabilities and is being amortized through interest expense over the remaining term of the structured indemnity contracts.

A summary of the fair value hedges that have been settled and their impact on results up to the indicated periods, as well as the remaining balance of the fair value hedges and average years remaining to maturity at March 31, 2018 and 2017, are shown below:



Settlement of Fair Value Hedges - Summary	Fair Value Hedges - Structured Indemnity Contracts March 31,
(U.S. dollars in thousands, except years)	2018		2017
Cumulative reduction to interest expense	$	124,255	$	122,118
Remaining balance	$	108,940	$	111,077
Weighted average years remaining to maturity	18.3		18.7

(d) Contingent Credit Features

Certain derivative agreements entered into by the Company or its subsidiaries contain credit rating downgrade provisions that permit early termination of the agreements by the counterparty if collateral is not posted following failure to maintain certain credit ratings from one or more of the principal credit rating agencies. If the Company were required to terminate such agreements early due to a credit rating downgrade, it could potentially be in a net liability position at the time of settlement of such agreements. The aggregate fair value of all derivative agreements containing such rating downgrade provisions that were in a liability position and any collateral posted under these agreements at March 31, 2018 and December 31, 2017 were as follows:



Contingent Credit Features - Summary: (U.S. dollars in thousands)	March 31, 2018			December 31, 2017
Aggregate fair value of derivative agreements with downgrade provisions in a net liability position	$	(7,872	)	$	7,464
Collateral posted to counterparty	$	6,720		$	40

XL GROUP LTD 10-Q