The accident period used may vary (e.g., year, quarter, or month);
In addition to when a comprehensive assumption study is completed, revisions to best estimate assumptions used to estimate future gross profits are necessary when the EGPs in the Company’s models fall outside of an independently determined reasonable range of EGPs. The Company performs a quantitative process each quarter to determine the reasonable range of EGPs. This process involves the use of internally developed models, which run a large number of stochastically determined scenarios of separate account fund performance. Incorporated in each scenario are assumptions with respect to lapse rates, mortality and expenses, based on the Company’s most recent assumption study. These scenarios are run for the Company’s individual variable annuity businesses in the United States and Japan, the Company’s Retirement Plans businesses, and for the Company’s individual variable universal life business and are used to calculate statistically significant ranges of reasonable EGPs. The statistical ranges produced from the stochastic scenarios are compared to the present value of EGPs used in the Company’s models. If EGPs used in the Company’s models fall outside of the statistical ranges of reasonable EGPs, an “Unlock” would be necessary. If EGPs used in the Company’s models fall inside of the statistical ranges of reasonable EGPs, the Company will not solely rely on the results of the quantitative analysis to determine the necessity of an Unlock. In addition, the Company considers, on a quarterly basis, other qualitative factors such as product, regulatory and policyholder behavior trends and may also revise EGPs if those trends are expected to be significant and were not or could not be included in the statistically significant ranges of reasonable EGPs. As of December 31, 2008, the EGPs used in the Company’s models fell within the statistical ranges of reasonable EGPs. As a result of this statistical test and review of qualitative factors, the Company did not “Unlock” the EGPs used in the Company’s models during the fourth quarter of 2008.
Derivative instruments classified as Level 3 include complex derivatives, primarily consisting of equity options and swaps, interest rate derivatives which have interest rate optionality, certain credit default swaps, and long-dated interest rate swaps. These derivative instruments are valued using pricing models which utilize both observable and unobservable inputs and, to a lesser extent, broker quotations. A derivative instrument that is priced using both observable and unobservable inputs will be classified as a Level 3 financial instrument in its entirety if the unobservable input is significant in developing the price.
Ongoing Operations’ net income decreased by $1.3 billion in 2008, from net income of $1.5 billion in 2007 to net income of $189 in 2008. Before income taxes, Ongoing Operations’ results deteriorated by $1.9 billion, primarily due to a $1.5 billion increase in net realized capital losses on investments, a $383 decrease in net investment income and a $366 increase in current accident year catastrophes, partially offset by a $210 increase in net favorable prior accident year development and more favorable underwriting results from personal auto and workers’ compensation lines of business. The increase in net realized capital losses of $1.5 billion in 2008 was primarily due to impairments of subordinated fixed maturities and preferred equity securities in the financial services sector as well as of securitized assets. Contributing to the $383 decrease in net investment income was a change from net income to net losses on limited partnerships and other alternative investments in 2008 and decreased fixed maturity income. The $366 increase in current accident year catastrophes was largely due to losses incurred from hurricane Ike in September of 2008 and an increase in losses from tornadoes and thunderstorms in the South and Midwest. The $210 increase in net favorable prior accident year development was primarily due to larger net reserve releases for workers’ compensation, professional liability and personal auto liability claims.
Other Operations reported a net loss of $97 in 2008 compared to net income of $30 in 2007. Before income taxes, Other Operations’ results deteriorated by $184, primarily due to a $196 increase in net realized capital losses on investments, largely driven by impairments of subordinated fixed maturities and preferred equity securities in the financial services sector as well as of securitized assets, and a $51 decrease in net investment income, partially offset by a $64 decrease in net unfavorable prior accident year reserve development.
Other Operations reported net income of $30 in 2007 compared to a net loss of $35 in 2006. The improvement in results was primarily due to a decrease in unfavorable prior accident year reserve development, partially offset by a change from net realized gains in 2006 to net realized losses in 2007 and a decrease in net investment income.
In 2009, the Company intends to review its variable annuity product features in an effort to reduce the risks and costs associated with variable annuity benefit features in the current economic environment.
International - Japan DAC amortization ratio, excluding DAC Unlock and certain realized gains or losses, increased due to actual gross profits being less than expected as a result of lower fees earned on declining assets resulting in negative true-ups and a higher DAC amortization rate, as well as the accelerated amortization associated with the impact of the 3 Win trigger.
Declines in assets under management in Retail, primarily driven by market depreciation of $37.8 billion for Individual Annuity and $20.2 billion for retail mutual funds during 2008, drove declines in fee income compared to 2007.
Lower amortization of DAC resulted from the unlock benefit in 2007 as compared to an unlock expense in 2006. This decrease in DAC amortization had a partial offset in amortization of deferred revenues, included in fee income.
During the year ended December 31, 2008, Life acquired the rights to service assets under administration (“AUA”) from Princeton Retirement Group. Servicing revenues from AUA are based on the number of plan participants and do not vary directly with asset levels. As such, they are not included in AUM upon which asset based returns are calculated.
The segment’s loss ratio (defined as benefits, losses and loss adjustment expenses as a percentage of premiums and other considerations excluding buyouts) for the year ended December 31, 2007, decreased slightly. Loss ratios experience volatility in period over period comparisons due to fluctuation in mortality and morbidity experience. Additionally there was a change in assumptions underlying the valuation of long term disability claims incurred in 2007.
Includes investment income and mark-to-market effects of equity securities held for trading supporting the international variable annuity business, which are classified in net investment income with corresponding amounts credited to policyholders within benefits, losses and loss adjustment expenses.
• The $366 increase in current accident year catastrophe losses was primarily due to more severe catastrophes in 2008, including losses from hurricane Ike and tornadoes and thunderstorms in the South and Midwest.
• Net non-catastrophe prior accident year reserve development in Ongoing Operations was more favorable in 2008 than in 2007. Favorable non-catastrophe reserve development of 3.2 points, or $333, in 2008 included, among other reserve changes, a $156 release of reserves for workers’ compensation claims, primarily related to accident years 2000 to 2007, a $105 release of general liability claims, primarily related to accident years 2001 to 2007, and a $75 release of reserves for professional liability claims related to accident years 2003 through 2006. See the “Reserves” section for a discussion of prior accident year reserve development for Ongoing Operations in 2008.
Included within prior accident year development for the year ended December 31, 2006 were the following reserve strengthenings (releases).
Primarily driving the $383 decrease in net investment income were a change from net income to net losses on limited partnerships and other alternative investments in 2008 and decreased fixed maturity income. The net losses on limited partnerships and other alternative investments in 2008 were largely due to negative returns on hedge funds and real estate partnerships as a result of the lack of liquidity in the financial markets and credit spread widening. The decrease in income from fixed maturities was attributable to lower income on variable rate securities due to declines in short term interest rates as well as an increased allocation to lower yielding U.S. Treasuries and short-term investments.
A $608 change from income tax expense to an income tax benefit
Auto earned premium was relatively flat in 2008 as the effect of earned pricing increases of 1% was largely offset by a decrease in new business since the middle of 2007. Homeowners’ earned premium grew 3% largely due to earned pricing increases of 3%.
• As written premium is earned over the 12-month term of the policies, the earned pricing changes during 2007 are primarily a reflection of the written pricing changes over the last six months of 2006 and the first six months of 2007.
Professional liability, fidelity and surety earned premium grew $35, or 5%, for the year ended December 31, 2007 due to an increase in earned premiums in professional liability and surety business. The increase in earned premium from professional liability business was primarily due to a decrease in the portion of risks ceded to outside reinsurers and an increase in the mix of lower limit middle market professional liability premium, partially offset by the effect of earned pricing decreases and a decrease in new business written premium. A lower frequency of class action cases in the past couple of years has put downward pressure on rates during 2006 and 2007. The increase in earned premium from surety business was primarily due to an increase in public construction spending and construction costs, resulting in more bonded work programs for current clients and larger bond limits.
Prior accident year reserve development changed from net unfavorable prior accident year reserve development of $84, or 5.8 points, in 2007 to net favorable prior accident year reserve development of $81, or 5.8 points, in 2008. Net favorable prior accident year reserve development of $81 in 2008 primarily included a $75 release of reserves for directors’ and officers insurance and errors and omissions insurance claims related to accident years 2003 to 2006.
Current accident year loss and loss adjustment expenses before catastrophes decreased by $64
Given the factors described above, the Company believes the actuarial tools and other techniques it employs to estimate the ultimate cost of claims for more traditional kinds of insurance exposure are less precise in estimating reserves for its asbestos and environmental exposures. For this reason, the Company relies on exposure-based analysis to estimate the ultimate costs of these claims and regularly evaluates new information in assessing its potential asbestos and environmental exposures.
In the fourth quarters of 2008, 2007 and 2006, the Company completed evaluations of certain of its non-asbestos and environmental reserves, including its assumed reinsurance liabilities. Based on these evaluations, the Company recognized favorable prior year development of $30 and $18 in 2008 and 2007, respectively, and unfavorable prior year development of $12 in 2006 for its HartRe assumed reinsurance liabilities. The improvement in 2008 and 2007 was the result of lower than expected reported losses. In 2008 and 2007, the favorable HartRe assumed reinsurance development was offset by unfavorable other non-asbestos and environmental prior year development of $30 and $17 in 2008 and 2007, respectively, including $25 of adverse development in 2008 for assumed reinsurance obligations of the Company’s Bermuda operations.
The following table displays gross environmental reserves and other statistics by category as of December 31, 2008.
The Company invests in private placement securities, mortgage loans and limited partnerships and other alternative investments in order to further diversify its investment portfolio. These investment types comprised approximately 20% and 23% of the fair value of its invested assets as of December 31, 2008 and 2007, respectively. These security types are typically less liquid than direct investments in publicly traded fixed income or equity investments. However, generally these securities have higher yields over the life of the investment to compensate for the liquidity risk.
Includes fees associated with securities lending activities of $70, $97 and $0, respectively, for the years ended December 31, 2008, 2007 and 2006. The income from securities lending activities is included within fixed maturities. Also included are derivatives that qualify for hedge accounting under SFAS 133. These derivatives hedge fixed maturities.
• See Note 4 in the Notes to the Consolidated Financial Statements for a discussion of variable annuity hedge program gains and losses.
At December 31, 2008 and 2007, the Company had relationships with five and seven VIEs, respectively, where the Company was the primary beneficiary. The following table sets forth the carrying value of assets and liabilities, and the Company’s maximum exposure to loss on these consolidated VIEs.
At December 31, 2008 and 2007, limited partnerships represent investments in two hedge funds that are financed by issuing equity shares to investors, and are VIEs based on the lack of decision making ability held by the equity investors. The primary source of variability generated by these VIEs is the fund’s investment portfolio and that variability is passed to equity holders. The Company holds a majority interest in the equity of the funds and as a result will absorb the majority of the funds’ expected losses or residual returns and therefore is the primary beneficiary. Consolidated assets and liabilities are classified in other investments and other liabilities, respectively.
Maximum exposure to loss represents issuance costs that were incurred to establish the contingent capital facility.
The vintage year represents the year the underlying loans in the pool were originated.
Includes monoline insured securities with an amortized cost and fair value of $102 and $38, respectively, at December 31, 2008, and amortized cost and fair value of $102 and $93, respectively, at December 31, 2007. Additionally, approximately half of the student loan-backed exposure is guaranteed by the Federal Family Education Loan Program, with the remainder comprised of loans to prime-borrowers.
The following discussions focus on the key market risk exposures within Life and Property & Casualty portfolios.
The Company also uses reinsurance to manage the risk exposure for a majority of the death benefit riders issued in the U.S. and a portion of the death benefit riders issued in Japan.
One of the measures Property & Casualty uses to quantify its exposure to interest rate risk inherent in its invested assets is duration. The weighted average duration of the fixed maturity portfolio was 4.9 years as of December 31, 2008 and 2007.
As of December 31, 2008, the Company’s key sources of liquidity included $11.8 billion of cash and short-term investments (which includes securities with maturities of one year or less at the time of purchase), of which $3.4 billion was collateral received from, and held on behalf of, derivative counterparties and $341 was collateral pledged to derivative counterparties. The Company also held $6.0 billion of treasury securities, of which $402 had been pledged to derivative counterparties.
The Company registered with the CPFF in order to sell up to a maximum of $375 to the facility of which it has issued the full amount as of December 31, 2008. The Company’s commercial paper must be rated A-1/P-1/F1 by at least two ratings agencies to be eligible for the program. Moody’s, S&P and Fitch all recently downgraded our commercial paper rating, rendering the Company ineligible to sell additional commercial paper under the CPFF program going forward. As a result, we will be required to pay the maturing commercial paper issued under the CPFF program from existing sources of liquidity.
Preferred stock - On October 17, 2008, the Company issued in a private placement to Allianz SE, 6,048,387 shares of the Company’s Series D non-voting contingent convertible preferred stock. Effective January 9, 2009, Allianz SE converted the preferred shares into 24.2 million shares of common stock.
The agencies consider many factors in determining the final rating of an insurance company. One consideration is the relative level of statutory surplus necessary to support the business written. Statutory surplus represents the capital of the insurance company reported in accordance with accounting practices prescribed by the applicable state insurance department.