Hartford Life occupies office space in Simsbury, Connecticut, leased from a third party by Hartford Fire Insurance Company ("Hartford Fire"), an indirect subsidiary of The Hartford. Expenses associated with these offices are allocated on a direct and indirect basis to Hartford Life and its subsidiaries by Hartford Fire.
(2) For financial reporting purposes, the Company has treated certain amounts previously allocated by The Hartford Financial Services Group, Inc. ("The Hartford") to the Company's life insurance subsidiaries as Allocated Advances from parent. Cash received in respect of Allocated Advances from parent was used to support the growth of the life insurance subsidiaries. For further information see the "Debt" discussion in the Capital Resources and Liquidity section of the Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") and also see Note 7 of Notes to Consolidated Financial Statements.
(3) Stockholders' equity beginning December 31, 1994 reflects the adoption of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities". Under SFAS No. 115 the Company's fixed maturity investments are classified as "available for sale" and, accordingly, these investments are reflected at fair value with the corresponding impact included as a component of stockholders' equity.
(5) In 1997, the Company adopted SFAS No. 128, "Earnings per Share". Pro forma basic earnings per share is calculated based upon the weighted average number of common shares outstanding during the respective periods. Pro forma diluted earnings per share are determined on the assumption that stock options were exercised upon issuance. For periods prior to the Company's Initial Public Offering ("IPO") (May 22, 1997), outstanding shares are based upon 114 million shares of Class B Common Stock owned by The Hartford plus an assumed issuance of 11 million shares of Class A Common Stock (the number of shares that, based upon the IPO price and the underwriting discounts and expenses payable by the Company, would result in net proceeds equal to the excess of the amount of the February and April 1997 dividends over the 1996 earnings and the allocated advances from parent). For the period subsequent to the closing of the IPO, outstanding shares are based upon 114 million shares of Class B Common Stock owned by The Hartford plus approximately 26 million shares of Class A Common Stock owned by the public. See Note 9 of Notes to Consolidated Financial Statements for further explanation associated with earnings per share for periods prior to the IPO.
MANAGEMENT'S DISCUSSION AND ANALYSIS SHOULD BE READ IN CONJUNCTION WITH THE CONSOLIDATED FINANCIAL STATEMENTS AND RELATED NOTES BEGINNING ON PAGE.
Consolidated Results of Operations 13 Annuity 15 Individual Life Insurance 16 Employee Benefits 17 Guaranteed Investment Contracts 18 Reserves 19 Investments 19 Capital Markets Risk Management 21 Capital Resources and Liquidity 28 Regulatory Initiatives and Contingencies 31 Effect of Inflation 32
Net income totaled $306 in 1997 as compared to $24 in 1996 and $150 in 1995. The 1996 results include a $225 net loss related to GIC, which when excluded, results in an increase in 1997 net income of $57, or 23%, over comparable 1996 results. The improvement in earnings, excluding GIC, for both comparative periods is primarily related to increased fee income earned on the Annuity segment's growing block of separate account assets due to strong sales and significant market appreciation and earnings growth in the Individual Life Insurance segment and Group Insurance operation of the Employee Benefits segment. Partially offsetting improved earnings in the principal segments were increased losses of $19 in the Corporate Operation due to the increased capital allocated to the other segments to fund their growth and higher interest expense due to increased indebtedness in connection with the Company's Initial Public Offering ("IPO").
Management believes that it has developed and implemented strategies to maintain and enhance its position as a market leader within the financial services industry, to continue the Company's asset growth, and to maximize shareholder value. Hartford Life's strong market position in each of its primary businesses, coupled with the growth potential management believes exists in its markets, provides opportunities to increase sales of the Company's products and services as individuals increasingly save and plan for retirement, protect themselves and their families against disability or death and prepare their estates for an efficient transfer of wealth between generations.
Revenues increased $298, or 31%, to $1.3 billion in 1997 from $1.0 billion in 1996. This increase was principally the result of a $230 increase in premiums and other considerations, reflecting a substantial increase in aggregate fees earned due to the segment's growing block of separate account assets. The average separate account assets of this segment increased to $50.7 billion in 1997, from $37.2 billion in 1996 primarily due to sales of individual variable annuities of approximately $9.7 billion in 1997, as well as significant market appreciation. Also, Group Annuity sales were $820 in 1997, an increase of $186, or 29%, over 1996. In addition, net investment income grew $68, or 16%, to $502 in 1997 primarily due to growth in average general account assets which increased to $8.1 billion in 1997 from $7.2 billion in 1996 largely as a result of growth in the general account portion of the individual variable annuity products.
A 33% growth in average account value in 1997, coupled with a reduction in individual annuity operating expenses as a percentage of total individual annuity account value to 25 basis points in 1997 from 28 basis points in 1996, contributed to the increase in net income of $57, or 39%, to $202 from $145 in 1996.
Similar factors generated an increase in 1996, as compared with 1995, in revenues of $253, or 35%, average general account assets of $1.0 billion, or 16%, average separate account assets of $11.1 billion, or 42%, total benefits, claims and expenses of $197, or 36%, net income of $32, or 28%, and a reduction in individual annuity operating expenses as a percentage of total individual annuity account value to 28 basis points in 1996 from 31 basis points in 1995.
Total benefits, claims and expenses increased $19, or 5%, to $423 in 1997 from $404 in 1996. Total benefits, claims and expenses, excluding IEL, increased $28, or 7%, in 1997. This increase was primarily driven by an increase in amortization of DPAC of $24 in 1997 related to the growth in new variable life business.
Revenues decreased $189 to $2.6 billion in 1997, which was primarily attributable to the COLI business for which associated revenues decreased $380, or 28%, to $980 from $1.4 billion in 1996. The decrease in COLI revenues is primarily a result of the elimination of sales of leveraged COLI due to the HIPA Act of 1996, which phases out the deductibility of interest on policy loans under leveraged COLI by the end of 1998. Excluding COLI, this segment's revenues increased $191, or 13%, to $1.7 billion, in 1997, as compared to $1.5 billion, in 1996. This increase was driven by Group Insurance which had growth in premiums and other considerations of $209, or 16%, in 1997 as compared to 1996. The increased Group Insurance premiums were primarily attributable to group disability business, where premiums increased $115, or 21%, in 1997 and group life business, where premiums increased $72, or 17%, in 1997 as compared to 1996. Group Insurance sales increased $68, or 17%, to $480 in 1997 as compared to $412 in 1996. Included in the 1997 results are group disability and group life premiums of $88 and $16, respectively, as a result of the acquisition of a block of business from the United States branch of Confederation Life Insurance Company. The 1996 results include $78 of group disability premiums and $23 of group life premiums related to the acquisition of a block of business from North American Life Assurance Company of Toronto.
As a result of the factors mentioned above, and the impact of favorable mortality and morbidity results, Group Insurance net income grew $13, or 29%, to $58 in 1997. Within Specialty Insurance, net income related to COLI increased $1 in 1997 to $27. In addition, the results of Specialty Insurance were impacted by a $6 operating loss arising from the Company's international operations. This loss was primarily attributable to the Company's operations in Argentina. In November 1997, the Company replaced the Argentine management team with a new management team and purchased the remaining 40% interest in ITT Hartford Sudamericana Holding, S.A. from the local shareholders. The Argentine loss was primarily due to higher than anticipated costs and expenditures.
The GIC segment consists of guaranteed rate contract ("GRC") business that is supported by assets held in either the Company's general account or a guaranteed separate account and includes Closed Book GRC. Historically, a significant majority of these contracts were sold as general account contracts with fixed rates and fixed maturities. The Company decided in 1995, after a thorough review of its GRC business, that it would significantly de-emphasize general account GRC, choosing instead to focus its distribution efforts on other products sold through other segments and selling general account GRC primarily as an accommodation to customers. From 1992 to 1994, the GIC segment sold over $5 billion of GRC. In contrast, the GIC segment sold only $47 and $108 of general account GRC in 1997 and 1996, respectively. Consistent with management's expectations, the segment had no net income in 1997 and expects no material income or loss from the GIC segment in the future.
Closed Book GRC results in 1996 and 1995 were negatively affected by lower investment rates and earnings in the related investment portfolio (primarily consisting of collateralized mortgage obligations and mortgage backed securities) due to prepayments experienced in excess of assumed and historical levels. Closed Book GRC was also affected by the interest rate rise in 1994 when the duration of its assets lengthened relative to that of the liabilities.
In accordance with applicable insurance regulations under which Hartford Life operates, life insurance subsidiaries of the Company establish and carry as liabilities actuarially determined reserves which are calculated to meet Hartford Life's future obligations. Reserves for life insurance and disability contracts are based on actuarially recognized methods using prescribed morbidity and mortality tables in general use in the United States, which are modified to reflect Hartford Life's actual experience when appropriate. These reserves are computed at amounts that, with additions from premiums to be received and with interest on such reserves compounded annually at certain assumed rates, are expected to be sufficient to meet the Company's policy obligations at their maturities or in the event of an insured's death. Reserves include unearned premiums, premium deposits, claims reported but not yet paid, claims incurred but not reported and claims in the process of settlement. Reserves for assumed reinsurance are computed on bases essentially comparable to direct insurance reserves.
The primary investment objective of the Company's general account and guaranteed separate accounts is to maximize after-tax returns consistent with acceptable risk parameters (including the management of the interest rate sensitivity of invested assets relative to that of policyholder obligations). The Company does not have any financial instruments entered into for trading purposes. The Company is exposed to two primary sources of investment risk: credit risk, relating to the uncertainty associated with an obligor's continued ability to make timely payment of principal and interest, and interest rate risk, relating to the market price and/or cash flow variability associated with changes in market yield curves. See the Capital Markets Risk Management section of the MD&A for further discussion of the Company's approach to managing these investment risks.
During 1997, the Company continued to concentrate on reducing exposure to CMO's and reallocated the funds into public and private corporate bonds, commercial mortgage backed securities and other non-residential asset backed securities. In general, commercial MBS and asset backed securities, although subject to prepayment risk, are significantly less sensitive to changes in interest rates as compared to CMO's and MBS.
As of December 31, 1997 and 1996, approximately 22.6% and 10.3%, respectively, of the Company's fixed maturity portfolio was invested in private placement securities (including Rule 144A offerings). Private placement securities are generally less liquid than public securities; however, covenants for private placements are designed to mitigate the impact of such increased liquidity risk. Most of the private placement securities in the Company's portfolio are rated by nationally recognized rating organizations. For further discussion of the Company's investment credit policies, see the Capital Markets Risk Management section of the MD&A under "Credit Risk".
The table below summarizes Hartford Life's results for the past three years.
For the year ended December 31, 1996, before-tax net investment income increased $83 to $1.5 billion. The increase in net investment income was primarily due to an increase in policy loans, new business cash flow invested in fixed maturities and asset mix changes offset by asset sales and maturities in Closed Book GRC. Yields on average invested assets increased to 7.7% in 1996 from 7.4% in 1995. The increase in the before-tax yield was primarily due to the increase in policy loan yields offset by a reduction in yields on fixed maturities as a result of sales and maturities of higher yielding assets reinvested at lower average yields.
As of December 31, 1997, more than 99% of the fixed maturity portfolio, including guaranteed separate accounts, was invested in investment-grade securities.
The Company's general account and guaranteed separate account investment portfolios primarily consist of investment-grade, fixed maturity securities, including corporate bonds, asset backed securities, mortgage backed securities and collateralized mortgage obligations. The fair value of these and the Company's other invested assets fluctuates depending on the interest rate environment
As described above, the Company holds a significant fixed maturity portfolio which includes both fixed and variable rate features. The following table reflects the principal amounts of the fixed and variable rate fixed maturity portfolio at December 31, 1997, along with the respective weighted average coupons by estimated maturity year. Expected maturities differ from contractual maturities due to call or prepayment provisions. The weighted average coupon on variable rate securities is based upon spot rates as of December 31, 1997, and is primarily based upon the London Interbank Offered Rate ("LIBOR"). Callable bonds and notes are distributed to either call dates or maturity depending on which date produces the most conservative yield. Asset backed securities, collateralized mortgage obligations and mortgage backed securities are distributed to maturity year based on estimates of the rate of future prepayments of principal over the remaining life of the securities. These estimates are developed using prepayment speeds provided in broker consensus data. Such estimates are derived from prepayment speeds previously experienced at the interest rate levels projected for the underlying collateral. Actual prepayment experience may vary from these estimates. Financial instruments with certain leverage features have been included in each of the fixed maturity categories. These instruments have not been separately displayed because they were immaterial to the Company's investment portfolio.
The table below provides information on debt obligations and reflects principal cashflows and related weighted average interest rate by maturity year.
Indexed Asset Accumulation Vehicles -- Products in this category are similar to the fixed rate asset accumulation vehicles but require the Company to pay a rate that is determined by an external index. The amount and/or timing of cash flows will therefore vary based on the level of the particular index. The primary risks inherent in these products are similar to the fixed rate asset accumulation vehicles, with an additional risk that changes in the index may adversely affect profitability. Product examples include indexed-guaranteed investment contracts with an estimated duration of up to two years.
Long-term Pay Out Liabilities -- Products in this category are long-term in nature and may contain significant actuarial (including mortality and morbidity) pricing and cash flow risks. The cash flows associated with these policy liabilities are not interest rate sensitive but do vary based on the timing and amount of benefit payments. The primary risks associated with these products are that the benefits will exceed expected actuarial pricing and/or that the actual timing of the cash flows will differ from those anticipated resulting in an investment return lower than that assumed in pricing. Product examples include structured settlement contracts, on-benefit annuities (i.e., the annuitant is currently receiving benefits thereon) and long-term disability contracts. Contract duration is generally 6 to 10 years but, at times, exceeds 30 years.
For liabilities whose cash flows are not substantially affected by changes in interest rates ("fixed liabilities") and where investment experience is substantially absorbed by the Company, the sensitivity of the net economic value (discounted present value of asset cash flows less the discounted present value of liability cash flows) of those portfolios to 100 basis point shifts in interest rates is shown in the table below. These fixed liabilities represent approximately 60% of the Company's general and guaranteed separate account liabilities. The remaining liabilities generally allow the Company significant flexibility to adjust credited rates to reflect actual investment experience and thereby pass through a substantial portion of actual investment experience to the policyholder. The fixed liability portfolios are managed and monitored relative to defined objectives and are analyzed regularly by management for internal risk management purposes using scenario simulation techniques, and evaluated annually consistent with regulatory requirements.
The Company's total capitalization, excluding net unrealized capital gains (losses) on securities, net of tax, increased $469, or 22%, to $2.6 billion in 1997 and $185, or 9%, to $2.1 billion in 1996. In 1997, the increase was primarily the result of net income of $306 and net proceeds from the IPO of $687, which were partially offset by a net reduction in debt of $193 and dividends of $341. As a result of the IPO and debt restructuring described below, both the debt to equity and debt to capitalization ratios decreased to 37% and 27% as of December 31, 1997, respectively, from 72% and 42% as of December 31, 1996, respectively. The Company's commercial paper and senior debt are rated by independent rating agencies and the Company continues to maintain debt to capital ratios consistent with these ratings.
On February 10, 1997, the Company filed a registration statement, as amended, with the Securities and Exchange Commission relating to an IPO of the Company's Class A Common Stock. Pursuant to the IPO on May 22, 1997, the Company sold to the public 26 million shares at $28.25 per share and received net proceeds of $687. Of the proceeds, $527 was used to retire debt related to the Company's outstanding promissory notes and line of credit with the remaining $160 contributed to the Company's insurance subsidiaries to support growth in its core businesses.
On February 7, 1997, the Company declared a dividend of $1.2 billion payable to its direct parent, Hartford Accident and Indemnity Company ("HA&I"). As a result, the Company borrowed $1.1 billion on February 18, 1997, pursuant to a $1.3 billion line of credit, with interest payable at the two-month Eurodollar rate plus 15 basis points, which, together with a promissory note in the amount of $100, was paid as a dividend to HA&I on February 20, 1997. Of the $1.2 billion dividend, $893 constituted a repayment of the portion of The Hartford's third party indebtedness internally allocated, for financial reporting purposes, to the Company's life insurance subsidiaries (the "Allocated Advances"). In addition, on April 4, 1997 the Company declared and paid a dividend of $25 to its parent in the form of a promissory note. Subsequently, $12 of this note was forgiven in the form of a capital contribution from HA&I.
On February 14, 1997, the Company filed a shelf registration statement for the issuance and sale of up to $1.0 billion in the aggregate of senior debt securities, subordinated debt securities and preferred stock. On June 12, 1997, the Company issued $650 of unsecured redeemable long-term debt in the form of notes and debentures. Of this amount, $200 was in the form of 6.90% notes due June 15, 2004, $200 of 7.10% notes due June 15, 2007, and $250 of 7.65% debentures due June 15, 2027. Interest on each of the notes and debentures is payable semi-annually on June 15 and December 15, of each year, commencing December 15, 1997. The Company also issued $50 of short-term debt in the form of commercial paper. Of the proceeds from these issuances, $670 was used to retire the remaining balance on the $1.3 billion line of credit with the remainder being used for working capital and other general corporate purposes. Subsequently, the Company reduced the capacity of the line of credit from $1.3 billion to $250, which will be primarily used to support the commercial paper program.
In 1997, a total of $25 in dividends was paid to holders of Class A and Class B Common Stock. See "Debt" discussion above for 1997 dividend payments made prior to the IPO.
In 1998, Hartford Life expects to continue paying quarterly dividends on its common stock of $0.09 per share. Dividend decisions will be based on, and affected by, a number of factors, including the operating results and financial requirements of Hartford Life on a stand-alone basis and the impact of the regulatory restrictions discussed in the Liquidity Requirements section below.
The Company received dividends from its regulated life insurance subsidiaries of $68 in 1997.
The liquidity requirements of Hartford Life have been and will continue to be met by funds from operations as well as the issuance of commercial paper, debt securities and bank borrowings. The principal sources of funds are premiums and investment income as well as maturities and sales of invested assets. Hartford Life is a holding company which receives operating cash flow in the form of dividends from its subsidiaries, enabling it to service debt.
primarily due to declines in investment-type contracts and changes in debt and dividends paid to the Company's parent, which were partially offset by proceeds from the IPO.
During 1996, cash provided by operating activities increased from the prior year due primarily to continued growth in business operations. The changes in cash provided by or used for both investing and financing activities were primarily due to increases in investment-type contract maturities, partially offset by changes in allocated advances from the Company's parent. Operating cash flows in each of the past three years have been more than adequate to meet liquidity requirements.
As an insurance and financial services company, Hartford Life has thousands of individual and business customers that have insurance policies, annuities, mutual funds and other financial products from Hartford Life. Nearly all of these policies and products
contain date sensitive data, such as policy expiration dates, birth dates, premium payment dates, and the like. In addition, Hartford Life has business relationships with numerous third parties that affect virtually all aspects of Hartford Life's business, including, without limitation, suppliers, computer hardware and software vendors, insurance agents and brokers, securities broker-dealers and other distributors of financial products.
In addition, as part of its Year 2000 program, Hartford Life is identifying third parties with which it has significant business relations in order to attempt to assess the potential impact on Hartford Life of their Year 2000 issues and remediation plans. Hartford Life currently anticipates that it will substantially complete this evaluation by the end of 1998, and will conduct systems testing with certain third parties through 1999. Hartford Life does not have control over these third parties and, as a result, Hartford Life cannot currently determine to what extent future operating results may be adversely affected by the failure of these third parties to successfully address their Year 2000 issues.