Pursuant to settlement agreements reached with regulators, several insurance companies have agreed to restrictions on the payment of contingent compensation relating to the placement of excess casualty insurance policies. These insurers have agreed that the restrictions may be extended in time, and to other property and casualty lines, if insurers in a given line or segment, that together represent more than 65% of the market share in the insurance line (based upon national gross written premiums), do not pay contingent compensation. On November 30, 2006, the New York Attorney General’s Office notified these insurers that the 65% threshold had been reached for a number of insurance lines, including personal automobile and homeowners insurance. As a result, beginning January 1, 2007, these insurers were prohibited from paying contingent compensation relating to the placement of these types of insurance. In addition, on December 21, 2006, Chubb Corporation agreed to forego the payment of contingent compensation for all P&C insurance lines pursuant to a settlement agreement reached with regulators. These insurers, including Chubb, have also agreed to support legislation and regulations to abolish contingent compensation and to require greater disclosure of compensation. At this time, it is not possible to predict the effect of these announced or potential future changes on our business or distribution strategies, but such changes could have a material adverse effect on us in the future.
loss adjustment expense reserves for workers’ compensation and package business related to accident years 2003 to 2005, and a $45 strengthening of Specialty Commercial construction defect claim reserves for accident years 1997 and prior. See “Reserves” within the Property and Casualty MD&A for further discussion of reserve developments.
In Business Insurance, workers’ compensation is the Company’s single biggest line of business and the line of business with the longest pattern of loss emergence. Reserve estimates for workers’ compensation are particularly sensitive to assumptions about medical inflation and the changing use of medical care procedures. In addition, changes in state legislative and regulatory environments impact the Company’s estimates. These changes increase the uncertainty in the application of development patterns.
It is also not possible to predict changes in the legal and legislative environment and their effect on the future development of asbestos and environmental claims. It is unknown whether potential Federal asbestos-related legislation will be enacted or what its effect would be on the Company’s aggregate asbestos liabilities.
The separate account DRD is estimated for the current year using information from the prior year-end, adjusted for current year equity market performance. The estimated DRD is generally updated in the third quarter for the provision-to-filed-return adjustments, and in the fourth quarter based on current year ultimate mutual fund distributions and fee income from the Company’s variable insurance products. The actual current year DRD can vary from the estimates based on, but not limited to, changes in eligible dividends received by the mutual funds, amounts of distributions from these mutual funds, the utilization of capital loss carry forwards at the mutual fund level and appropriate levels of taxable income.
Life’s profitability in its individual life insurance and group benefits businesses depends largely on the size of its in force block, the adequacy of product pricing and underwriting discipline, actual mortality and morbidity experience, and the efficiency of its claims and expense management.
The increase in U.S. variable annuity account values can be attributed to market growth during 2006.
As discussed above, traditional insurance type products, such as those sold by Group Benefits, collect premiums from policyholders in exchange for financial protection for the policy holder from a specified insurable loss, such as death or disability. These premiums together with net investment income earned from the overall investment strategy are used to pay the contractual obligations under these insurance contracts. Two major factors, new sales and persistency, impact premium growth. Sales can increase or decrease in a given year based on a number of factors, including but not limited to, customer demand for the Company’s product offerings, pricing competition, distribution channels and the Company’s reputation and ratings. A majority of sales correspond with the open enrollment periods of employers’ benefits, typically January 1 or July 1. Persistency is the percentage of insurance policies remaining in force from year to year as measured by premiums.
Lower amortization of DAC resulted from a $20 benefit due to the unlocking of Retirement Plans DAC assumptions during the fourth quarter of 2006 in both the 401(k) and Government businesses of $25 and ($5) after-tax, respectively. (For further discussion, see DAC Unlock and Sensitivity Analysis in this section of the MD&A).
Net income increased for the year ended December 31, 2006, primarily due to higher earned premiums and a lower expense ratio excluding the financial institution business. The results for the year ended December 31, 2006 included a net benefit of $11 resulting from the completion of life reserve studies during the fourth quarter. The results for the year ended December 31, 2005 included a non-recurring tax benefit of $9 related to the CNA Acquisition. The following factors contributed to the earnings increase:
The increased scale of the group life and disability operations and the expanded distribution network for its products and services has generated strong premium and sales growth in 2006. Fully insured ongoing premiums for the year ended December 31, 2006 was $4.1 billion, a 9% increase over the prior year. Sales for the year ended December 31, 2006 were $861 (excluding buyout premiums and premium equivalents) representing an increase of 11% over the prior year. Management is committed to selling competitively priced products that meet the Company’s internal rate of return guidelines and sales may be negatively affected by the competitive pricing environment in the marketplace. Although sales may fluctuate from year to year, the Company has experienced consistent premium growth over the past few years which results from the combination of sales, renewal pricing and persistency.
A $90 decrease in 2004 earned premiums under retrospectively-rated policies, and
The decline in the Specialty Commercial earned premium growth rate primarily resulted from a decrease in property business due to a decline in new business and the Company’s exit from the multi-peril crop insurance business.
the Company’s method of allocating net investment income for the Hartford Fire Insurance Pool and the net investment income earned by Other Operations on its separate investment portfolios, in 2006, the after-tax investment yield for Ongoing Operations was 4.2% and the after-tax investment yield for Other Operations was 3.9%.
A significant portion of the gross incurred loss and loss adjustment expenses are recoverable from reinsurers under the Company’s principal catastrophe reinsurance program in addition to other reinsurance programs. Reinsurance recoveries under the Company’s principal catastrophe reinsurance program, which covers multiple lines of business, are allocated to the segments in accordance with a pre-established methodology that is consistent with the method used to allocate the ceded premium to each segment. In addition to its retention, the Company has a co-participation in the losses ceded under the principal catastrophe reinsurance program, which varies by layer, and is recorded in Specialty Commercial. In the third and fourth quarters of 2005, the Company reinstated the limits under its reinsurance programs that were exhausted by hurricane Katrina and Wilma, resulting in additional ceded premium of $73, which is reflected as a reduction in earned premium.
of required reserve levels. Subsequent changes can generally be thought of as being the result of the emergence of additional facts that were not known or anticipated at the time of the prior reserve estimate and/or changes in interpretations of information and trends.
Total Ongoing Operations’ earned premiums grew $682, or 7%, due primarily to growth in Business Insurance and Personal Lines. Earned premiums were net of third and fourth quarter property catastrophe reinstatement premiums related to hurricanes totaling $73 in 2005 and $17 in 2004.
The current accident year loss and loss adjustment expense ratio before catastrophes decreased by 1.0 point, to 62.7, primarily due to improved current accident year performance for auto bodily injury and workers’ compensation claims, partially offset by the effect of an increase in non-catastrophe property loss costs. Non-catastrophe property loss costs increased primarily due to increasing claim severity and, in specialty property, increasing claim frequency as well.
Before reinstatement premium, a lower combined ratio before catastrophes and prior accident year development improved current accident year underwriting results before catastrophes by $25. The 0.3 point decrease in the combined ratio before catastrophes and prior accident year development, to 89.4, was primarily driven by a 0.6 point improvement in the expense ratio, partially offset by a 0.5 point increase in the current accident year loss and loss adjustment expense ratio before catastrophes.
Personal Lines provides automobile, homeowners’ and home-based business coverages to the members of AARP through a direct marketing operation and to individuals who prefer local agent involvement through a network of independent agents in the standard personal lines market (“Standard”). Up until the sale of the business on November 30, 2006, the Company also sold non-standard auto insurance through the Company’s Omni Insurance Group, Inc. (“Omni”) subsidiary. Personal Lines also operates a member contact center for health insurance products offered through AARP’s Health Care Options. The Hartford’s exclusive licensing arrangement with AARP continues until January 1, 2020 for automobile, homeowners and home-based business. The Health Care Options agreement continues through 2009.
For the Agency business, management expects to increase written premium by further enhancing the Dimensions product and increasing the number of appointed agents. Throughout 2007, the focus will be to successfully engage new and recently appointed agents. The Company sold its Omni non-standard auto business on November 30, 2006 and because Omni accounted for 3% of written premium in 2006, Personal Lines written premium growth will be moderated by the sale of this business.
Strong underwriting profitability within the past couple of years has intensified the level of competition, putting downward pressure on rates. For auto, written pricing in 2006 was down 1% and, for homeowners, written pricing increases in 2006 of 5% were lower than they had been in 2005. Non-catastrophe loss costs in homeowners increased in 2006, driven largely by an increase in claim severity. Management expects claim severity to increase again in 2007 and claim frequency to be slightly negative. While earned pricing and
Current accident year catastrophe losses increased by $53, from $111 in 2004 to $164 in 2005. Catastrophe losses in 2005 for hurricanes Katrina, Rita and Wilma were $145 compared to catastrophe losses in 2004 for hurricanes Charley, Frances, Ivan and Jeanne of $81. Catastrophe losses in 2005 and 2004 include $70 and $19, respectively, of catastrophe losses assumed under inter-segment reinsurance programs.
In 2007, the Company expects written premium growth of 3% to 6%. Property written premium was relatively flat in 2006 as the effect of significant direct written pricing increases offset by a decline in new business growth, lower written premium renewal retention and higher reinsurance costs. Contributing to the higher reinsurance costs in 2006 was the cost of second event coverage following the 2005 hurricanes which was fully expensed by June 30, 2006. The Company expects that rate increases and new business growth will result in a written premium increase in property business in 2007, although the level of property business written in 2007 will largely depend on how much rates continue to increase to reflect higher reinsurance costs.
A $22 decrease in net investment income, primarily as a result of a decrease in invested assets resulting from net loss and loss adjustment expenses paid. Other Operations’ net investment income includes income earned on the separate portfolios of Heritage Holdings, and its subsidiaries, and on the Hartford Fire invested asset portfolio, which is allocated between Ongoing Operations and Other Operations. The Company attributes capital and invested assets to each segment using an internally developed risk-based capital attribution methodology.
A $222 increase in underwriting results, primarily due to a $197 decrease in prior year loss development. Reserve development in 2005 included $85 of reserve strengthening for assumed reinsurance, $37 of environmental reserve strengthening, and a $20 increase in the allowance for uncollectible reinsurance. In 2004, reserve development included a $181 provision for the reinsurance recoverable asset associated with older, long-term casualty liabilities, $170 of reserve strengthening for assumed reinsurance, and $75 of environmental reserve strengthening, which was partially offset by a $97 release of September 11 reserves.
The Hartford’s investment portfolios are primarily divided between Life and Property & Casualty. The investment portfolios of Life and Property & Casualty are managed by Hartford Investment Management Company (“HIMCO”), a wholly-owned subsidiary of The Hartford. HIMCO manages the portfolios to maximize economic value, while attempting to generate the income necessary to support the Company’s various product obligations, within internally established objectives, guidelines and risk tolerances. The portfolio objectives and guidelines are developed based upon the asset/liability profile, including duration, convexity and other characteristics within specified risk tolerances. The risk tolerances considered include, for example, asset and credit issuer allocation limits, maximum portfolio below investment grade (“BIG”) holdings and foreign currency exposure. The Company attempts to minimize adverse impacts to the portfolio and the Company’s results of operations due to changes in economic conditions through asset allocation limits, asset/liability duration matching and through the use of derivatives. For a further discussion of how the investment portfolio’s credit and market risks are assessed and managed, see the Investment Credit Risk and Capital Markets Risk Management sections of the MD&A.
The following table identifies the invested assets by type held as of December 31, 2006 and 2005.
Securities that have characteristics of fixed maturities and equity securities are a type of hybrid security. Hybrid securities that have a preponderance of economic attributes more akin to fixed maturities such as a stated interest rate, a mandatory redemption date or a punitive interest rate step-up feature which would compel the issuer to redeem the security at a specified call date, except in remote circumstances, are included within fixed maturities. Accordingly, the fair value of hybrid securities included in the tables above at December 31, 2006 and 2005 are $3.5 billion and $3.6 billion, respectively.
The Company’s statutory financial results also have exposure to equity market volatility due to the issuance of variable annuity contracts with guarantees. Specifically, in scenarios where equity markets decline substantially, we would expect significant increases in the amount of statutory surplus the Company would have to devote to maintain targeted rating agency and regulatory risk based capital (“RBC”) ratios (via the C3 Phase II methodology) and other similar solvency margin ratios. Various actions have been taken to partially mitigate this risk including the use of guaranteed benefit reinsurance, dynamic hedging programs of U.S. GMWB’s, and other statutory reserve hedges.
In January 2007, the commercial paper program of HLI was terminated.