4 Derivative financial instruments

The Group uses a variety of derivative financial instruments including swaps, options, forwards, credit derivatives and exchange-traded financial futures in its trading and hedging strategies, in line with the Group’s overall risk management strategy. The objectives include managing exposure to price, foreign currency and/or interest rate risk on planned or anticipated investment purchases, existing assets or liabilities, as well as locking in attractive investment conditions for future available funds.

The fair values represent the gross carrying value amounts at the reporting date for each class of derivative contract held or issued by the Group. The gross fair values are not an indication of credit risk, as many over-the-counter transactions are contracted and documented under ISDA master agreements or their equivalent. Management believes that such agreements provide for legally enforceable setoff in the event of default, which substantially reduces credit exposure.

Fair values and notional amounts of derivative financial instruments

As of 31 December, the fair values and notional amounts of the derivatives outstanding were as follows:

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2012
USD millions

Notional amount assets/liabilities

Fair value assets

Fair value liabilities

Carrying value assets/liabilities

Derivatives not designated as hedging instruments

 

 

 

 

Interest rate contracts

125 577

4 609

–4 177

432

Foreign exchange contracts

25 739

441

–785

–344

Equity contracts

17 917

1 178

–655

523

Credit contracts

33 137

615

–683

–68

Other contracts

22 965

266

–2 394

–2 128

Total

225 335

7 109

–8 694

–1 585

 

 

 

 

 

Derivatives designated as hedging instruments

 

 

 

 

Interest rate contracts

2 828

820

 

820

Foreign exchange contracts

1 609

 

–19

–19

Total

4 437

820

–19

801

 

 

 

 

 

Total derivative financial instruments

229 772

7 929

–8 713

–784

 

 

 

 

 

Amount offset

 

 

 

 

Where a right of setoff exists

 

–4 466

4 466

 

Due to cash collateral

 

–1 179

524

 

Total net amount of derivative financial instruments

 

2 284

–3 723

–1 439

 

 

 

 

 

 

 

 

 

 

2013
USD millions

Notional amount assets/liabilities

Fair value assets

Fair value liabilities

Carrying value assets/liabilities

Derivatives not designated as hedging instruments

 

 

 

 

Interest rate contracts

81 197

2 380

–2 123

257

Foreign exchange contracts

15 580

252

–417

–165

Equity contracts

20 111

1 266

–731

535

Credit contracts

2 676

46

–49

–3

Other contracts

23 055

140

–773

–633

Total

142 619

4 084

–4 093

–9

 

 

 

 

 

Derivatives designated as hedging instruments

 

 

 

 

Interest rate contracts

 

 

 

0

Foreign exchange contracts

1 472

15

–11

4

Total

1 472

15

–11

4

 

 

 

 

 

Total derivative financial instruments

144 091

4 099

–4 104

–5

 

 

 

 

 

Amount offset

 

 

 

 

Where a right of setoff exists

 

–2 353

2 353

 

Due to cash collateral

 

–524

303

 

Total net amount of derivative financial instruments

 

1 222

–1 448

–226

The notional amounts of derivative financial instruments give an indication of the Group’s volume of derivative activity. The fair value assets are included in “Other invested assets” and the fair value liabilities are included in “Accrued expenses and other liabilities”. The fair value amounts that were not offset were nil as of 31 December 2012 and 2013.

Non-hedging activities

The Group primarily uses derivative financial instruments for risk management and trading strategies. Gains and losses of derivative financial instruments not designated as hedging instruments are recorded in “Net realised investment gains/losses” in the income statement. For the years ended 31 December, the gains and losses of derivative financial instruments not designated as hedging instruments were as follows:

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USD millions

2012

2013

Derivatives not designated as hedging instruments

 

 

Interest rate contracts

–141

–241

Foreign exchange contracts

–547

–584

Equity contracts

–774

–962

Credit contracts

–82

–71

Other contracts

1 030

1 728

Total gain/loss recognised in income

–514

–130

Hedging activities

The Group designates certain derivative financial instruments as hedging instruments. The designation of derivative financial instruments is primarily used for overall portfolio and risk management strategies. As of 31 December 2012 and 2013, the following hedging relationships were outstanding:

Fair value hedges

The Group enters into interest rate and foreign exchange swaps to reduce the exposure to interest rate and foreign exchange volatility for certain of its issued debt positions. These derivative instruments are designated as hedging instruments in qualifying fair value hedges. Gains and losses on derivative financial instruments designated as fair value hedging instruments are recorded in “Net realised investment gains/losses” in the income statement. For the years ended 31 December, the gains and losses attributable to the hedged risks were as follows:

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2012

2013

USD millions

Gains/losses on derivatives

Gains/losses on hedged items

Gains/losses on derivatives

Gains/losses on hedged items

Fair value hedging relationships

 

 

 

 

Interest rate contracts

–26

33

–240

255

Foreign exchange contracts

–24

11

2

–1

Total gain/loss recognised in income

–50

44

–238

254

Hedges of the net investment in foreign operations

The Group designates non-derivative monetary financial instruments as hedging the foreign currency exposure of its net investment in certain foreign operations.

For the years ended 31 December 2012 and 2013, the Group recorded an accumulated net unrealised foreign currency remeasurement gain of USD 220 million and a gain of USD 29 million, respectively, in shareholders’ equity. These offset translation gains and losses on the hedged net investment.

Maximum potential loss

In consideration of the rights of setoff and the qualifying master netting arrangements with various counterparties, the maximum potential loss as of 31 December 2012 and 2013 was approximately USD 3 463 million and USD 1 746 million, respectively. The maximum potential loss is based on the positive market replacement cost assuming non-performance of all counterparties, excluding cash collateral.

Credit risk-related contingent features

Certain derivative instruments held by the Group contain provisions that require its debt to maintain an investment-grade credit rating. If the Group’s credit rating were downgraded or no longer rated, the counterparties could request immediate payment, guarantee or an ongoing full overnight collateralisation on derivative instruments in net liability positions.

The total fair value of derivative financial instruments containing credit risk-related contingent features amounted to USD 1 446 million and USD 855 million as of 31 December 2012 and 2013, respectively. For derivative financial instruments containing credit risk-related contingent features, the Group posted collateral of USD 524 million and USD 303 million as of 31 December 2012 and 2013, respectively. In the event of a reduction of the Group’s credit rating to below investment grade, a fair value of USD 552 million additional collateral would have had to be posted as of 31 December 2013. The total equals the amount needed to settle the instruments immediately as of 31 December 2012 and 2013, respectively.

Credit derivatives written/sold

The Group writes/sells credit derivatives, including credit default swaps, credit spread options and credit index products, and total return swaps. The total return swaps, for which the Group assumes asset risk mainly of variable interest entities, qualify as guarantees under FASB ASC Topic 460. These activities are part of the Group’s overall portfolio and risk management strategies. The events that could require the Group to perform include bankruptcy, default, obligation acceleration or moratorium of the credit derivative’s underlying.

The following tables show the fair values and the maximum potential payout of the credit derivatives written/sold as of 31 December 2012 and 2013, categorised by the type of credit derivative and credit spreads, which were based on external market data. The fair values represent the gross carrying values, excluding the effects of netting under ISDA master agreements and cash collateral netting. The maximum potential payout is based on the notional values of the derivatives and represents the gross undiscounted future payments the Group would be required to make, assuming the default of all credit derivatives’ underlyings.

The fair values of the credit derivatives written/sold do not represent the Group’s effective net exposure as the ISDA master agreement and the cash collateral netting are excluded.

The Group has purchased protection to manage the performance/payment risks related to credit derivatives. As of 31 December 2012 and 2013, the total purchased credit protection based on notional values was USD 16 689 million and USD 2 061 million, respectively, of which USD 8 220 million and USD 514 million, respectively, were related to identical underlyings for which the Group sold credit protection. For tranched indexes and baskets, only matching tranches of the respective index were determined as identical. In addition to the purchased credit protection, the Group manages the performance/payment risks through a correlation hedge, which is established with non-identical offsetting positions.

The maximum potential payout is based on notional values of the credit derivatives. The Group enters into total return swaps mainly with variable interest entities which issue insurance-linked and credit-linked securities.

As of 31 December, the fair values and maximum potential payout of the written credit derivatives outstanding were as follows:

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Total fair values of credit derivatives written/sold

Maximum potential payout (time to maturity)

Total maximum potential payout

2012
USD millions

0–5 years

5–10 years

Over 10 years

Credit Default Swaps

 

 

 

 

 

Credit spread in basis points

 

 

 

 

 

0–250

9

1 174

 

 

1 174

251–500

–1

38

 

 

38

501–1 000

–11

96

 

34

130

Greater than 1 000

–92

146

 

133

279

Total

–95

1 454

0

167

1 621

 

 

 

 

 

 

Credit Index Products

 

 

 

 

 

Credit spread in basis points

 

 

 

 

 

0–250

–63

14 400

 

 

14 400

251–500

30

427

 

 

427

Total

–33

14 827

0

0

14 827

 

 

 

 

 

 

Total Return Swaps

 

 

 

 

 

Credit spread in basis points

 

 

 

 

 

No credit spread available

72

773

 

 

773

Total

72

773

0

0

773

 

 

 

 

 

 

Total credit derivatives written/sold

–56

17 054

0

167

17 221

 

 

 

 

 

 

 

 

 

 

 

 

 

Total fair values of credit derivatives written/sold

Maximum potential payout (time to maturity)

Total maximum potential payout

2013
USD millions

0–5 years

5–10 years

Over 10 years

Credit Default Swaps

 

 

 

 

 

Credit spread in basis points

 

 

 

 

 

0–250

–15

59

 

60

119

251–500

 

 

 

 

0

501–1 000

 

 

 

 

0

Greater than 1 000

 

 

 

 

0

Total

–15

59

0

60

119

 

 

 

 

 

 

Credit Index Products

 

 

 

 

 

Credit spread in basis points

 

 

 

 

 

0–250

15

96

400

 

496

251–500

 

 

 

 

0

Total

15

96

400

0

496

 

 

 

 

 

 

Total Return Swaps

 

 

 

 

 

Credit spread in basis points

 

 

 

 

 

No credit spread available

1

25

 

 

25

Total

1

25

0

0

25

 

 

 

 

 

 

Total credit derivatives written/sold

1

180

400

60

640