XNYS:FFG FBL Financial Group Inc Quarterly Report 10-Q Filing - 3/31/2012
Effective Date 3/31/2012
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 FORM 10-Q
Commission File Number: 1-11917 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] Yes [ ] No Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). [X] Yes [ ] No Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
FBL FINANCIAL GROUP, INC. FORM 10-Q FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2012 TABLE OF CONTENTS
1 ITEM 1. FINANCIAL STATEMENTS FBL FINANCIAL GROUP, INC. CONSOLIDATED BALANCE SHEETS (Unaudited) (Dollars in thousands)
2 FBL FINANCIAL GROUP, INC. CONSOLIDATED BALANCE SHEETS (Continued) (Dollars in thousands)
See accompanying notes. 3 FBL FINANCIAL GROUP, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited) (Dollars in thousands, except per share data)
See accompanying notes. 4 FBL FINANCIAL GROUP, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited) (Dollars in thousands)
See accompanying notes. 5 FBL FINANCIAL GROUP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Dollars in thousands)
6 FBL FINANCIAL GROUP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) (Dollars in thousands)
(a) Our consolidated statements of cash flows combine the cash flows from discontinued operations with the cash flows from continuing operations within each major category (operating, investing and financing) of the statement and supplemental disclosures. See accompanying notes. 7 FBL FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) March 31, 2012 1. Significant Accounting Policies Basis of Presentation The accompanying unaudited consolidated financial statements of FBL Financial Group, Inc. (we or the Company) have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. Our financial statements include all adjustments (consisting of normal recurring accruals) necessary for a fair presentation of our financial position and results of operations. Operating results for the three month period ended March 31, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012. We encourage you to refer to our consolidated financial statements and notes for the year ended December 31, 2011 included in our Annual Report on Form 10-K for a complete description of our material accounting policies. Also included in the Form 10-K is a description of areas of judgments and estimates and other information necessary to understand our financial position and results of operations. See Note 2 for information on the recent sale of our former subsidiary, EquiTrust Life Insurance Company (EquiTrust Life). Financial results of this business component have been reclassified in the prior period financial statements and excluded from the notes to the consolidated financial statements, unless otherwise noted. Adoption of Recent Accounting Pronouncements Effective January 1, 2012, we adopted guidance issued by the Financial Accounting Standards Board (FASB) related to accounting for costs associated with acquiring or renewing insurance contracts. This guidance defines allowable deferred acquisition costs as the incremental direct cost of contract acquisition and certain costs related directly to underwriting, policy issuance and processing. This guidance also allows for the deferral of advertising costs if directly linked to a sale. We have applied the guidance retrospectively, resulting in a reduction to stockholders' equity of $75.8 million at January 1, 2012 and $101.7 million at January 1, 2011. Income from continuing operations for the first quarter of 2011 was reduced by $0.9 million ($0.03 per basic and diluted common share). Income from discontinued operations for the first quarter of 2011 was reduced by $0.6 million ($0.02 per basic and diluted common share). The following tables present the effect of the change on financial statement line items for prior periods that were retrospectively adjusted:
8 March 31, 2012
Effective January 1, 2012, we adopted guidance issued by the FASB related to the presentation of comprehensive income. This guidance requires us to report components of comprehensive income in either (1) a continuous statement of comprehensive income or (2) two separate but consecutive statements. This guidance removes the presentation option allowing comprehensive income disclosures in the statement of changes in stockholders' equity, but does not change the items that must be reported in other comprehensive income. We have elected to present a single continuous statement for the 2012 interim reporting periods and expect to present a separate statement of comprehensive income immediately following our consolidated statements of operations for annual periods. Other than this presentation change, the adoption of this guidance did not have any impact on our consolidated financial statements. Reclassifications The 2011 consolidated financial statements have been reclassified to conform to the current financial statement presentation. 2. Discontinued Operations On December 30, 2011, we sold our wholly-owned subsidiary, EquiTrust Life. The loss on sale of subsidiary recorded during the quarter ended March 31, 2012 includes a $3.5 million pre-tax reduction in the preliminary purchase price due to post-closing adjustments based on a final statutory net worth reconciliation. The adoption of new accounting guidance related to deferred acquisition costs discussed in Note 1 reduced the loss on sale reported in the fourth quarter of 2011 by $14.4 million, after tax. The total after-tax loss on the sale of EquiTrust Life after these adjustments was $56.4 million. In addition, we have entered into an agreement with EquiTrust Life to provide interim and transition services for a period of up to six months, beginning immediately after closing, with EquiTrust Life retaining the option to extend the agreement with respect to certain of the services for up to six additional months. Transition-related expenses are being reimbursed by the buyer and are estimated to be approximately $3.1 million for the six-month period. For the three months ended March 31, 2012, other income includes $1.5 million from transition-related fee income. As a result of the sale, our consolidated financial statements are presented to reflect the operations of the component sold as discontinued operations. A summary of income (loss) from discontinued operations is as follows:
Charges recorded in connection with the disposal of business included estimates that are subject to subsequent adjustment. Interest expense in 2012 relates to unaffiliated debt extinguished on January 30, 2012 as discussed below. 9 March 31, 2012 Notes Redemptions In connection with the EquiTrust Life sale, we redeemed $225.0 million of our long-term debt in accordance with the mandatory redemption provisions of the underlying notes. This included $50.0 million Senior Notes with our affiliate, Farm Bureau Property & Casualty Insurance Company (Farm Bureau Property & Casualty), which was extinguished on December 30, 2011. The remaining $175.0 million of unaffiliated debt was extinguished on January 30, 2012, at the make-whole redemption price of $210.9 million. On December 30, 2011, we exercised the provisions of the trust indentures and deposited $211.6 million into two irrevocable defeasance trusts for the principal, accrued interest and estimated make-whole premium. The trust funds were not withdrawable by us, and consisted of $126.4 million in cash and $85.2 million in short-term investments at December 31, 2011. The note holders were paid from assets in the trusts on January 30, 2012. The make-whole redemption premium was based on U.S. Treasury yields and considered an embedded derivative. Due to the EquiTrust Life sale, this derivative liability had a fair value of $33.1 million at December 31, 2011. The change in fair value during the first quarter of 2012 was offset by the write-off of deferred debt issuance costs and reported as loss on debt redemption in the consolidated statements of comprehensive income. 3. Investment Operations Fixed Maturity and Equity Securities
10 March 31, 2012
Short-term investments have been excluded from the above schedules as amortized cost approximates fair value for these securities.
Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Fixed maturities not due at a single maturity date have been included in the above table in the year of final contractual maturity. 11 March 31, 2012
The changes in net unrealized investment gains and losses are recorded net of deferred income taxes and other adjustments for assumed changes in the amortization pattern of deferred acquisition costs, value of insurance in force acquired and unearned revenue reserve totaling $18.1 million for the three months ended March 31, 2012 and $62.0 million for the three months ended March 31, 2011. Subsequent changes in fair value of securities, for which a previous non-credit other-than-temporary impairment loss was recognized in accumulated other comprehensive income, are reported along with changes in fair value for which no other-than-temporary impairment losses were previously recognized.
12 March 31, 2012
Included in the above tables are 208 securities from 169 issuers at March 31, 2012 and 249 securities from 204 issuers at December 31, 2011. The unrealized losses in fixed maturities are primarily due to wider spreads between the risk-free and corporate and other bond yields relative to the spreads when the securities were purchased. Because we do not intend to sell or do not believe we will be required to sell these fixed maturities before their anticipated recovery of amortized cost, we do not consider these investments to be other-than-temporarily impaired at March 31, 2012. The following summarizes the more significant unrealized losses of fixed maturities by investment category as of March 31, 2012. Corporate securities: The unrealized losses on corporate securities represent 36.7% of our total unrealized losses. The largest losses remain in the finance sector ($164.7 million carrying value and $15.3 million unrealized loss). The largest unrealized losses in the finance sector were in the banking ($92.7 million carrying value and $11.2 million unrealized loss) and the real estate investment trust ($20.8 million carrying value and $1.8 million unrealized loss) sub-sectors. The unrealized losses across the finance sector are primarily attributable to a general widening in spread levels relative to the spreads at which we acquired the securities. Finance sector spreads have narrowed but remain historically wide in comparison to the narrowing experienced in the remaining sectors, contributing to the proportionately larger amount of unrealized losses for this sector. The next largest unrealized loss on corporate securities is in the utilities sector ($46.8 million carrying value and $4.1 million unrealized loss). The unrealized loss in this sector is generally due to spread widening among several issuers that continue to experience a challenging operating environment. Residential mortgage-backed securities: The unrealized losses on residential mortgage-backed securities represent 18.0% of our total unrealized losses, and were caused primarily by continued uncertainty regarding mortgage defaults on Alt-A loans. We purchased most of these investments at a discount to their face amount and the contractual cash flows of these investments are based on mortgages and other assets backing the securities. Commercial mortgage-backed securities: The unrealized losses on commercial mortgage-backed securities represent 11.3% of our total unrealized losses and were caused primarily by spread widening and industry concerns regarding the potential for future commercial mortgage defaults. The contractual cash flows of these investments are based on mortgages backing the securities. Unrealized losses on military housing bonds were mainly attributed to a limited number of investors and negative publicity regarding this sector. The military housing bonds are also impacted by lack of printed underlying ratings on insured bonds. Other asset-backed securities: The unrealized losses on other asset-backed securities represent 29.3% of our total unrealized losses, and were caused primarily by concerns regarding defaults on subprime mortgages and home equity loans. We purchased most of these investments at a discount to their face amount and the contractual cash flows of these investments are based on mortgages and other assets backing the securities. State, municipal and other governments: The unrealized losses on state, municipal and other governments represent 4.7% of our total unrealized losses, and were primarily caused by general spread widening relative to spreads at which we acquired the bonds. The decline in fair value is primarily attributable to increased spreads on lower-rated bonds and market concerns regarding specific areas of the sector. 13 March 31, 2012 Equity securities: We had $0.6 million of gross unrealized losses on investment grade non-redeemable perpetual preferred securities within the finance sector as of March 31, 2012. These securities provide periodic cash flows, contain call features and are similarly rated and priced like other long-term callable bonds and are evaluated for other-than-temporary impairment similar to fixed maturities. The decline in fair value is primarily attributable to market concerns regarding the sector. Excluding mortgage and asset-backed securities, no securities from the same issuer had an aggregate unrealized loss in excess of $4.0 million at March 31, 2012. The $4.0 million unrealized loss is from hybrid Tier 1 capital bonds in the financial sector. With respect to mortgage and asset-backed securities not backed by the United States Government, no securities from the same issuer had an aggregate unrealized loss in excess of $9.8 million at March 31, 2012. The $9.8 million unrealized loss from one issuer relates to three different securities that are backed by different pools of Alt-A residential mortgage loans. All three of the securities are rated non-investment grade and the largest unrealized loss totaled $5.2 million. The carrying values of all our investments are reviewed on an ongoing basis for credit deterioration. When our review indicates a decline in fair value for a fixed maturity security is other than temporary and we do not intend to sell or believe we will be required to sell the security before recovery of our amortized cost, a specific write down is charged to earnings for the credit loss and a specific charge is recognized in accumulated other comprehensive income for the non-credit loss component. If we intend to sell or believe we will be required to sell a fixed maturity security before its recovery, the full amount of the impairment write down to fair value is charged to earnings. For all equity securities, the full amount of an other-than-temporary impairment write down is recognized as a realized loss on investments in the statements of operations and the new cost basis for the security is equal to its fair value. We monitor the financial condition and operations of the issuers of fixed maturities and equity securities that could potentially have a credit impairment that is other than temporary. In determining whether or not an unrealized loss is other than temporary, we review factors such as:
In order to determine the credit and non-credit impairment loss for fixed maturities, every quarter we estimate the future cash flows we expect to receive over the remaining life of the instrument as well as review our plans to hold or sell the instrument. Significant assumptions regarding the present value of expected cash flows for each security are used when an other-than-temporary impairment occurs and there is a non-credit portion of the unrealized loss that won't be recognized in earnings. Our assumptions for residential mortgage-backed securities, commercial mortgage-backed securities and other asset-backed securities include collateral pledged, guarantees, vintage, anticipated principal and interest payments, prepayments, default levels, severity assumptions, delinquency rates and the level of nonperforming assets for the remainder of the investments' expected term. We use a single best estimate of cash flows approach and use the effective yield prior to the date of impairment to calculate the present value of cash flows. Our assumptions for corporate and other fixed maturities include anticipated principal and interest payments and an estimated recovery value, generally based on a percentage return of the current market value. After an other-than-temporary write down of all equity securities and any fixed maturities with a credit-only impairment, the cost basis is generally not adjusted for subsequent recoveries in fair value. For fixed maturities for which we can reasonably estimate future cash flows after a write down, the discount or reduced premium recorded, based on the new cost basis, is amortized over the remaining life of the security. Amortization in this instance is computed using the prospective method and the current estimate of the amount and timing of future cash flows. 14 March 31, 2012 Credit Loss Component of Other-Than-Temporary Impairments on Fixed Maturities The following table sets forth the amount of credit loss impairments on fixed maturities we held as of the dates indicated for which a portion of the other-than-temporary impairment was recognized in other comprehensive income and corresponding changes in such amounts.
In addition to the other-than-temporary impairment losses recognized above, we also incurred other-than-temporary impairment losses on fixed maturities not previously impaired, which based on declines in credit quality or other circumstances changed our intent to retain the securities. Other-than-temporary impairment losses of $0.6 million for the three-month period ended March 31, 2012 and $1.4 million for the three-month period ended March 31, 2011 were recognized on these securities.
Proceeds from sales of fixed maturities available totaled $27.1 million at March 31, 2012 and $17.9 million at March 31, 2011. Realized gains and losses on sales of investments are determined on the basis of specific identification. Mortgage Loans Our mortgage loan portfolio consists principally of commercial mortgage loans that we have originated. Our lending policies require that the loans be collateralized by the value of the related property, establish limits on the amount that can be loaned to one borrower and require diversification by geographic location and collateral type. We originate loans with an initial loan to value ratio that provides sufficient excess collateral to absorb losses should we be required to foreclose and take possession of the collateral. In order to identify impairment losses timely, management maintains and reviews a watch list of mortgage loans that have heightened risk. These loans may include those with borrowers delinquent on contractual payments, borrowers experiencing financial difficulty, increases in rental real estate vacancies and significant declines in collateral value. We evaluate each of our mortgage loans individually and establish an allowance as needed for possible losses against our mortgage loan portfolio. An allowance is needed for loans in which we do not believe we will collect all amounts due according to the contractual terms of the respective loan agreements or a modification which has been classified as a troubled debt restructuring. 15 March 31, 2012 Any loans delinquent on contractual payments are considered non-performing. Non-performing loans totaled $16.8 million at March 31, 2012 and $18.9 million at December 31, 2011. At March 31, 2012, there were two non-performing loans over 90 days past due on contractual payments with a carrying value of $16.8 million. At December 31, 2011, there were three non-performing loan over 90 days past due on contractual payments with a carrying value of $18.9 million. During the first quarter of 2012, we foreclosed on one non-performing loan with a book value of $2.1 million at December 31, 2011 and took possession of the real estate with an appraised value of $2.4 million. We discontinued the accrual of interest on one loan totaling $1.9 million at March 31, 2012 and two loans totaling $4.0 million at December 31, 2011. We continued to accrue for the other non-performing loan as we believe that we will collect all of the amounts due.
16 March 31, 2012
Variable Interest Entities We evaluate our variable interest entity (VIE) investees to determine whether the level of our direct ownership interest, our rights to manage operations or our obligation to provide ongoing financial support are such that we are the primary beneficiary of the entity, and are then required to consolidate it for financial reporting purposes. None of our VIE investees were required to be consolidated during 2012 or 2011. Our VIE investments are as follows:
We did not have any commitments for further fundings to investees designated as VIEs during 2012 or 2011. Other At March 31, 2012, we had committed to provide additional funds for investments in limited partnerships. The amounts of these unfunded commitments totaled $52.1 million. 4. Derivative Instruments As discussed in Note 2, the make-whole redemption feature of our unaffiliated senior notes was an embedded derivative based on U.S. Treasury yields at December 31, 2011. This derivative liability had a fair value of $33.1 million at December 31, 2011 and zero at March 31, 2012 due to the repayment of debt during the first quarter. The derivative liability was reported in other 17 March 31, 2012 liabilities in the consolidated balance sheet. The change in fair value is included in the loss on debt redemption line in the consolidated statements of comprehensive income. We are not significantly involved in hedging activities and have limited exposure to derivatives. We do not apply hedge accounting to any of our derivative positions. Derivative assets, which are primarily reported in reinsurance recoverable and other investments, totaled $4.3 million at March 31, 2012 and $3.7 million at December 31, 2011. Our derivative assets consist of derivatives embedded within our modified coinsurance agreements, collateralized debt obligation and call options which provide an economic hedge for a small block of index annuity contracts. Derivative liabilities, excluding the make-whole redemption feature, totaled $0.4 million at March 31, 2012 and December 31, 2011 and include derivatives embedded within our index annuity contracts and derivatives embedded within our modified coinsurance agreements. The net loss recognized on these derivatives was $0.4 million for the three months ended March 31, 2012 and March 31, 2011. During prior years we held interest rate swaps to manage the interest rate risk associated with a portion of our flexible premium deferred annuity contracts. A $50.0 million notional amount interest rate swap associated with the deferred annuity contracts matured on June 1, 2011. 5. Fair Values The carrying and estimated fair values of our financial instruments are as follows:
Fair value is based on an exit price, which is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. As not all financial instruments are actively traded, various valuation methods may be used to estimate fair value. These methods rely on observable data and where observable data is not available, the best information available. Significant judgment may be required to interpret the data and select the assumptions used in the valuation estimates, particularly when observable market data is not available. In the discussion that follows, we have ranked our financial instruments by the level of judgment used in the determination of the fair values presented above. The levels are defined as follows:
18 March 31, 2012
In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, a financial instrument's level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the financial instrument. From time to time there may be movements between levels as inputs become more or less observable, which may depend on several factors including the activity of the market for the specific security, the activity of the market for similar securities, the level of risk spreads and the source of the information from which we obtain the information. Transfers in or out of any level are measured as of the beginning of the period. The following methods and assumptions were used in estimating the fair value of our financial instruments: Fixed maturities: Level 1 fixed maturities consist of U.S. Treasury issues that are actively traded, allowing us to use current market prices as an estimate of their fair value. Level 2 fixed maturities consist of corporate, mortgage and other asset-backed, United States Government agencies and private placement securities with observable market data, and in some circumstance recent trade activity. We obtain our Level 2 fixed maturity fair values from a variety of external independent pricing sources with access to observable data for these instruments. These external sources consider recent trade values, if available, and rely on matrix pricing utilizing observable data which we would expect a market participant to use. Matrix pricing uses a discounted cash flow analysis using a spread over U.S. Treasury bond yields, considers call features and is adjusted for maturity/average life differences. Spread adjustments also reflect, as applicable, a liquidity premium and take into account a variety of factors including, but not limited to, senior unsecured versus secured status, par amount outstanding, number of holders, maturity, average life, composition of lending group and debt rating. Level 3 fixed maturity securities include private placements as well as corporate, mortgage and other asset-backed and state and municipal securities for which there is little or no current market data available. We use external pricing sources, or if prices are not available will estimate fair value internally. Fair values of private investments in Level 3 are determined by reference to public market, private transactions or valuations for comparable companies or assets in the relevant asset class when such amounts are available. For other securities where an exit price based on relevant observable inputs is not obtained, the fair value is determined using a matrix calculation. Fair values estimated through use of matrix pricing methods rely on an estimate of credit spreads to a risk free U.S. Treasury yield. Selecting the credit spread requires judgment based on an understanding of the security and may include a market liquidity premium. Our selection of comparable companies as well as the level of spread requires significant judgment. Increases in spreads used in our matrix models, or those used to value comparable companies, will result in a decrease in discounted cash flows used, and accordingly in the estimated fair value of the security. We obtain fixed maturity fair values from a variety of external independent pricing services, including brokers, with access to observable data including recent trade information, if available. In certain circumstances in which an external price is not available for a Level 3 security, we will internally estimate its fair value. Our process for evaluation and selection of the fair values includes:
19 March 31, 2012 as for newly issued, private placement and other instruments that are not widely traded. For those securities for which an externally provided fair value is not available we use cash flow modeling techniques to estimate fair value.
Equity securities: Level 1 equity securities consist of listed common stocks and mutual funds that are actively traded, allowing us to use current market prices as an estimate of their fair value. Level 2 equity securities consist of common stock issued by the Federal Home Loan Bank, with estimated fair value based on the current redemption value of the shares and non-redeemable preferred stock with estimated fair value obtained from external pricing sources using a matrix pricing approach. Level 3 equity securities consist of a non-redeemable preferred stock for which no active market exists, and fair value estimates for these securities is based on the values of comparable securities which are actively traded. Increases in spreads used in our matrix models, or those used to value comparable companies, will result in a decrease in discounted cash flows used, and accordingly in the estimated fair value of the security. In the case where external pricing services are used for certain Level 1 and Level 2 equity securities, our review process is consistent with the process used to determine the fair value of fixed maturity securities discussed above. Mortgage loans: Mortgage loans are not measured at fair value on a recurring basis. Mortgage loans are a Level 3 measurement as there is no current market for the loans as we are not actively involved in the purchase and sale of these loans. The fair value of our mortgages is estimated internally using a matrix pricing approach which we would expect to use to acquire a seasoned loan. Along with specific loan terms, two key management assumptions are required including the risk rating of the loan (our current rating system A-highest quality, B-moderate quality, C-low quality and W-watch or F-foreclosure) and spreads over the U.S. Treasury yield curve. Loans are reviewed and rated annually and adjusted quarterly should significant changes occur, with spreads updated on a quarterly basis. Our determination of each loan's risk rating as well as selection of the credit spread requires significant judgment. A higher risk rating, as well as an increase in spreads, would result in a decrease in discounted cash flows used, and accordingly the fair value of the loan. Policy loans: Policy loans are not measured at fair value on a recurring basis. Policy loans are a Level 3 measurement as there is no current market, as they are specifically tied to the underlying insurance policy. The loans are relatively risk free as they cannot exceed the cash surrender value of the insurance policy. Fair values are estimated by discounting expected cash flows using a risk-free interest rate based on the U.S. Treasury curve. An increase in spreads would result in a decrease in discounted cash flows used, and accordingly the fair value of the loan. 20 March 31, 2012 Other investments: Level 2 other investments include call options with fair values based on counterparty market prices adjusted for a credit component of the counterparty. Cash and short-term investments: Level 1 cash and short-term investments are highly liquid instruments for which historical cost approximates fair value. Restricted debt defeasance trust assets: Level 1 restricted debt defeasance trust assets consist of cash and listed mutual funds that are actively traded, allowing us to use current market prices as an estimate of their fair value. Reinsurance recoverable: Level 2 reinsurance recoverable includes embedded derivatives in our modified coinsurance contracts under which we cede or assume business. Fair values of these embedded derivatives are based on the difference between the fair value and the cost basis of the underlying fixed maturities. Assets held in separate accounts: Level 1 assets held in separate accounts consist of mutual funds that are actively traded, allowing us to use current market prices as an estimate of their fair value. Future policy benefits, supplemental contracts without life contingencies and advance premiums and other deposits: Level 3 policy related financial instruments are those for which there is no active market. These are not measured at fair value on a recurring basis. Fair values of our liabilities under contracts not involving significant mortality or morbidity risks (principally deferred annuities, deposit administration funds, funding agreements and supplementary contracts) are estimated using one of two methods. For contracts with known maturities, fair value is determined using discounted cash flow valuation techniques based on current interest rates adjusted to reflect our credit risk and an additional provision for adverse deviation. For deposit liabilities with no defined maturities, fair value is the amount payable on demand. Significant judgment is required in selecting the assumptions used to estimate the fair values of these financial instruments. For contracts with known maturities, increases in current rates will result in a decrease in discounted cash flows and a decrease in the estimated fair value of the policy obligation. Certain annuity contracts include embedded derivatives and are measured at fair value on a recurring basis. These embedded derivatives are a Level 3 measurement. The fair value of the embedded derivatives is based on the discounted excess of projected account values (including a risk margin) over projected guaranteed account values. The key unobservable inputs required in the projection of future values which require management judgment include the risk margin as well as the credit risk of our company. Should the risk margin increase or the credit risk decrease the discounted cash flows and the estimated fair value of the obligation will increase. Short-term and long-term debt: Short-term and long-term debt are not measured at fair value on a recurring basis. Short-term and long-term debt are a Level 3 measurement. The fair value of our outstanding debt at March 31, 2012 and excluding our short-term debt at December 31, 2011, is estimated using a discounted cash flow method based on the market's assessment or our current incremental borrowing rate for similar types of borrowing arrangements adjusted, as needed, to reflect our credit risk. Fair value of the short-term debt in 2011 was equal to the par value as the related fair value for the make-whole redemption price is reflected as an embedded derivative in other liabilities. Our selection of the credit spread requires significant judgment. A decrease in the spread will increase the estimated fair value of the outstanding debt. Stock repurchase obligation: Level 2 stock repurchase obligation is a short-term obligation, originated on March 27, 2012 and fully settled for its carrying amount by April 11, 2012. Its carrying value approximates its fair value. 21 March 31, 2012 Other liabilities: Level 2 other liabilities include the embedded derivatives in our modified coinsurance contracts under which we cede business. Fair values of these derivatives are based on the difference between the fair value and the cost basis of the underlying fixed maturities. Level 3 other liabilities include an embedded derivative related to the make-whole redemption feature of our unaffiliated senior notes. Fair value was determined using a discounted cash flow valuation analysis based on applicable U.S. Treasury rates and make-whole spread. Liabilities related to separate accounts: Separate account liabilities are not measured at fair value on a recurring basis. Level 3 separate account liabilities fair value is based on the cash surrender value of the underlying contract, which is the cost we would incur the extinguish the liability.
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