Travelers 2005 Annual Report Download - page 209

THE ST. PAUL TRAVELERS COMPANIES, INC.AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
197
16. DERIVATIVE FINANCIAL INSTRUMENTS AND FAIRVALUE OF FINANCIAL INSTRUMENTS
Derivative Financial Instruments
The Company may use derivative financial instruments,including interest rate swaps, equity swaps,
credit derivatives, options, financial futures and forwardcontracts, as a means of hedging exposure to
interest rate, equity price change and foreign currency risk. The Company’s insurance subsidiaries do not
hold or issue derivatives for trading purposes.
Derivative Instruments Designated as Hedging Instruments
For a derivative instrument to qualify as a hedge, the hedge relationship must be 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 derivativehas to be highly effective in accomplishing the objective of
offsetting either changes in fair value or cash flows for the risk being hedged. 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). The recognition of gains or losses on derivative
instruments that have been designated and qualify as a hedge depends upon whether the derivative
instrumentis a fair value hedge, a cash flow hedge or a foreign currency hedge.
The Company has foreign currency hedges of neti
nvestments in foreign operations in which
derivatives (foreign currency forward contracts) hedge the foreign currency exposure. 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, 2005 and 2004, the amount
included in the foreign currency translation adjustment in equity from nonowner sources was a $2 million
loss and a $4 million loss, respectively. During 2005, the Company incurred net realized losses of less than
$1 million from hedge ineffectiveness, and in 2004, theCompany had no net realized gains or losses from
hedge ineffectiveness.
Derivative Instruments not Designated as Hedging Instruments
Derivatives that are not designated or do not qualify as hedges are 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,
2005 and 2004.
The Company engaged in U.S. Treasury note futures transactions to modify the duration of specific
assets within the investment portfolio. The Company enters into90-day futures contracts on 2-year, 5-year,
10-year and 30-year U.S. Treasury notes which require a daily mark-to-market settlement with the broker.
The notional value of the open U.S. Treasury futures contracts was $1.20 billion and $1.33 billion at
December 31, 2005 and December 31, 2004, respectively. These derivative instruments are not designated
and do not qualify as hedges under FAS 133 and as such the daily mark-to-market changes in fair value are
reflected in net realized investment gains (losses). Net realized investment gains (losses) in 2005 and 2004
included net gains of $13 million and net losses of $44million, respectively, related to U.S. Treasury
futures contracts which are settled daily.