Travelers 2004 Annual Report Download - page 194

THE ST. PAUL TRAVELERS COMPANIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
16. DERIVATIVE FINANCIAL INSTRUMENTS AND FAIR VALUE OF FINANCIAL
INSTRUMENTS, Continued
To qualify as a hedge, the hedge relationship is designated and formally documented at inception detailing
the particular risk management objective and strategy for the hedge, which includes the item and risk that is
being hedged, the derivative that is being used, as well as how effectiveness is being assessed. A derivative has to
be highly effective in accomplishing the objective of offsetting either changes in fair value or cash flows for the
risk being hedged.
For fair value hedges, changes in the fair value of derivatives are reflected in net realized investment gains
(losses), together with changes in the fair value of the related hedged item. At December 31, 2004, the amount
that the Company expects to include in earnings over the next twelve months for fair value hedges is not
significant. The Company did not utilize fair value hedges during the year ended December 31, 2003. The
Company’s fair value hedges result from Nuveen Investments’ utilization of interest rate swaps entered into to
hedge a portion of the fair value of its private placement debt. The swaps were terminated in 2004.
For cash flow hedges, the accounting treatment depends on the effectiveness of the hedge. To the extent
these derivatives are effective in offsetting the variability of the hedged cash flows, changes in the derivatives’
fair value will not be included in current earnings but are reported in accumulated other changes in equity from
nonowner sources. These changes in fair value will be included in the earnings of future periods when earnings
are also affected by the variability of the hedged cash flows. At December 31, 2004, the amount that the
Company expects to include in net realized investment gains (losses) over the next twelve months for these cash
flow hedges is not significant. To the extent these derivatives are not effective, changes in their fair value are
immediately included in net realized investment gains (losses). The Company’s cash flow hedges primarily
include hedges of floating rate available-for-sale securities and certain forecasted transactions up to a maximum
tenure of one year.
For net investment hedges in which derivatives hedge the foreign currency exposure of a net investment in a
foreign operation, the accounting treatment will similarly depend on the effectiveness of the hedge. The effective
portion of the change in fair value of the derivative hedging the net investment, including any forward premium
or discount, is reflected in the accumulated other changes in equity from nonowner sources as part of the foreign
currency translation adjustment. For the years ended December 31, 2004 and 2003, the amount included in the
foreign currency translation adjustment in equity from nonowner sources was a $4 million loss and a $17 million
loss, respectively. The ineffective portion is reflected in net realized investment gains (losses).
The effectiveness of these hedging relationships is evaluated on a retrospective and prospective basis using
quantitative measures of correlation. If a hedge relationship is found to be ineffective, it no longer qualifies as a
hedge, and any excess gains or losses attributable to such ineffectiveness as well as subsequent changes in fair
value are recognized in net realized investment gains (losses). During the years ended December 31, 2004 and
2003, the Company had no realized gains or losses from hedge ineffectiveness.
Derivatives that are not designated or do not qualify as hedges are also carried at fair value with changes in
value reflected in net realized investment gains (losses). The Company has certain U.S. treasury futures contracts
and foreign currency forward contracts, which are not designated as hedges at December 31, 2004 and 2003.
For those hedge relationships that are terminated, hedge designations removed, or forecasted transactions
that are no longer expected to occur, the hedge accounting treatment described in the paragraphs above will no
longer apply. For fair value hedges, any changes to the hedged item remain as part of the basis of the asset and
182