Allstate 2015 Annual Report Download - page 220

214 www.allstate.com
Allstate Financial utilizes several derivative strategies to manage risk. Asset-liability management is a risk management
strategy that is principally employed by Allstate Financial to balance the respective interest-rate sensitivities of its assets
and liabilities. Depending upon the attributes of the assets acquired and liabilities issued, derivative instruments such
as interest rate swaps, caps, swaptions and futures are utilized to change the interest rate characteristics of existing
assets and liabilities to ensure the relationship is maintained within specified ranges and to reduce exposure to rising or
falling interest rates. Credit default swaps are typically used to mitigate the credit risk within the Allstate Financial fixed
income portfolio. Financial futures and interest rate swaps are used to hedge anticipated asset purchases and liability
issuances and futures and options for hedging the equity exposure contained in Allstate Financial’s equity indexed life
and annuity product contracts that offer equity returns to contractholders. In addition, Allstate Financial uses equity
index futures to offset valuation losses in the equity portfolio during periods of declining equity market values. Interest
rate swaps are used to hedge interest rate risk inherent in funding agreements. Foreign currency swaps and forwards
are primarily used by Allstate Financial to reduce the foreign currency risk associated with holding foreign currency
denominated investments.
The Company may also use derivatives to manage the risk associated with corporate actions, including the sale of a
business. During 2014 and December 2013, swaptions were utilized to hedge the expected proceeds from the disposition
of LBL.
Asset replication refers to the “synthetic” creation of assets through the use of derivatives. The Company replicates fixed
income securities using a combination of a credit default swap or a foreign currency forward contract and one or more highly
rated fixed income securities, primarily investment grade host bonds, to synthetically replicate the economic characteristics
of one or more cash market securities. The Company replicates equity securities using futures to increase equity exposure.
The Company also has derivatives embedded in non-derivative host contracts that are required to be separated from
the host contracts and accounted for at fair value with changes in fair value of embedded derivatives reported in net
income. The Company’s primary embedded derivatives are equity options in life and annuity product contracts, which
provide equity returns to contractholders; conversion options in fixed income securities, which provide the Company
with the right to convert the instrument into a predetermined number of shares of common stock; credit default swaps
in synthetic collateralized debt obligations, which provide enhanced coupon rates as a result of selling credit protection;
and equity-indexed notes containing equity call options, which provide a coupon payout that is determined using one or
more equity-based indices.
When derivatives meet specific criteria, they may be designated as accounting hedges and accounted for as fair
value, cash flow, foreign currency fair value or foreign currency cash flow hedges. Allstate Financial designates certain
of its interest rate and foreign currency swap contracts and certain investment risk transfer reinsurance agreements as
fair value hedges when the hedging instrument is highly effective in offsetting the risk of changes in the fair value of the
hedged item. Allstate Financial designates certain of its foreign currency swap contracts as cash flow hedges when the
hedging instrument is highly effective in offsetting the exposure of variations in cash flows for the hedged risk that could
affect net income. Amounts are reclassified to net investment income or realized capital gains and losses as the hedged
item affects net income.
The notional amounts specified in the contracts are used to calculate the exchange of contractual payments under
the agreements and are generally not representative of the potential for gain or loss on these agreements. However,
the notional amounts specified in credit default swaps where the Company has sold credit protection represent the
maximum amount of potential loss, assuming no recoveries.
Fair value, which is equal to the carrying value, is the estimated amount that the Company would receive or
pay to terminate the derivative contracts at the reporting date. The carrying value amounts for OTC derivatives are
further adjusted for the effects, if any, of enforceable master netting agreements and are presented on a net basis, by
counterparty agreement, in the Consolidated Statements of Financial Position. For certain exchange traded and cleared
derivatives, margin deposits are required as well as daily cash settlements of margin accounts. As of December 31, 2015,
the Company pledged $20 million of cash in the form of margin deposits.
For those derivatives which qualify for fair value hedge accounting, net income includes the changes in the fair value
of both the derivative instrument and the hedged risk, and therefore reflects any hedging ineffectiveness. For cash flow
hedges, gains and losses are amortized from accumulated other comprehensive income and are reported in net income
in the same period the forecasted transactions being hedged impact net income.
Non-hedge accounting is generally used for “portfolio” level hedging strategies where the terms of the individual
hedged items do not meet the strict homogeneity requirements to permit the application of hedge accounting. For non-
hedge derivatives, net income includes changes in fair value and accrued periodic settlements, when applicable. With the