2004 includes a $216 tax benefit related to agreement with the IRS on the resolution of matters pertaining to tax years prior to 2004. 2003 includes an after-tax charge of $1.7 billion related to the Company’s 2003 asbestos reserve addition, $40 of after-tax expense related to the settlement of a certain litigation dispute, $30 of tax benefit in Life primarily related to the favorable treatment of certain tax items arising during the 1996-2002 tax years, and $27 of after-tax severance charges in Property & Casualty. 2002 includes $76 tax benefit in Life, $11 after-tax expense in Life related to a certain litigation dispute and an $8 after-tax benefit in Life’s September 11 exposure.
Certain of the statements contained herein are forward-looking statements. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include estimates and assumptions related to economic, competitive and legislative developments. These forward-looking statements are subject to change and uncertainty which are, in many instances, beyond the Company’s control and have been made based upon management’s expectations and beliefs concerning future developments and their potential effect upon the Company. There can be no assurance that future developments will be in accordance with management’s expectations or that the effect of future developments on The Hartford will be those anticipated by management. Actual results could differ materially from those expected by the Company, depending on the outcome of various factors, including, but not limited to, those set forth in Part II, Item 1A, Risk Factors. These factors include: the difficulty in predicting the Company’s potential exposure for asbestos and environmental claims; the possible occurrence of terrorist attacks; the response of reinsurance companies under reinsurance contracts and the availability, pricing and adequacy of reinsurance to protect the Company against losses; changes in the stock markets, interest rates or other financial markets, including the potential effect on the Company’s statutory capital levels; the inability to effectively mitigate the impact of equity market volatility on the Company’s financial position and results of operations arising from obligations under annuity product guarantees; the Company’s potential exposure arising out of regulatory proceedings or private claims relating to incentive compensation or payments made to brokers or other producers and alleged anti-competitive conduct; the uncertain effect on the Company of regulatory and market-driven changes in practices relating to the payment of incentive compensation to brokers and other producers, including changes that have been announced and those which may occur in the future; the possibility of unfavorable loss development; the incidence and severity of catastrophes, both natural and man-made; stronger than anticipated competitive activity; unfavorable judicial or legislative developments; the potential effect of domestic and foreign regulatory developments, including those which could increase the Company’s business costs and required capital levels; the possibility of general economic and business conditions that are less favorable than anticipated; the Company’s ability to distribute its products through distribution channels, both current and future; the uncertain effects of emerging claim and coverage issues; a downgrade in the Company’s financial strength or credit ratings; the ability of the Company’s subsidiaries to pay dividends to the Company; the Company’s ability to adequately price its property and casualty policies; the ability to recover the Company’s systems and information in the event of a disaster or other unanticipated event; potential for difficulties arising from outsourcing relationships; potential changes in Federal or State tax laws; and other factors described in such forward-looking statements.
The Hartford is a diversified insurance and financial services company with operations dating back to 1810. The Company is headquartered in Connecticut and is organized into two major operations: Life and Property & Casualty, each containing reporting segments. Within the Life and Property & Casualty operations, The Hartford conducts business principally in ten operating segments. Additionally, Corporate primarily includes the Company’s debt financing and related interest expense, as well as certain capital raising activities and purchase accounting adjustments.
Many of the principal factors that drive the profitability of The Hartford’s Life and Property & Casualty operations are separate and distinct. Management considers this diversification to be a strength of The Hartford that distinguishes the Company from many of its peers. To present its operations in a more meaningful and organized way, management has included separate overviews within the Life and Property & Casualty sections of MD&A. For further overview of Life’s profitability and analysis, see page 51. For further overview of Property & Casualty’s profitability and analysis, see page 70.
The Company has identified the following estimates as critical in that they involve a higher degree of judgment and are subject to a significant degree of variability: property and casualty reserves for unpaid losses and loss adjustment expenses, net of reinsurance; Life deferred policy acquisition costs and present value of future profits associated with variable annuity and other universal life-type contracts; the evaluation of other-than-temporary impairments on investments in available-for-sale securities; the valuation of guaranteed minimum withdrawal benefit derivatives; pension and other postretirement benefit obligations; and contingencies relating to corporate litigation and regulatory matters. In developing these estimates management makes subjective and complex judgments that are inherently uncertain and subject to material change as facts and circumstances develop. Although variability is inherent in these estimates, management believes the amounts provided are appropriate based upon the facts available upon compilation of the financial statements.
The Hartford establishes property and casualty reserves to provide for the estimated costs of paying claims under insurance policies written by the Company. These reserves include estimates for both claims that have been reported and those that have been incurred but not reported, and include estimates of all expenses associated with processing and settling these claims. Estimating the ultimate cost of future losses and loss adjustment expenses is an uncertain and complex process. This estimation process is based largely on the assumption that past developments are an appropriate predictor of future events and involves a variety of actuarial techniques that analyze experience, trends and other relevant factors. Reserve estimates can change over time because of unexpected changes in the external environment. Potential external factors include (1) changes in the inflation rate for goods and services related to covered damages such as medical care, hospital care, auto parts, wages and home repair, (2) changes in the general economic environment that could cause unanticipated changes in the claim frequency per unit insured, (3) changes in the litigation environment as evidenced by changes in claimant attorney representation in the claims negotiation and settlement process, (4) changes in the judicial environment regarding the interpretation of policy provisions relating to the determination of coverage and/or the amount of damages awarded for certain types of damages, (5) changes in the social environment regarding the general attitude of juries in the determination of liability and damages, (6) changes in the legislative environment regarding the definition of damages and (7) new types of injuries caused by new types of injurious exposure: past examples include breast implants, lead paint and construction defects. Reserve estimates can also change over time because of changes in internal company operations. Potential internal factors include (1) periodic changes in claims handling procedures, (2) growth in new lines of business where exposure and loss development patterns are not well established or (3) changes in the quality of risk selection in the underwriting process. In the case of assumed reinsurance, all of the above risks apply. In addition, changes in ceding company case reserving and reporting patterns can create additional factors that need to be considered in estimating the reserves. Due to the inherent complexity of the assumptions used, final claim settlements may vary significantly from the present estimates, particularly when those settlements may not occur until well into the future.
The Company provides an allowance for uncollectible reinsurance, reflecting management’s best estimate of reinsurance cessions that may be uncollectible in the future due to reinsurers’ unwillingness or inability to pay. The Company analyzes recent developments in commutation activity between reinsurers and cedants, recent trends in arbitration and litigation outcomes in disputes between reinsurers and cedants and the overall credit quality of the Company’s reinsurers. Where its contracts permit, the Company secures future claim obligations with various forms of collateral, including irrevocable letters of credit, secured trusts, funds held accounts and group-wide offsets. The allowance for uncollectible reinsurance was $412 as of December 31, 2006, including $294 related to Other Operations and $118 related to Ongoing Operations.
The Hartford, like other insurance companies, categorizes and tracks its insurance reserves for its segments by “line of business”, such as property, auto physical damage, auto liability, commercial multi-peril package business, workers’ compensation, general liability professional liability and fidelity and surety. Furthermore, The Hartford regularly reviews the appropriateness of reserve levels at the line of business level, taking into consideration the variety of trends that impact the ultimate settlement of claims for the subsets of claims in each particular line of business. In addition, within the Other Operations segment, the Company has reserves for asbestos and environmental (A&E) claims. Adjustments to previously established reserves, which may be material, are reflected in the operating results of the period in which the adjustment is determined to be necessary. In the judgment of management, information currently available has been properly considered in the reserves established for losses and loss adjustment expenses. Incurred but not reported (IBNR) reserves represent the difference between the estimated ultimate cost of all claims and the actual reported loss and loss adjustment expenses (“reported losses”). Reported losses represent cumulative loss and loss adjustment expenses paid plus case reserves for outstanding reported claims. Company actuaries evaluate the total reserves (IBNR and case reserves) on an accident year basis. An accident year is the calendar year in which a loss is incurred, or, in the case of claims-made policies, the calendar year in which a loss is reported.
For short-tail lines of business, emergence of paid loss and case reserves is credible and likely indicative of ultimate losses. For long-tail lines of business, emergence of paid losses and case reserves is less credible in the early periods and, accordingly may not be indicative of ultimate losses.
Company reserving actuaries, who are independent of the business units, regularly review reserves for both current and prior accident years using the most current claim data. These reserve reviews incorporate a variety of actuarial methods and judgments and involve rigorous analysis. Most non-A&E reserves are reviewed fully each quarter, including loss reserves for property, auto physical damage, auto liability, package business, workers’ compensation, most general liability, professional liability and fidelity and surety. Other non-A&E reserves are reviewed semi-annually (twice per year) or annually. These include, but are not limited to, reserves for allocated loss adjustment expenses, assumed reinsurance, latent exposures such as construction defects, unallocated loss adjustment expense and all other non-A&E exposures within Other Operations. For reserves that are reviewed semi-annually and annually, management monitors the emergence of paid and reported losses in the intervening quarters to either confirm that its estimate of ultimate losses should not change or, if necessary, perform a reserve review to determine whether the reserve estimate should change.
For most lines of business, a variety of actuarial methods are reviewed and the actuaries select methods and specific assumptions appropriate for each line of business based on the current circumstances affecting that line of business. These selections incorporate input, as judged by the reserving actuaries to be appropriate, from claims personnel, pricing actuaries and operating management on
Expected Loss Ratio techniques are useful for early periods of maturity on long-tailed lines of business, where very little paid or reported loss information is available.
For one sub-set of professional liability business, management estimates frequency, not through historical claim count development, but through an analysis of the securities class actions filed and policy listings
Auto Liability - Personal Lines. For auto liability, and bodily injury in particular, the Company performs a greater number of techniques than it does for property and auto physical damage, including paid and reported development, and several frequency / severity approaches. The Company generally uses the reported development method for older accident years and the frequency / severity methods for more recent accident years. Recent periods are heavily influenced by changes in case reserve practices and changing disposal rates, and the frequency / severity techniques are not affected as much by these changes.
The following discussion includes disclosure of possible variation from current estimates of loss reserves due to a change in certain key assumptions. Each of the impacts described below is estimated individually, without consideration for any correlation among key assumptions or among lines of business. Therefore, it would be inappropriate to take each of the amounts described below and add them together in an attempt to estimate volatility for the Company’s reserves in total. The estimated variation in reserves due to changes
Recorded reserves for workers’ compensation, net of reinsurance, are $5.7 billion across Business Insurance and Specialty Commercial. The two most important assumptions for workers’ compensation reserves are loss development factors and loss cost trends, particularly medical cost inflation. Loss development patterns are dependent on medical cost inflation. Approximately half of the workers’ compensation net reserves are related to future medical costs. A review of National Council on Compensation Insurance (“NCCI”) data suggests that the annual growth in industry medical claim costs has varied from -2% to +12% since 1991. This data shows that medical inflation has been highly variable over the past decade. Across the entire workers’ compensation reserve base, a 1 point change in calendar year medical inflation would change the estimated net reserve by $600, in either direction.
Recorded reserves for auto liability, net of reinsurance, are $2.2 billion across all lines, $1.5 billion of which is in Personal Lines. Personal auto liability reserves are shorter-tailed than other lines of business (such as workers’ compensation) and, therefore, less volatile. However, the size of the reserve base means that future changes in estimates could be material to the Company’s results of operations in any given period. The key assumption for Personal Lines auto liability is the annual loss cost trend, particularly the severity trend component of loss costs. A review of Insurance Services Office (“ISO”) data suggests that annual growth in industry severity since 1999 has varied from +1% to +6%. The ISO data shows recent severity changes to be in the middle of this range. A 2.5 point change in assumed annual severity is within historical variation for the industry and for the Company. A 2.5 point change in assumed annual severity for the two most recent accident years would change the estimated net reserve need by $70, in either direction. Assumed annual severity for accident years prior to the two most recent accident years is likely to have minimal variability.
Recorded reserves for general liability, net of reinsurance, are $2.1 billion across Business Insurance and Specialty Commercial. Reported loss development patterns are a key assumption for this line of business, particularly for more mature accident years. Historically, assumptions on reported loss development patterns have been impacted by, among other things, emergence of new types of claims (e.g. construction defect claims) or a shift in the mixture between smaller, more routine claims and larger, more complex claims. The Company has reviewed the historical variation in reported loss development patterns. If the reported loss development patterns change by 10%, a change that is within historical variation, the estimated net reserve need would change by $300, in either direction. A 10% change in reported loss development patterns is within historical variation, as measured by the variation around the average development factors as reported in statutory accident year reports.
Similarly, a ground-up exposure review approach is used to establish environmental reserves. The Company’s evaluation of its insureds’ estimated liabilities for environmental claims involves consideration of several factors, including historical values of similar claims, the number of sites involved, the insureds’ alleged activities at each site, the alleged environmental damage at each site, the
uncertainties, which are detailed in Note 12 of Notes to Consolidated Financial Statements. Due to these uncertainties, further developments could cause the Company to change its estimates and ranges of its asbestos and environmental reserves, and the effect of these changes could be material to the Company’s consolidated operating results, financial condition and liquidity.
Life policy acquisition costs include commissions and certain other expenses that vary with and are primarily associated with acquiring business. Present value of future profits (“PVFP”) is an intangible asset recorded upon applying purchase accounting in an acquisition of a life insurance company. Deferred policy acquisition costs and the present value of future profits intangible asset are amortized in the same way. Both are amortized over the estimated life of the contracts acquired. Within the following discussion, deferred policy acquisition costs and the present value of future profits intangible asset will be referred to as “DAC”. At December 31, 2006 and December 31, 2005, the carrying value of the Company’s Life DAC asset was $9.1 billion and $8.6 billion, respectively. Of those amounts, $4.4 billion and $4.5 billion related to individual variable annuities sold in the U.S., $1.4 billion and $1.2 billion related to individual variable annuities sold in Japan and $2.1 billion and $1.9 billion related to universal life-type contracts sold by Individual Life.
Each year, the Company develops future EGPs for the products sold during that year. The EGPs for products sold in a particular year are aggregated into cohorts. Future gross profits are projected for the estimated lives of the contracts, and are, to a large extent, a function of future account value projections for individual variable annuity products and to a lesser extent for variable universal life products. The projection of future account values requires the use of certain assumptions. The assumptions considered to be important in the projection of future account value, and hence the EGPs, include separate account fund performance, which is impacted by separate account fund mix, less fees assessed against the contract holder’s account balance, surrender and lapse rates, interest margin, and mortality. The assumptions are developed as part of an annual process and are dependent upon the Company’s current best estimates of future events. The Company’s current aggregate separate account return assumption is approximately 8.0% (after fund fees, but before mortality and expense charges) for U.S. products and 5.0% (after fund fees, but before mortality and expense charges) in aggregate for all Japanese products, but varies from product to product. The overall actual return generated by the separate account is dependent on several factors, including the relative mix of the underlying sub-accounts among bond funds and equity funds as well as equity sector weightings. The Company’s overall U.S. separate account fund performance has been reasonably correlated to the overall performance of the S&P 500 Index (which closed at 1,418 on December 29, 2006), although no assurance can be provided that this correlation will continue in the future.
During the fourth quarter of 2006, the Company refined its estimation process for DAC amortization and completed a comprehensive study of assumptions. The Company plans to complete a comprehensive assumption study and refine its estimate of future gross profits in the third quarter of 2007 and at least annually thereafter.
Upon completion of an assumption study, the Company revises its assumptions to reflect its current best estimate, thereby changing its estimate of projected account values and the related EGPs in the DAC, sales inducement and unearned revenue reserve amortization models as well as the guaranteed minimum death and income benefit reserving models. The cumulative balance of DAC as well as sales inducement assets, unearned revenue reserves and guaranteed minimum death and income benefit reserves are adjusted with an offsetting benefit or charge to income to reflect such changes in the period of the revision, a process known as “unlocking”. An unlock that results in an after-tax benefit generally occurs as a result of actual experience or future expectations being favorable compared to previous estimates of account value growth and EGPs. An unlock that results in an after-tax charge generally occurs as a result of actual experience or future expectations being unfavorable compared to previous estimates of account value growth and EGPs.
As a result of the unlock, death benefit reserves, in the Retail Products Group, increased $294, offset by an increase of $279 in reinsurance recoverables.
The Company performs sensitivity analyses with respect to the effect certain assumptions have on our DAC balances. Each of the sensitivities illustrated below are estimated individually, without consideration for any correlation among the key assumptions. Therefore, it would be inappropriate to take each of the sensitivity amounts below and add them together in an attempt to estimate volatility for the respective DAC balances in total. The following tables depict the estimated sensitivities for U.S. variable annuities and Japan variable annuities DAC:
These sensitivities do not include the estimated impacts on sales inducement assets, unearned revenue reserves and death and income benefit reserves and are not reflective of any future refinements to the Company’s gross profit estimation process. The Company’s DAC models assume that separate account returns are earned linearly and that lapses occur linearly (except for certain dynamic lapse features) throughout the year. Similarly, the sensitivities assume that differential separate account and lapse rates are linear and parallel and persist throughout a full 12 month period. These sensitivities are not perfectly linear nor perfectly symmetrical for increases and decreases and are most accurate for small changes in assumptions. As such, extrapolating results over a wide range will decrease the accuracy of the sensitivities’ predictive ability. Sensitivity results are, in part, based on the current “in-the-moneyness” of various guarantees offered with the products. Future market conditions could significantly change the sensitivity results.
An “unlock” only revises EGPs to reflect current best estimate assumptions. The Company must also test the aggregate recoverability of the DAC asset by comparing the amounts deferred to the present value of total EGPs. In addition, the Company routinely stress tests its DAC asset for recoverability against severe declines in its separate account assets, which could occur if the equity markets experienced a significant sell-off, as the majority of policyholders’ funds in the separate accounts is invested in the equity market. As of December 31, 2006, the Company believed U.S. individual and Japan individual variable annuity separate account assets could fall, through a combination of negative market returns, lapses and mortality, by at least 53% and 70%, respectively, before portions of its DAC asset would be unrecoverable.
income. As markets change, mature and evolve and actual policyholder behavior emerges, management continually evaluates the appropriateness of its assumptions. In addition, management regularly evaluates the valuation model, incorporating emerging valuation techniques where appropriate, including drawing on the expertise of market participants and valuation experts. Upon adoption of Statement of Financial Accounting Standard No. 157, “Fair Value Measurements”, (SFAS 157) the Company will revise many of the assumptions used to value GMWB. See Note 1 in Notes to Consolidated Financial Statements for a discussion of SFAS 157.
The evaluation of impairments is a quantitative and qualitative process, which is subject to risks and uncertainties and is intended to determine whether declines in the fair value of investments should be recognized in current period earnings. The risks and uncertainties include changes in general economic conditions, the issuer’s financial condition or near term recovery prospects and the effects of changes in interest rates. The Company has a security monitoring process overseen by a committee of investment and accounting professionals (“the committee”) that identifies securities that, due to certain characteristics, as described below, are subjected to an enhanced analysis on a quarterly basis.
For certain securitized financial assets with contractual cash flows including asset-backed securities, (“ABS”), EITF Issue No. 99-20 requires the Company to periodically update its best estimate of cash flows over the life of the security. If the fair value of a securitized financial asset is less than its cost or amortized cost and there has been a decrease in the present value of the estimated cash flows since the last revised estimate, considering both timing and amount, an other-than-temporary impairment charge is recognized. The Company also considers its intent and ability to retain a temporarily depressed security until recovery. Estimating future cash flows is a quantitative and qualitative process that incorporates information received from third party sources along with certain internal assumptions and judgments regarding the future performance of the underlying collateral. In addition, projections of expected future cash flows may change based upon new information regarding the performance of the underlying collateral.
The Company determines the expected long-term rate of return assumption based on an analysis of the Plan portfolio’s historical compound rates of return since 1979 (the earliest date for which comparable portfolio data is available) and over rolling 5 year and 10 year periods, balanced along with future long-term return expectations that generally anticipate an investment mix of 60% equity securities and 40% fixed income securities. The Company selected these periods, as well as shorter durations, to assess the portfolio’s volatility, duration and total returns as they relate to pension obligation characteristics, which are influenced by the Company’s workforce demographics. In addition, the Company also applies market return assumptions, utilized in Life’s DAC analysis, to an investment mix that generally anticipates 60% equity securities and 40% fixed income securities to derive an expected long-term rate of return. Based upon this analysis, the portfolio’s historical rates of return and management’s outlook with respect to market returns and the planned asset mix, management maintained the long-term rate of return assumption at 8.00% as of December 31, 2006. This assumption is used to determine the Company’s 2007 expense. The long-term rate of return assumption at December 31, 2005 was 8.00%.
To illustrate the impact of these assumptions on annual pension and other postretirement expense for 2007 and going forward, a 25 basis point change in the discount rate will increase/decrease pension and other postretirement expense by approximately $15 and a 25 basis point change in the long-term asset return assumption will increase/decrease pension and other postretirement expense by approximately $9.
Life’s net income increased $237 primarily due to growth in assets under management resulting from market growth and strong sales along with higher earned premiums. Also contributing to Life’s increased net income were the following:
A decrease in net investment income of $1.7 billion, driven primarily by a $2.0 billion decrease in net investment income on the Company’s equity securities, held for trading. The underlying fund performance of assets supporting the Company’s Japanese variable annuity business was not as strong in 2006 as compared to 2005, resulting in a decrease in net investment income from equity securities, held for trading. The increase in net investment income on securities available-for-sale and other of $307 was primarily due to income earned on higher average invested assets base, increase in interest rates and a change in asset mix to a greater investment in mortgage loans and limited partnerships.
The improvement in underwriting results for Other Operations was primarily due to a reduction in net unfavorable prior accident year loss reserve development. The increase in net investment income was primarily due to higher assets under management resulting from increased cash flows from underwriting, higher investment yields on fixed maturity investments and an increase in income from limited partnership investments.
To a large extent, the future profitability of Life will depend on Life’s ability to increase assets under management across all businesses and maintain its investment spread on general account products. Management believes the market for retirement products continues to expand as individuals increasingly save and plan for retirement. Demographic trends suggest that as the “baby boom” generation matures, a significant portion of the United States population will allocate a greater percentage of their disposable incomes to saving for their retirement years due to uncertainty surrounding the Social Security system and increases in average life expectancy.
Competition has increased substantially in the variable annuities market with most major variable annuity writers now offering living benefits such as GMWB riders. The highly competitive environment in this market and the success of these riders and any new product will ultimately be based on customer acceptance. Future sales and revenues will be largely dependent on the Company’s ability to attract new customers and to retain contract holder’s account values in existing or new product offerings as they reach the end of the surrender charge period of their contract. The Company’s strategy in 2007 revolves around introducing new products and continually evaluating the portfolio of products currently offered. As a result, sales may be lower than the level of sales attained in 2006 when considering the highly competitive environment, the risk of disruption on new sales from product offering changes, customer acceptance of new products and the effect on the distribution related to product offering changes.
In 2007, Life will begin selling mutual fund based products in the 401(k) market that will increase Life’s ability to grow assets under management in the medium size 401(k) market. Life will also be selling mutual fund based products in the 403(b) market as it looks to grow assets in a highly competitive environment. Disciplined expense management will continue to be a focus; however, as Life looks to expand its reach in these markets, additional investments in service and technology will occur.
IIP has launched new products in 2006 to provide solutions that deal specifically with longevity risk, and will continue to introduce products in 2007. Longevity risk is defined as the likelihood of an individual outliving their assets. IIP is also designing innovative solutions to corporation’s defined benefit liabilities. The focus of the PPLI business is variable PPLI products to fund non-qualified benefits or other post employment benefit liabilities. The market served by PPLI is subject to extensive legal and regulatory review that could have an adverse effect on its business.
Individual Life continues to focus on its core distribution model of sales through financial advisors, while also pursuing growth opportunities through other distribution sources such as independent life professionals. Variable universal life sales and account values remain sensitive to equity market levels and returns. Individual Life continues to face uncertainty surrounding estate tax legislation, a high level of competition from other life insurance providers, reduced availability and higher price of reinsurance, and the current regulatory environment related to reserving for universal life products with no-lapse guarantees, which may negatively affect Individual Life’s future earnings.
Management continues to be optimistic about growth potential of the retirement savings market in Japan. Several trends such as an aging population, longer life expectancies and declining birth rate leading to a smaller number of younger workers to support each retiree have resulted in greater need for an individual to plan and adequately fund retirement savings.
Competition has continued to increase in the Japanese market with the most significant competition the result of the strengthening of domestic competitors. This competition has resulted in changes in key distribution relationships that have negatively impacted current year deposits and could potentially impact future deposits. The Company continues to focus its efforts on strengthening our distribution relationships and improving our wholesaling and servicing efforts. In addition, the Company continues to evaluate product designs that meet customers’ needs while maintaining prudent risk management. In the first quarter 2007, the Company is launching a new variable annuity product to complement its existing variable annuity product offerings. The success of the Company’s enhanced product offering will ultimately be based on customer acceptance in an highly competitive environment.
In 2007, management expects continued growth in written and earned premiums in Business Insurance and Personal Lines and a return to written premium growth in Specialty Commercial.
Within Business Insurance, management expects written premium to grow 2% to 5% in 2007, comprised of 4% to 7% growth in small commercial and no growth in middle market. Growth in small commercial is expected to primarily come from an increase in agency appointments, better segmented pricing and improved product features. As competition among P&C insurers puts downward pressure on prices in Business Insurance, the Company’ may non-renew some accounts or decide to write less new business.
Within Specialty Commercial, management expects written premium growth of 3% to 6% in 2007, driven by increases in property, casualty and professional liability, fidelity and surety.
Current accident year catastrophe losses in 2006, at 1.9 percent of Ongoing Operations’ earned premium, were lower than the long-term historical average. While catastrophe losses vary significantly from year to year and are unpredictable, management has assumed that catastrophe losses in 2007 will be closer to 3.0% to 3.5% of earned premium. Despite a mild hurricane season and a relatively low level of catastrophe losses in 2006, the Company will continue to manage its exposure to catastrophe losses through the ongoing assessment of its risk, disciplined underwriting and the use of reinsurance and other risk transfer alternatives, as appropriate. As of January 1, 2007, the Company’s retention under its principal property catastrophe reinsurance program was increased from $175 to $250 per catastrophe event, although under certain conditions, the Company’s loss retention from a single event could be reduced to
Life charges direct operating expenses to the appropriate segment and allocates the majority of indirect expenses to the segments based on an intercompany expense arrangement. Intersegment revenues primarily occur between Life’s Other category and the operating segments. These amounts primarily include interest income on allocated surplus, interest charges on excess separate account surplus, the allocation of certain net realized capital gains and losses and the allocation of credit risk charges.
Life’s profitability in its variable annuity, mutual fund and, to a lesser extent, variable universal life businesses, depends largely on the amount of the contract holder account value or assets under management on which it earns fees and the level of fees charged. Changes
in account value or assets under management are driven by two main factors: net flows, which measure the success of the Company’s asset gathering and retention efforts, and the market return of the funds, which is heavily influenced by the return realized in the equity markets. Net flows are comprised of new sales and other deposits less surrenders, death benefits, policy charges and annuitizations of investment type contracts, such as: variable annuity contracts. In the mutual fund business, net flows are known as net sales. Net sales are comprised of new sales less redemptions by mutual fund customers. Life uses the average daily value of the S&P 500 Index as an indicator for evaluating market returns of the underlying account portfolios in the United States. Relative profitability of variable products is highly correlated to the growth in account values or assets under management since these products generally earn fee income on a daily basis. An immediate significant downturn in the financial markets could result in a charge against deferred acquisition costs. See the Critical Accounting Estimates section of the MD&A for further information on DAC unlocks.
Changes in market value were based on market conditions and investment management performance in 2005.
Japan annuity account values and net flows grew as a result of strong deposits and significant market growth in 2005.
Certain investment type contracts such as fixed annuities and other spread-based contracts generate deposits that the Company collects and invests to earn investment income. These investment type contracts use this investment income to credit the contract holder an amount of interest specified in the respective contract; therefore, management evaluates performance of these products based on the spread between net investment income and interest credited. Net investment income and interest credited can be volatile period over period, which can have a significant positive or negative effect on the operating results of each segment. The volatile nature of net investment income is driven primarily by prepayments on securities and earnings on partnership investments. In addition, insurance type contracts such as those sold by Group Benefits (discussed below) collect and invest premiums to pay for losses specified in the particular insurance contract and those sold by Institutional, collect and invest premiums for certain life contingent benefits. For these insurance products the investment spread is reflected in net investment income and policyholder benefits. Finally, the return of the funds underlying the Japan variable annuities is reported in net investment income in Other with an offsetting amount credited to those contractholders in interest credited. The net investment income and interest credited from the Japan variable annuities will be volatile due to the volatile performance of the funds and, similar to returns on U.S. separate account assets, accrues to the benefit of the policyholders, not the Company.
Net investment income and interest credited on general account assets in Retail declined due to a decline in general account assets as a result of surrenders on market value adjusted (“MVA”) fixed annuity products at the end of the guarantee period. Also contributing to the decline in general account assets were transfers within variable annuity products from the general account to separate account funds.
Net investment income and interest credited on general account assets in Institutional increased primarily due to an increase in general account assets as a result of sales in the Company’s funding agreement backed Investor Notes program.
Net investment income and interest credited in Other decreased due to a decrease in the mark-to-market effects of trading account securities supporting the Japanese variable annuity business.
Net investment income and interest credited on general account assets in Retail declined due to lower assets under management from surrenders on market value adjusted (“MVA”) fixed annuity products at the end of their guarantee period.
In addition to interest credited on general account assets, Institutional also had other contract benefits for limited payment contracts of $292 and $279 for the years ended December 31, 2005 and 2004, respectively. These amounts need to be deducted from net investment income to understand the net interest spread on these businesses because these contracts are accounted for as traditional insurance products.
The persistency rate represents group life and disability business sold to employer groups, which accounts for, on average, 72% to 75% of in-force premiums.
Earned premiums and other considerations include $12, $27 and $4 in buyout premiums for the years ended December 31, 2006, 2005 and 2004 respectively. The increase in premiums and other considerations for Group Benefits in 2006 compared to 2005 was driven by sales growth of 11%. The increase in premiums and other considerations for Group Benefits in 2005 compared to 2004 was driven by sales growth of 23%.
The second major category is insurance operating costs and expenses, which is commonly expressed in a ratio of a revenue measure depending on the type of business. The third category is the amortization of deferred policy acquisition costs and the present value of
The ratio of individual annuity DAC amortization increased due to the DAC unlock in 2006. Excluding the DAC unlock, the ratio was 50.8%, slightly higher than 2005 and consistent with 2004.
Individual Life death benefits increased 4% in 2006 primarily due to a larger insurance inforce. Individual Life Insurance expenses, net of deferrals increased 7% for 2006 consistent with the growth of life insurance inforce. Death benefits decreased in 2005 as compared to 2004 due to favorable mortality in 2005.
The Group Benefits loss ratio, excluding buyouts, for 2006 decreased due to favorable mortality experience, partially offset by unfavorable morbidity experience. Loss ratios experience volatility in period over period comparisons due to fluctuations in mortality and morbidity experience.
The Group Benefits loss ratio, excluding buyouts, for 2005, decreased due to favorable mortality and morbidity experience, as compared to 2004.
The International DAC amortization ratio decreased due to the DAC unlock in 2006. Excluding the DAC unlock, the ratio was down slightly to 38.8%.
The change in Life’s net income was due to the following:
During 2005, the Company recorded an after-tax expense of $46, related to the termination of a provision of an agreement with a mutual fund distribution partner of the Company’s retail mutual funds.
The effective tax rate was 21% for Life operations for the current year as compared to an effective tax rate of 13% for Life operations for the respective prior year period. The 2005 higher effective tax rate was attributed to the absence of the 2004 tax benefit of $190 offset by an increase in the DRD tax benefit of $50.
The effective tax rate for 2006, 2005 and 2004 was 23%, 21% and 13%, respectively. The principal causes of the difference between the effective rate and the U.S. statutory rate of 35% for 2006 and 2005 were tax-exempt interest earned on invested assets and the separate account dividends received deduction (“DRD”). For 2004, the principal causes were tax exempt interest earned on invested assets, the separate account DRD and the tax benefit associated with the settlement of the 1998-2001 IRS audit. For additional information, see Note 13 of Notes to Consolidated Financial Statements.
[2] Includes policyholders’ balances for investment contracts and reserve for future policy benefits for insurance contracts.
Net income in the Retail segment for the year ended December 31, 2006 increased primarily due to improved fee income partially offset by higher amortization of DAC resulting from the DAC unlock during the fourth quarter of 2006. Higher fee income was driven by higher assets under management resulting primarily from market growth. A more expanded discussion of earnings can be found below:
The increase in fee income in the variable annuity business for the year ended December 31, 2006 was mainly a result of growth in average account values. The year-over-year increase in average account values of 7% or $7.4 billion can be attributed to market appreciation of $12.2 billion during 2006. Variable annuities had net outflows of $3.2 billion for the year ended December 31, 2006 compared to net outflows of $881 for the year ended December 31, 2005. Net outflows from additional surrender activity were due to increased deposits competition, particularly from competitors offering variable annuity products with guaranteed living benefits.
Benefits, losses and loss adjustment expenses have decreased for the year ended December 31, 2006 due to a decline in interest credited as a result of fixed annuity outflows which decreased fixed annuity account values.
Higher amortization of DAC resulted from the DAC unlock during the fourth quarter of 2006. The earnings impact of the DAC unlock was an increase to amortization of $72 after-tax. (For further discussion, see DAC Unlock Analysis in the Critical Accounting Estimates section of the MD&A).
The effective tax rate remained steady for the year ended December 31, 2006 compared to the prior year.
Mutual fund fee income increased for the year ended December 31, 2005 due to increased assets under management driven by market appreciation of $2.6 billion and net deposits of $1.3 billion. Despite the increase in assets under management, the amount of net deposits has declined for the year ended December 31, 2005 compared to the prior year. This decrease is attributed to market competition and higher redemption amounts.
Benefits and losses and loss adjustment expenses have decreased for the year ended December 31, 2005 due to an increase in reserves in 2004 related to the acquisition of a block of acquired business from London Pacific Life and Annuity Company in liquidation. The increase in reserves of $62 was offset by an equivalent increase in earned premium. Also contributing to the decrease in benefits expense is a decrease in interest credited as older fixed annuity MVA business with higher credited rates matures and either lapses or renews at lower credited rates.
Individual annuity deposits of $13.1 billion in 2006 increased 14% compared to prior year levels of $11.5 billion. Significantly contributing to the Company’s variable annuity deposits since August of 2002 are GMWB riders. The highly competitive environment in this market and the success of these riders and new product development will ultimately be based on customer acceptance. Future
The growth and profitability of the individual annuity and mutual fund businesses is dependent to a large degree on the performance of the equity markets. In periods of favorable equity market performance, Life may experience stronger deposits and higher net flows, which will increase assets under management and thus increase fee income earned on those assets. In addition, higher equity market levels will generally reduce certain costs to Life of individual annuities, such as guaranteed minimum death benefit (“GMDB”) and GMWB benefits. Conversely, weak equity markets may dampen deposits activity and increase surrender activity causing declines in assets under management and lower fee income. Such declines in the equity markets will also increase the cost to Retail of GMDB and GMWB benefits associated with individual annuities. Life attempts to mitigate some of the volatility associated with the GMDB and GMWB benefits using reinsurance or other risk management strategies, such as hedging. Future net income for Life will be affected by the effectiveness of the risk management strategies Life has implemented to mitigate the net income volatility associated with the GMDB and GMWB benefits of variable annuity contracts. For spread-based products sold in the Life segment, the future growth will depend on the ability to earn targeted returns on new business given competition, retention of account values in the fixed annuity business when the contract holder’s rate guarantee expires and the future interest rate environment.
Retail mutual fund net sales of $4.5 billion to $5.5 billion
Individual annuity return on assets of 55 to 57 basis points
Other retail return on assets of 13 to 15 basis points
The Retirement Plans segment primarily offers customized wealth creation and financial protection for corporate and government employers through its two business units, Government and 401(k).
Fee income for 401(k) increased 34%, or $37 for the year ended December 31, 2006 compared to the prior year due to the growth in average account values. This growth is primarily driven by positive net flows of $2.0 billion during the year resulting from strong deposits. Total 401(k) deposits and net flows increased by 22% and 16%, respectively, over the prior year. The increase in average account values can also be attributed to market appreciation of $1.1 billion during the year.
General account spread decreased for both 401(k) and Governmental businesses for December 31, 2005 compared to prior year. The decrease is attributable to a decrease in the net investment income earned rate for both businesses. Average general account assets for the Retirement segment increased approximately 7% in 2005 compared to 2004, while net investment income increased only 2%. Benefits and claims expense, which mainly consists of interest credited, increased 5% for the year ended December 31, 2005 compared to prior year.
An increase in insurance operating costs and other expenses of $19 for the year ended December 31, 2005 was principally driven by the 401(k) business. The additional costs can be attributed to greater deposits and assets under management, resulting in a 20% increase in commissions, technology expenditures, and marketing and servicing costs supporting the segment’s business. However, the increase in 401(k) deposits has driven down the overall general insurance expense per case by over 4% compared to prior year.
Institutional investment product account values include transfers from Retirement Plans and Retail of $763 during 2006.
Higher net investment income increased in Institutional driven by positive net flows of $2.2 billion during the year, which resulted in higher assets under management. Net flows for IIP were strong primarily as a result of the Company’s funding agreement backed Investor Notes program. Investor Note deposits for the years ended December 31, 2006 and 2005 were $2.3 billion and $2.0 billion, respectively.
For the year ended December 31, 2006, earned premiums increased as a result of two large terminal funding cases that were sold during the period. This increase in earned premiums was offset by a corresponding increase in benefits, losses and loss adjustment expenses.
PPLI’s net income increased compared to prior year primarily due to asset growth in the variable business combined with increased tax benefits.
Total revenues increased in Institutional driven by positive net flows of $2.4 billion during 2005, which resulted in higher assets under management. Net flows for Institutional increased for the year ended December 31, 2005 compared to the prior year, primarily as a result of the Company’s funding agreement backed Investor Notes program, which was launched in the third quarter of 2004. Investor Note deposits for the years ended December 31, 2005 and 2004 were $2.0 billion and $643, respectively.
General account spread is one of the main drivers of net income for the Institutional line of business. An increase in spread income in 2005 was driven by higher assets under management noted above, combined with improved partnership income and mortality gains related to terminal funding and structured settlement contracts that include life contingencies. For the year ended December 31, 2005 and 2004, gains related to mortality, investments or other activity were $10 and $3 after-tax, respectively. During 2005, the Company invested in more variable rate assets to back the increasing block of variable rate liabilities sold under the stable value product line. This asset/liability matching strategy decreased portfolio yields, as variable rate assets had lower initial coupon yields then fixed rate assets. At the same time, the stable value variable rate liabilities have lower crediting rates in 2005 than stable value fixed rate liabilities, which allowed the Company to maintain-to-slightly-increase its general account spread on a yield basis.
Individual Life provides life insurance strategies to a wide array of business intermediaries to solve the wealth protection, accumulation and transfer needs of their affluent, emerging affluent and small business insurance clients.
Net Income in Individual Life for 2006, includes an unfavorable $18 after tax impact related to the DAC unlock in the fourth quarter of 2006, partially offset by $7, after-tax, favorable revisions to prior year net DAC estimates reflected in the first half of 2006. Excluding these net impacts of $11, net income increased $15 or 9% for 2006 primarily due to growth in life insurance and account values, and favorable mortality experience in 2006 compared to 2005. The following factors contributed to the earnings results:
Fee income increased $35 for the year ended December 31, 2005 compared to 2004. Cost of insurance charges, a component of total fee income, increased $22 in 2005, driven by business growth and aging of the prior year block of variable universal, universal, and interest-sensitive whole life insurance inforce. Other fee income, another component of total fee income, increased $7 in 2005 primarily due to growth and improved product performance primarily in interest-sensitive whole life and variable universal life insurance products. Variable fee income grew $6 in 2005, as equity market performance and premiums in excess of withdrawals added to the variable universal life account value.
Net investment income increased moderately for the year ended December 31, 2005 compared to 2004 due to increased general account assets from business growth, partially offset by lower interest rates on new investments and reduced prepayments on bonds in 2005.
Benefits, losses and loss adjustment expenses decreased for the year ended December 31, 2005 compared to 2004 consistent with growth in account values and life insurance inforce.
Income tax expense and the resulting tax rate for the year ended December 31, 2005 was impacted by a DRD tax benefit of $7, whereas income tax expense for the year ended December 31, 2004 included a DRD tax benefit of $5.
Variable universal life sales and account values remain sensitive to equity market levels and returns. Individual Life continues to face uncertainty surrounding estate tax legislation, a high level of competition from other life insurance providers, reduced availability and higher price of reinsurance, and the current regulatory environment related to reserving for universal life products with no-lapse guarantees, which may negatively affect Individual Life’s future earnings.
Group Benefits has a block of financial institution business that is experience rated. This business comprised approximately 10%, 9% and 9% of the segment’s 2006, 2005 and 2004 premiums and other considerations (excluding buyouts) respectively, and, on average, 4% to 5% of the segment’s 2006, 2005 and 2004 net income.
Earned premiums, excluding buyouts, increased 4% driven by sales growth of 23%, particularly in disability, for the year ended December 31, 2005 and continued strong persistency during 2005.
The segment’s loss ratio (defined as benefits, losses and loss adjustment expenses as a percentage of premiums and other considerations excluding buyouts) was 73.1% for the year ended December 31, 2005, down from 74.0% in the prior year due to improved morbidity experience as well as favorable mortality experience. Excluding financial institutions, the loss ratio was 77.3%, down from 78.7% in the prior year.
Partially offsetting the positive earnings drivers noted above was the following item:
After tax margin, on earned premiums and other (excluding buyout premiums), between 6.8% and 7.2%, which reflects the estimated impact of adopting SOP 05-1 “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connections with Modifications or Exchanges of Insurance Contracts.”
International, with operations in Japan, Brazil, Ireland and the United Kingdom, focuses on the savings and retirement needs of the growing number of individuals outside the United States who are preparing for retirement, or have already retired, through the sale of variable annuities, fixed annuities and other insurance and savings products. The Company’s Japan operation, which began selling
variable annuities at the end of 2000, has grown significantly to become a significant distributor of variable annuities and is the market leader in variable annuity assets under management in Japan and is the largest component of the International segment.
Net income in International increased for the year ended December 31, 2006, principally driven by higher fee income in Japan, which was derived from an increase in average assets under management. A more expanded discussion of earnings growth can be found below:
Fee income increased $217 or 45%, for the year ended December 31, 2006. As of December 31, 2006, Japan’s variable annuity assets under management were $29.7 billion, a 20% increase from the prior year period. The increase in average assets under management was driven by positive net flows of $4.2 billion and market appreciation of $1.2 billion during the year. The amount of variable annuity deposits has declined for the year ended December 31, 2006 by 46%, compared to the prior year periods primarily due to increased competition and changes in key distribution relationships.
The decrease in benefits, losses and loss adjustment expenses by 93% over prior year can be attributed to the unlock of the GMDB/GMIB reserve of $27 after-tax. For further discussion, see DAC Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A.
Contributing to the increase in net income for the year ended December 31, 2006 was a cumulative tax benefit of $9, that resulted from a change in the effective tax rate on Japan earnings resulting from a change in management’s intent under APB 23.
DAC amortization was higher due to higher actual gross profits consistent with growth in the Japan operation, off-set by $26 after-tax amortization benefit associated with the DAC amortization “unlock.” For further discussion, see DAC Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A.
Net income increased significantly for the year ended December 31, 2005, principally driven by higher fee income and investment spread in Japan, derived from a 78% increase in the assets under management. A more expanded discussion of earnings growth can be found below:
Higher fees in 2005 were also the result of increased surrender activity, as customers surrendered policies in order to take advantage of significant appreciation in their account balances.
The increase in operating costs in 2005 was primarily due to the significant growth in the Japan operation and investment in our Ireland operation.
Management continues to be optimistic about growth potential of the retirement savings market in Japan. Several trends such as an aging population, longer life expectancies and declining birth rates leading to a smaller number of younger workers to support each retiree, have resulted in greater need for an individual to plan and adequately fund retirement savings.
Management’s full year projections for Japan for 2007 are now as follows (using ¥118/$1 exchange rate for 2007):
Variable annuity net flows of ¥350 billion to ¥650 billion ($3.0 billion to $5.5 billion)
Income tax benefit decreased for the year ended December 31, 2005 due to the absence of a $190 tax benefit recorded during 2004.
Property & Casualty is organized into four reportable operating segments: the underwriting segments of Business Insurance, Personal Lines and Specialty Commercial (collectively “Ongoing Operations”); and the Other Operations segment.
A $436 increase in Business Insurance and Personal Lines earned premium before considering catastrophe treaty reinstatement premium, primarily driven by new business outpacing non-renewals in Personal Lines auto, Personal Lines homeowners and small commercial,
$73 of catastrophe treaty reinstatement premium related to the 2005 hurricanes that depressed 2005 earned premium, and
Non-renewal of a single captive insurance program in specialty casualty that accounted for $241 of earned premium in 2005, and
Year ended December 31, 2006 compared to the year ended December 31, 2005
A $41 reduction of estimated Citizens’ assessments in 2006 related to the 2005 hurricanes compared to a charge of $64 for Citizens assessments in 2005 related to the 2005 and 2004 hurricanes,
A $67 increase in income tax expense, reflecting an increase in income before income taxes, partially offset by a $49 income tax benefit resulting from the sale of Omni,
The $152 decrease in current accident year catastrophe losses was largely due to $264 of losses in 2005 related to hurricanes Katrina, Rita and Wilma, partially offset by an increase in non-hurricane catastrophe losses in 2006. The current accident year loss and loss adjustment expense ratio before catastrophes of 62.4 for Ongoing Operations was relatively flat from 2005 to 2006 as a lower current accident year loss and loss adjustment expense ratio for workers’ compensation business in small commercial was largely offset by an increase in non-catastrophe property loss costs in middle market Business Insurance and Personal Lines homeowners.
Primarily driving the $121 increase in net investment income was a larger investment base due to increased cash flows from underwriting as well as an increase in interest rates and a change in asset mix (i.e., a greater share of investments in mortgage loans and limited partnerships). The $35 decrease in net realized capital gains was primarily due to a $24 pre-tax realized capital loss from the sale of Omni, an increase in other-than-temporary-impairments and losses on the sale of fixed maturity investments, partially offset by an increase in income from other sources. (See the Other-Than-Temporary Impairments discussion within Investment Results for more information on the increase in impairments).
The $48 increase in net unfavorable prior accident year development was primarily due to a $148 increase in net unfavorable loss development in Other Operations, partially offset by a change in Ongoing Operations from $36 of net unfavorable prior accident year development in 2005 to $64 of net favorable prior accident year development in 2006. The $148 increase in net unfavorable prior accident year development in Other Operations was primarily due to a $243 reduction of reinsurance recoverables in 2006 resulting from an agreement with Equitas and the Company’s evaluation of the reinsurance recoverables and allowance for uncollectible reinsurance associated with older, long-term casualty liabilities. The $64 of net favorable prior accident year development in 2006 for
$64 of Citizens assessments in 2005 related to the 2005 and 2004 hurricanes,
Primarily driving the $117 increase in net investment income was a larger investment base due to increased cash flows from underwriting, higher investment yields on fixed maturity investments and an increase in income from limited partnership investments.
The Company considers several measures and ratios to be the key performance indicators for the property and casualty underwriting businesses. The following table and the segment discussions for the years ended December 31, 2006, 2005 and 2004 include various ratios and measures of profitability. Management believes that these ratios and measures are useful in understanding the underlying trends in The Hartford’s property and casualty insurance underwriting business. However, these key performance indicators should only be used in conjunction with, and not in lieu of, underwriting income for the underwriting segments of Business Insurance, Personal Lines and Specialty Commercial and net income for the Property & Casualty business as a whole, Ongoing Operations and Other Operations. These ratios and measures may not be comparable to other performance measures used by the Company’s competitors.
Prior accident year catastrophe reserves were reduced by $70 in 2006 primarily due to $83 of favorable development related to the 2005 and 2004 hurricanes. Net prior accident year development for non-catastrophe claims was not significant as reserve strengthenings were largely offset by reserve releases. See the “Reserves” section for a discussion of prior accident year reserve development for Ongoing Operations in 2006.
The decrease in the earned premium growth rate for Personal Lines was primarily due to lower earned pricing increases in both auto and homeowners business, a decrease in premium renewal retention and a decline in Omni and Other Affinity earned premium.
Before catastrophes and prior accident year development, the combined ratio improved from 2004 to 2005 principally 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 loss costs for property coverages and an increase in the expense ratio, which was largely due to the hurricane-related assessments of $64 in 2005.
The decrease in the current accident year catastrophe ratio for 2005 was primarily due to $264 of net losses incurred for hurricanes Katrina, Rita and Wilma in 2005 compared to $394 of losses from Hurricanes Charley, Frances, Ivan and Jeanne in 2004.
Net prior accident year development was not significant in 2005 as reserve strengthenings were largely offset by reserve releases. In 2004, strengthening of non-catastrophe loss reserves was almost entirely offset by a release of catastrophe reserves. Prior accident year catastrophe reserves related to September 11 were reduced by $298 in 2004. Net prior accident year reserve increases in 2004 for non-catastrophe losses included $190 for construction defects claims, $38 for small commercial package business and $25 for auto liability claims. See the “Reserves” section for a discussion of net favorable prior accident year reserve development for Ongoing Operations in 2006.
Other Operations reported net income of $71 for 2005 compared to a net loss of $45 for 2004. The change from a net loss to net income was primarily due to a $233 decrease in unfavorable prior accident year development, partially offset by a $62 decrease in net investment income and a change to income tax expense due to the pre-tax income in 2005. The $233 decrease in net reserve strengthening was primarily due to $181 of unfavorable development in 2004 related to a reduction in the reinsurance recoverable asset associated with older, long-term casualty liabilities, including asbestos liabilities, as well as $85 more of unfavorable prior accident year reserve development in 2004 on assumed reinsurance reserves. The $62 decrease in net investment income was
The average annual invested assets increased over the same period as a result of net underwriting cash inflows and investment income.
Written premium is a statutory accounting financial measure which represents the amount of premiums charged for policies issued, net of reinsurance, during a fiscal period. Earned premium is a GAAP and statutory measure. Premiums are considered earned and are included in the financial results on a pro rata basis over the policy period. Management believes that written premium is a performance measure that is useful to investors as it reflects current trends in the Company’s sale of property and casualty insurance products. Written and earned premium are recorded net of ceded reinsurance premium.
Policies in force represent the number of policies with coverage in effect as of the end of the period. The number of policies in force is a growth measure used for Personal Lines only and is affected by both new business growth and premium renewal retention, including growth in both AARP and Agency lines of business.
The current year loss and loss adjustment expense ratio is a measure of the cost of claims incurred in the current accident year divided by earned premiums. The current accident year loss and loss adjustment expense ratio includes both the current accident year loss and loss adjustment expense ratio before catastrophes and the current accident year catastrophe ratio. Management believes that the current accident year loss and loss adjustment expense ratio before catastrophes is a performance measure that is useful to investors as it removes the impact of volatile and unpredictable catastrophe losses and prior accident year reserve development.
The combined ratio is the sum of the loss and loss adjustment expense ratio, the expense ratio and the policyholder dividend ratio. This ratio is a relative measurement that describes the related cost of losses and expense for every $100 of earned premiums. A combined ratio below 100.0 demonstrates underwriting profit; a combined ratio above 100.0 demonstrates underwriting losses.
Property & Casualty maintains one portfolio of invested assets for all business written by the Hartford Fire Insurance Pool companies, including business reported in both the Ongoing Operations and Other Operations segments. Separate investment portfolios are maintained within Other Operations for the runoff of international assumed reinsurance claims and for the runoff business of Heritage Holdings, Inc., including its subsidiaries, Excess Insurance Company Ltd., First State Insurance Company and Heritage Reinsurance Company, Ltd. Within the Hartford Fire Insurance Pool, invested assets are attributed to Ongoing Operations and Other Operations pursuant to the Company’s capital attribution process.
Released Business Insurance allocated loss adjustment expense reserves by $58 for accident years 2003 to 2005, primarily for workers’ compensation business and package business, as a result of cost reduction initiatives implemented by the Company to reduce allocated loss adjustment expenses for both legal and non-legal expenses. The Company began implementing cost reduction initiatives in late 2003. It was initially uncertain what effect those efforts would have on controlling allocated loss adjustment expenses. During 2004, favorable trends started to emerge, particularly on shorter-tailed auto liability claims, but it was not clear if these trends would be sustained. In early 2005, favorable trends continued and the Company analyzed claims involving legal expenses separate from claims that do not involve legal expenses. This analysis included a review of the trends in the number of claims involving legal expenses, the average expenses incurred and trends in legal expenses. During the second quarter of 2005, the Company released allocated loss adjustment expense reserves on shorter-tailed auto liability claims as the favorable trends on shorter-tailed business emerged more quickly and were determined to be reliable. During both the second and fourth quarter of 2006, the Company determined that the favorable development on package business and workers’ compensation business had become a verifiable trend and, accordingly, reserves were reduced. The $58 reserve release represented 1% of Business Insurance net reserves as of December 31, 2005.
2005 accident year catastrophe loss and loss adjustment expenses record in 2005
In 2005, the current accident year provision for loss and loss adjustment expenses of $6.7 billion included net catastrophe loss and loss adjustment expenses of $351, of which $264 related to hurricanes Katrina, Rita and Wilma. The following table shows current accident year catastrophe impacts in 2005, including reinstatement premium owed to reinsurers:
Net current accident year catastrophe losses decreased by $171, from $522 in 2004 to $351 in 2005, as the increase in ceded catastrophe losses exceeded the increase in gross catastrophe losses. While gross current accident year catastrophe losses increased by $514, from $811 in 2004 to $1,325 in 2005, ceded current accident year catastrophe losses increased by $686, from $288 in 2004, to $974 in 2005. The amount of gross losses ceded to reinsurers depends, in large part, on the extent to which gross losses incurred from a single event exceed the Company’s attachment point under its principal catastrophe reinsurance program. Compared to the hurricanes of 2004, the individual hurricanes in 2005 significantly exceeded the attachment point, resulting in greater reinsurance recoveries. Most of the current accident year catastrophe losses ceded in 2004 related to hurricanes Charley and Francis. Most of the current accident year catastrophe losses ceded in 2005 related to hurricanes Katrina and Wilma.
The Company’s estimate of loss and loss expenses under hurricanes Katrina, Rita and Wilma is based on covered losses under the terms of the policies. The Company does not provide residential flood insurance on its Personal Lines homeowners policies so the Company’s estimate of hurricane losses on Personal Lines homeowners business does not include any provision for damages arising from flood waters. The Company acts as an administrator for the Write Your Own flood program on behalf of the National Flood Insurance Program under FEMA, for which it earns a fee for collecting premiums and processing claims. Under the program, the Company services both personal lines and commercial lines flood insurance policies and does not assume any underwriting risk. As a result, catastrophe losses in the above table do not include any losses related to the Write Your Own flood program.
Included within prior accident year development for the year ended December 31, 2005 were the following reserve strengthenings (releases).
Strengthened workers’ compensation reserves for claim payments expected to emerge after 20 years of development by $120. For workers’ compensation claims involving permanent disability, it is particularly difficult to estimate how such claims will develop more than 20 years after the year the claims were incurred (known as “the tail”). During 2005, the Company’s actuaries performed an actuarial study to re-estimate the required reserves for additional development beyond the 20th year following a claim being incurred. This study involved gathering extensive historical data dating back over 50 years which could be used for making these estimates and incorporated modeling using actuarial techniques that have recently been developed within the actuarial profession. Based on the results of this analysis the Company changed its previous estimate and increased the percentage of ultimate claim costs expected to be paid after 20 years of development. As an example, within Business Insurance this development percentage was increased from 8% to 9%. The $120 of reserve strengthening represented a change in estimate which was 3% of the Company’s net reserves for workers’ compensation claims as of December 31, 2004.
Strengthened reserves for loss and loss adjustment expenses related to the third quarter 2004 hurricanes by a total of $33. The main drivers of the increase were late-reported claims for condominium assessments and increases in the costs of building materials and contracting services.
A rollforward of liabilities for unpaid losses and loss adjustment expenses by segment for Property & Casualty for the year ended December 31, 2004 follows:
2004 accident year catastrophe loss and loss adjustment expenses recorded in 2004
In 2004, the current accident year provision for loss and loss adjustment expenses of $6.6 billon included net catastrophe loss and loss adjustment expenses of $523, of which $394 related to hurricanes Charley, Frances, Ivan and Jeanne. Gross of reinsurance, current accident year catastrophe losses were $811.
Included within prior accident year development for the year ended December 31, 2004 were the following reserve strengthenings (releases).
During the year ended December 31, 2004, the Company’s re-estimates of prior accident year reserves included the following significant reserve changes.
Reduced the reinsurance recoverable asset associated with older, long-term casualty liabilities, including asbestos liabilities, by $181. Strengthened environmental reserves by $75.
Released September 11 net reserves by $97 due to favorable developments, including a lack of significant additional loss notices on assumed reinsurance property treaties.
The table below shows the range of annual reserve re-estimates experienced by The Hartford over the past six years. The amount of prior accident year development (as shown in the reserve rollforward) for a given calendar year is expressed as a percent of the beginning calendar year reserves, net of reinsurance. The percentage relationships presented are significantly influenced by the facts and circumstances of each particular year and by the fact that only the last six years are included in the range. Accordingly, these percentages are not intended to be a prediction of the range of possible future variability. See “Impact of key assumptions on reserve volatility” within Critical Accounting Estimates for further discussion of the potential for variability in recorded loss reserves.
Bracketed prior accident year development indicates favorable development. Unbracketed amounts represent unfavorable development.
The Hartford’s property and casualty operations have processes to manage catastrophic risk exposures to natural disasters, such as hurricanes and earthquakes, and other perils, such as terrorism. The Hartford’s risk management processes include, but are not limited to, disciplined underwriting protocols, exposure controls, sophisticated risk modeling, effective risk transfer, and efficient capital management strategies.
In managing risk, The Hartford’s management processes involve establishing underwriting guidelines for both individual risks, including individual policy limits, and in aggregate, including aggregate exposure limits by geographic zone and peril. The Company establishes risk limits and actively monitors the risk exposures as a percent of Property & Casualty surplus. For natural catastrophe perils, the Company generally limits its estimated loss to natural catastrophes from a single 250-year event prior to reinsurance to less than 30% of statutory surplus of the Property & Casualty operations and its estimated loss to natural catastrophes from a single 250-year event after reinsurance to less than 15% of statutory surplus of the Property & Casualty operations. Currently, the Company’s estimated pre-tax loss to a single 250-year natural catastrophe event prior to reinsurance is 31% of statutory surplus of the Property & Casualty operations and the Company’s estimated pre-tax loss net of reinsurance is less than 15% of statutory surplus of the Property & Casualty operations. For terrorism, the Company monitors its exposure in major metropolitan areas to a single-site conventional terrorism attack scenario, and manages its potential estimated loss, including exposures resulting from the Company’s Group Life operations, to less than 7% of the combined statutory surplus of the Life and Property and Casualty operations. Among the 208 locations specifically monitored by the Company, the largest estimated modeled loss arising from a single event is approximately $736, which represents 5.1% of the combined statutory surplus of the Life and Property and Casualty operations as of December 31, 2006. The Company monitors exposures monthly and employs both internally developed and vendor-licensed loss modeling tools as part of its risk management discipline.
A variety of traditional reinsurance products are used as part of the Company’s risk management strategy, including excess of loss occurrence-based products that protect aggregate property and workers’ compensation exposures, and individual risk or quota share arrangements, that protect specific classes or lines of business. There are no significant finite risk contracts in place and the statutory surplus benefit from all such prior year contracts is immaterial. Facultative reinsurance is also used to manage policy-specific risk exposures based on established underwriting guidelines. The Hartford also participates in governmentally administered reinsurance facilities such as the Florida Hurricane Catastrophe Fund (“FHCF”), the Terrorism Risk Insurance Program established under The
The following table summarizes the terms of the reinsurance treaties with Foundation Re and Foundation Re II that were in place as of January 1, 2007:
The Company’s modeled loss estimates are derived by averaging 21 modeled loss events representing a 250-year return period loss. For the peril of earthquake, the 21 events averaged to determine the modeled loss estimate include events occurring in California as well as the Northeastern, Southeastern and Midwestern regions of the United States with associated magnitudes ranging from 6.5 to 7.9 on the Richter scale. For the peril of hurricane, the 21 events averaged to determine the modeled loss estimate include category 3, 4 and 5 events in Florida as well as other Southeastern, Northeastern and Gulf region landfalls.
occurred. Surcharges to recover the amount of regular assessments may not be recorded as an asset until the related premium is written. Emergency assessments that may be levied by Citizens are not recorded in the income statement.
In the fourth quarter of 2005, the Company accrued an estimated $46 for regular assessments based on estimates of the deficits in each account at the time. In the second quarter of 2006, the Florida legislature approved the use of $715 of state tax revenues to partially offset the deficits in Citizens’ High Risk, Commercial Lines and Personal Lines accounts. During the second quarter of 2006, Citizens’ management also finalized its estimate of the 2004 and 2005 hurricane losses that would be used in calculating the deficits in each account. In the third quarter of 2006, the Board of Governors of Citizens approved a final assessment for the 2005 account year and the Company received the assessment notice during the fourth quarter of 2006. The estimates of the deficits in the Personal Lines account and Commercial Lines account were lower than previously anticipated by the Company. As a result of these changes in estimates, during the Company reduced its accrual for Citizens’ assessments by $41, from $46 to $5. The reduction in the amount of the estimated regular assessment also reduces the amount of surcharges that will be billed to policyholders to recoup the assessments in the future. As of December 31, 2006, the Company has collected $12 in surcharges related to the $15 Citizens assessment for the 2004 Florida hurricanes.
The following table shows the components of the gross and net reinsurance recoverable as of December 31, 2006 and 2005:
Reinsurance recoverables represent loss and loss adjustment expenses recoverable from a number of entities, including reinsurers and pools. As shown in the following table, a portion of the total gross reinsurance recoverable relates to the Company’s mandatory participation in various involuntary assigned risk pools and the value of annuity contracts held under structured settlement agreements. Reinsurance recoverables due from mandatory pools are backed by the financial strength of the property and casualty insurance industry. Annuities purchased from third party life insurers under structured settlements are recognized as reinsurance recoverables in cases where the Company has not obtained a release from the claimant. Of the remaining gross reinsurance recoverable as of December 31, 2006 and 2005, the following table shows the portion of recoverables due from companies rated by A.M. Best.
Where its contracts permit, the Company secures future claim obligations with various forms of collateral, including irrevocable letters of credit, secured trusts, funds held accounts and group wide offsets. As part of its reinsurance recoverable review, the Company analyzes recent developments in commutation activity between reinsurers and cedants, recent trends in arbitration and litigation outcomes in disputes between cedants and reinsurers and the overall credit quality of the Company’s reinsurers. Due to the inherent uncertainties as to collection and the length of time before such amounts will be due, it is possible that future adjustments to the Company’s reinsurance recoverables, net of the allowance, could be required, which could have a material adverse effect on the Company’s consolidated results of operations or cash flows in a particular quarterly or annual period.
To manage the potential credit risk resulting from the use of reinsurance, management evaluates the credit standing, financial performance, management and operational quality of each potential reinsurer. Through that process, the Company maintains a list of reinsurers approved for participation on all treaty and facultative reinsurance placements. The Company’s approval designations reflect the differing credit exposure associated with various classes of business. Participation authorizations are categorized along property, short-tail casualty and long-tail casualty lines. In addition to defining participation eligibility, the Company regularly monitors each active reinsurer’s credit risk exposure in the aggregate and limits that exposure based upon independent credit rating levels.
Unless otherwise specified, the following discussion speaks to changes for the year ended December 31, 2006 compared to the year ended December 31, 2005 and the year ended December 31, 2005 compared to the year ended December 31, 2004.
Net income increased by $283, or 23%, as a result of a $389 increase in Ongoing Operations’ net income partially offset by a $106 decrease in Other Operations’ results. Other Operations reported a net loss of $35 in 2006 compared to net income of $71 in 2005. See the Ongoing Operations and Other Operations segment MD&A discussions for an analysis of the underwriting results and investment performance driving the change in net income.
Earned premium growth is an objective for Business Insurance and Personal Lines. Earned premium growth is not a specific objective for Specialty Commercial since Specialty Commercial is comprised of transactional businesses where premium writings may fluctuate based on the segment’s view of perceived market opportunity. Written premiums are earned over the policy term, which is six months for certain Personal Lines auto business and 12 months for substantially all of the remainder of the Company’s business. Written pricing, new business growth and premium renewal retention are factors that contribute to growth in written and earned premium.
Earned premium growth of $486 in Business Insurance was primarily driven by new business premium growth outpacing non-renewals over the last six months of 2004 and the full year of 2005. Earned premium growth of $165 in Personal Lines was primarily driven by new business growth outpacing non-renewals in auto and the effect of earned pricing increases in homeowners.
Specialty Commercial earned premiums increased by $31, primarily driven by a $90 reduction in earned premiums under retrospectively-rated policies during 2004 and increases in casualty, professional liability, fidelity and surety and other premiums, partially offset by a $216 decrease in property earned premiums, primarily due to a decrease of $127 from exiting the multi-peril crop insurance business during 2004.
Net income increased by $389, or 33%, driven primarily by the following factors:
A $420 increase in underwriting results with a corresponding decrease in the combined ratio of 3.9 points, to 89.3, and
Partially offsetting the improvements in net income were the following factors:
Net realized capital losses were $17 in 2006 compared to net realized gains of $19 in 2005,
A $20 increase in other expenses, due primarily to lower bad debt expense in 2005, and
A $122 increase in income tax expense, primarily reflecting an increase in income before income taxes, partially offset by a $49 income tax benefit resulting from the sale of Omni.
A 0.9 point decrease in the expense ratio, to 25.6, largely because of a $41 decrease in estimated Citizens’ assessments in 2006 compared to a $64 increase in Citizens assessments in 2005. Almost all of the Citizens assessments are for assessments charged by the Citizens Property Insurance Corporation (Citizens) in Florida, a company established by the State of Florida to provide personal and commercial insurance to individuals and businesses in Florida who are in high risk areas of the state and are unable to obtain insurance through the private insurance markets.
The $64 of net favorable prior accident year development in 2006 for Ongoing Operations was primarily due to an $83 release of prior accident year hurricane reserves and a $58 release of allocated loss adjustment expense reserves for workers’ compensation and package business, partially offset by reserve strengthenings in Specialty Commercial. Net unfavorable reserve development of $36 in 2005 included a $120 increase in workers’ compensation reserves related to reserves for claim payments expected to emerge after 20 years of development, a $40 strengthening of general liability reserves within Business Insurance for accident years 2000 to 2003 due to higher than anticipated loss payments beyond four years of development and $33 of reserve strengthening related to the third quarter 2004 hurricanes. Partially offsetting the reserve increases in 2005 was a $95 reduction in prior accident year reserves for allocated loss adjustment expenses, predominantly related to auto liability claims and a $75 reduction in workers’ compensation reserves recorded related to accident years 2003 and 2004. See the “Reserves” section of the MD&A for further discussion of reserve development.
The $143 increase in net investment income was primarily because of a larger investment base due to increased cash flows from underwriting and an increase in capital and invested assets attributed to Ongoing Operations as well as an increase in interest rates and
A $246 increase in underwriting results with a corresponding 2.1 point improvement in the combined ratio, from 95.3 to 93.2, and
A $79 decrease in net realized capital gains due to lower net realized gains on the sale of fixed maturity investments and lower net gains on non-qualifying derivatives, and
Current accident year catastrophe losses decreased by $171, from $522 in 2004 to $351 in 2005. Catastrophe losses in 2005 for Hurricanes Katrina, Rita and Wilma were $264 compared to catastrophe losses in 2004 for Hurricanes Charley, Frances, Ivan and Jeanne of $394.
Before reinstatement premium, a lower combined ratio before catastrophes and prior accident year development improved current accident year underwriting results before catastrophes by $85. The 0.3 point decrease in the combined ratio before catastrophes and prior accident year development, to 89.4, was primarily driven by a 1.0 point decrease in the current accident year loss and loss adjustment expense ratio before catastrophes, partially offset by a 0.6 point increase in the expense ratio.
There was a $31 increase in net unfavorable prior accident year reserve development, from $5 of net unfavorable prior accident year development in 2004 to $36 of net unfavorable prior accident year reserve development in 2005. Net unfavorable reserve development of $36 in 2005 included a $120 increase in workers’ compensation reserves related to reserves for claim payments expected to emerge after 20 years of development, a $40 strengthening of general liability reserves within Business Insurance for accident years 2000 to 2003 due to higher than anticipated loss payments beyond four years of development and $33 of reserve strengthening related to the third quarter 2004 hurricanes. Partially offsetting the reserve increases in 2005 was a $95 reduction in prior accident year reserves for allocated loss adjustment expenses, predominantly related to auto liability claims and a $75 reduction in workers’ compensation reserves recorded related to accident years 2003 and 2004. Net unfavorable prior accident year reserve development of $5 in 2004 included reserve increases of $303, partially offset by a reserve release of $298 for September 11. Reserve increases in 2004 included $190 for construction defect claims, $38 for small commercial package business and $25 for auto liability claims.
The $179 increase in net investment income was due, in part, to a larger investment base due to increased cash flows from underwriting, higher investment yields on fixed maturity investments and an increase in income from limited partnership investments.
The difference between written premiums and earned premiums is attributable to the change in unearned premium reserve .
Earned premiums for the Business Insurance segment increased $333, or 7%. The increase was primarily due to new business growth outpacing non-renewals in both small commercial and middle market over the last six months of 2005 and the full year of 2006. Also contributing to the increase in earned premiums was $16 of catastrophe treaty reinstatement premium payable to reinsurers recorded as a reduction of earned premium in 2005. Partially offsetting the increase in earned premium was the effect of earned pricing decreases in middle market and higher property catastrophe treaty reinsurance costs.
Small commercial earned premium grew $231, or 10%, driven primarily by earned premium growth in workers’ compensation and package business for both Select Xpand and traditional Select business. Premium renewal retention for small commercial decreased slightly for the year ended December 31, 2006, from 88% to 87%, primarily due to commercial auto business. New business written premium for small commercial decreased by $47, or 8%, for the year ended December 31, 2006, primarily due to lower production of new workers’ compensation, auto and package policies. Despite an increase in the number of appointed agents to expand writings in certain territories, actions taken by some of the Company’s competitors to increase commissions for workers’ compensation business may be contributing to the Company’s lower new business growth.
Middle market earned premium grew $102, or 4%, driven primarily by growth in workers’ compensation and marine earned premium. Premium renewal retention for middle market increased slightly for the year ended December 31, 2006, from 81% to 82%, primarily driven by workers’ compensation business. In response to increased competition, management has focused heavily on premium renewal retention. New business written premium for middle market decreased by $138, or 23%, for the year ended December 31, 2006, primarily due to increased competition for workers’ compensation business.
As written premium is earned over the 12 month term of the policies, the unfavorable trend in earned pricing during 2006 was primarily a reflection of the written pricing changes over the last six months of 2005 and the year ended December 31, 2006.
Growth in small commercial earned premium was driven primarily by growth in workers’ compensation and package business for both Select Xpand and traditional Select. New business written premium for small commercial increased by $5, or 1%, as an increase in new business for workers’ compensation was largely offset by a decrease in new business for package and commercial auto. Premium renewal retention for small commercial increased from 87% to 88%, primarily due to workers’ compensation and package business, partially offset by lower written pricing increases.
The $121 improvement in current accident year underwriting results before catastrophes was primarily due to:
There was a change from $22 of net unfavorable prior accident year reserve development in 2005 to $61 of net favorable prior accident year reserve development in 2006. Net favorable reserve development of $61 in 2006 included a $58 reduction in allocated loss adjustment expense reserves, primarily for workers’ compensation and package business related to accident years 2003 to 2005 and a $25 reduction in prior accident year catastrophe reserves in 2006, of which $9 related to hurricanes Katrina, Rita and Wilma in 2005 and $16 related to hurricanes Charley, Frances and Jeanne in 2004. Net unfavorable reserve development of $22 in 2005 included a $50 increase in workers’ compensation reserves related to reserves for claim payments expected to emerge after 20 years of development and a $40 strengthening of general liability reserves for accident years 2000 to 2003 due to higher than anticipated loss payments beyond four years of development. Partially offsetting the reserve increases in 2005 was a $75 reduction in workers’ compensation reserves related to accident years 2003 and 2004.
Underwriting results increased by $36, with a 0.1 point increase in the combined ratio to 91.7. The net increase in underwriting results was principally driven by the following factors:
The $67 improvement in current accident year underwriting results before catastrophes was primarily due to:
There was a change from $67 of net favorable prior accident year reserve development in 2004 to $22 of net unfavorable prior accident year reserve development in 2005. Net unfavorable reserve development of $22 in 2005 included a $50 increase in workers’ compensation reserves related to reserves for claim payments expected to emerge after 20 years of development and a $40 strengthening of general liability reserves for accident years 2000 to 2003 due to higher than anticipated loss payments beyond four years of development. Partially offsetting the reserve increases in 2005 was a $75 reduction in workers’ compensation reserves recorded related to accident years 2003 and 2004. Net favorable reserve development of $67 in 2004 included a $175 release of September 11 reserves, partially offset by a $38 strengthening of reserves for small commercial package business, a $25 strengthening of automobile liability reserves and a $23 strengthening of reserves for construction defects claims.
For the 2007 full year, management expects the Business Insurance segment to achieve 2% to 5% written premium growth compared to written premium growth of 4% achieved in 2006. In small commercial, the Company expects to generate 4% to 7% written premium growth in 2007 by further increasing the number of appointed agents and growing premium in under-represented territories. In addition, small commercial expects to grow new business by expanding its underwriting appetite, refining its pricing models and upgrading product features. To support the expected increase in premium writings, small commercial continues to build a low-cost operating model that is scalable for further expansion.
Within middle market, the Company expects no written premium growth in 2007 as the Company takes a disciplined approach to evaluating and pricing risks in the face of a decline in written pricing. Nevertheless, the Company will seek to increase its market share in a number of regions where the Company is currently under-represented. While the Company will continue to focus on growing its workers’ compensation business in the most profitable states, the Company expects to shift the mix of middle market business from workers’ compensation to other lines in 2007. To support this objective, the Company plans to develop new underwriting and pricing models for commercial auto and property business. In 2007, the Company will continue to focus on renewal retention, particularly in the mid-Western states, where competition is expected to be particularly strong.
Written premium growth of 2% to 5%, including growth of 4% to 7% in small commercial and no growth in middle market
Earned premiums for the Personal Lines segment increased $150, or 4%, due primarily to earned premium growth in both AARP and Agency business, partially offset by higher property catastrophe treaty reinsurance costs and a reduction in other earned premium. Also
contributing to the increase in earned premiums was $31 of catastrophe treaty reinstatement premium payable to reinsurers recorded as a reduction of earned premium in 2005. Other earned premium consists of premium earned on non-standard auto business written by Omni and on business written through affinity partners other than AARP.
Agency earned premium grew $71, or 7%, primarily as a result of an increase in the number of agency appointments and further refinement of the Dimensions class plans first introduced in 2003. Dimensions, which had been rolled out to 42 states for auto and 39 states for homeowners as of December 31, 2006, enables agents to generate a customized price for each policyholder, independent of the risks and rates of other members of the same household. The plan, which is available through the company’s network of independent agents, was enhanced beginning in the third quarter of 2006 as “Dimensions with Auto Packages” and the enhanced plan is now offered in 29 states with four distinct package offerings.
Auto new business written premium increased by $43, or 10%, to $469 in 2006. The increase in new business written premium was primarily due to an increase in AARP and Agency new business, partially offset by a decrease in other new business. Growth in new business was particularly strong in AARP with a growth rate of 20% in 2006. Homeowners’ new business written premium increased by $30, or 23%, to $161 in 2006. The increase in homeowners’ new business written premium was due to an increase in both AARP and Agency new business.
The trend in earned pricing during 2006 was a reflection of the written pricing changes in the last six months of 2005 and the year ended December 31, 2006. Auto written pricing decreases are driven by an extended period of favorable results factoring into the rate setting process. Homeowners’ written pricing continues to increase moderately due to insurance to value increases.
Earned premiums increased $165, or 5%, due primarily to earned premium growth in both AARP and Agency, partially offset by a reduction in other earned premium. Other earned premium consists of premium earned on non-standard auto business written by Omni and on business written through affinity partners other than AARP.
Other earned premium decreased by $75, or 19%, primarily because of a strategic decision by management to focus on more profitable non-standard auto business.
Auto earned premium grew $106, or 4%, primarily from growth in AARP and Agency, offset by a decline in other earned premiums. Before considering the decline in other earned premium, auto earned premium grew $240, or 8%. Homeowners’ earned premium grew $59, or 7%, due to growth in AARP and Agency business, partially offset by a decline in the Affinity business included within other
earned premiums. Consistent with the growth in earned premium, the number of policies in force has increased in auto and homeowners. The growth in policies in force does not correspond directly with the growth in earned premiums due to the effect of earned pricing changes and because policy in force counts are as of a point in time rather than over a period of time.
Despite lower hurricane losses in 2006, current accident year catastrophe losses increased by $22, from $98 in 2005 to $120 in 2006. Catastrophe losses increased principally due to losses in 2006 from tornados and hail storms in the Midwest and windstorms in Texas and on the East coast. Catastrophe losses in 2005 included $51 of losses from Hurricanes Katrina, Rita and Wilma.
The 0.8 point decrease in the combined ratio before catastrophes and prior accident year development was primarily driven by a 1.0 point decrease in the expense ratio, to 22.7, partially offset by a 0.3 point increase in the current accident year loss and loss adjustment expense ratio before catastrophes, from 63.5 to 63.8.
The 0.3 point increase in the current accident year loss and loss adjustment expense ratio before catastrophes was principally due to an increase in non-catastrophe property loss costs for homeowners, primarily driven by an increase in claim severity, and an increase in the loss and loss adjustment expense ratio for auto liability claims, partially due to a shift to more Dimensions product business within Agency. Partially offsetting the increase in the current accident year loss and loss adjustment expense ratio before catastrophes was the effect of catastrophe treaty reinstatement premiums recorded as a reduction of earned premium in 2005.
Current accident year catastrophe losses decreased by $166, from $264 in 2004 to $98 in 2005. Catastrophe losses in 2005 for Hurricanes Katrina, Rita and Wilma were $51 compared to catastrophe losses in 2004 for hurricanes Charley, Frances, Ivan and Jeanne of $215.
The $58 improvement in current accident year underwriting results before catastrophes was primarily due to:
Before reinstatement premium, a lower combined ratio before catastrophes and prior accident year development improved current accident year underwriting results before catastrophes by $58. The 1.0 point decrease in the combined ratio before catastrophes and prior accident year development, to 87.2, was primarily driven by a 1.6 point decrease in the current accident year loss and loss adjustment expense ratio before catastrophes, partially offset by a 0.6 point increase in the expense ratio.
The 1.6 point decrease in the current accident year loss and loss adjustment expense ratio before catastrophes was primarily due to lower current accident year loss costs for auto liability claims and earned pricing increases for homeowners business slightly outpacing increases in non-catastrophe property loss costs, partially offset by the effect on the ratio of an increase in catastrophe treaty reinstatement premium. The lower current accident year loss and loss adjustment expense ratio for auto liability claims was consistent with the favorable prior accident year development on auto liability allocated loss adjustment expense reserves recognized in 2005. Within homeowners, an increase in loss costs was due entirely to increasing claim severity.
Written premium growth of 4% to 7%, including growth of 3% to 6% in auto and 7% to 10% in homeowners
Property earned premium decreased by $32, or 13%, primarily due to a decrease in new business and renewals in the latter half of 2005 and the full year of 2006 as well as the effect of an increase in reinsurance costs for 2006 treaties and additional catastrophe reinsurance purchased in the fourth quarter of 2005. Partially offsetting the decrease in earned premiums was $34 of catastrophe treaty reinstatement premiums payable to reinsurers recorded as a reduction of earned premium in 2005 and double digit earned pricing increases during 2006. The reduction in new business and renewals reflects a decision to reduce catastrophe loss exposures in certain geographic areas and a determination that, despite rate increases, rates on some business opportunities were not adequate. Property business has experienced significant rate increases throughout 2006, reflecting a hardening of the market after the 2005 hurricanes.
Professional liability, fidelity and surety earned premium grew $95, or 17%, due primarily to a decrease in the portion of risks ceded to outside reinsurers, new business growth in commercial and contract surety business, earned pricing increases in contract surety business and new business growth in middle market and small commercial professional liability business, partially offset by earned pricing decreases in professional liability. The growth in commercial and contract surety was primarily driven by an increase in the number of fidelity and surety bonds issued to existing accounts.
Within the “other” category, earned premium decreased by $50, or 29%. The “other” category of earned premiums includes premiums assumed and ceded under inter-segment arrangements and co-participations. Under an inter-segment arrangement, beginning in the first quarter of 2006, the Company allocated more of the premiums ceded under the principal property catastrophe
reinsurance program to Specialty Commercial and less to Business Insurance and Personal Lines. In addition, beginning in the third quarter of 2006, the Company reduced the premiums assumed by Specialty Commercial under inter-segment arrangements covering certain liability claims.
Property earned premium decreased $216, or 47%, primarily because of a decline in new business and a decrease of $127 due to the decision made in the fourth quarter of 2004 to exit the multi-peril crop insurance (“MPCI”) business, partially offset by an increase in premium renewal retention. Also reducing earned premium was a $22 increase in reinstatement premiums paid to reinstate reinsurance treaty limits as a result of losses ceded from third and fourth quarter hurricanes of 2005 compared to reinstatement premiums paid in 2004 as a result of losses ceded from the third quarter hurricanes of 2004.
Casualty earned premiums grew $152, or 24%, primarily because earned premium in 2004 included a $90 decrease in earned premiums under retrospectively-rated policies. The remaining growth of $62 was largely attributable to the effect of earned pricing increases, partially offset by a decrease in new business growth. In 2005 and 2004, a single captive insurance program accounted for earned premium of $241 and $226, respectively.
Professional liability, fidelity and surety earned premium grew $32, or 6%, due to a decrease in the portion of risks ceded to outside reinsurers, new business growth in commercial and contract surety business, an increase in earned pricing for fidelity and surety business, and a decrease in the price of fidelity and surety reinsurance, partially offset by earned pricing decreases in professional liability.
Current accident year catastrophe losses decreased from by $156, $164 in 2005 to $8 in 2006. Catastrophe losses in 2005 included $145 of losses for hurricanes Katrina, Rita and Wilma.
Net unfavorable prior accident year reserve development of $35 in 2006 included a $45 strengthening of reserves for construction defects claims on casualty business for accident years 1997 and prior and a $20 strengthening of allocated loss adjustment expense reserves on workers’ compensation policies for claim payments expected to emerge after 20 years of development, partially offset by a $35 reduction in catastrophe reserves related to the 2005 hurricanes. The reduction in catastrophe reserves included a $28 reduction in net losses related to hurricane Katrina, despite a $24 increase in the gross loss estimate for hurricane Katrina. The decrease in net catastrophe loss reserves was primarily because hurricane Katrina losses on specialty property business were reimbursable under a specialty property reinsurance treaty covering national account business as well as under the Company’s principal property catastrophe reinsurance program. Under the provisions of an inter-segment reinsurance arrangement, a portion of the recoveries from the Company’s principal property catastrophe reinsurance program related to the reserve strengthening were allocated to Specialty Commercial.
Net unfavorable prior accident year reserve development of $109 in 2005 included a $70 strengthening of workers’ compensation reserves for claim payments expected to emerge after 20 years of development and a $20 strengthening of reserves for large deductible workers’ compensation policies related to accident years 1999 to 2001. Reserve development in 2005 also included a release of reserves for directors and officers insurance related to accident years 2003 and 2004 and strengthening of prior accident year reserves for contracts that provide auto financing gap coverage and auto lease residual value coverage; the release and offsetting strengthening were each approximately $80.
Before considering the $26 decrease in catastrophe treaty reinstatement premium, current accident year underwriting results before catastrophes for Specialty Commercial decreased by $27. Current accident year underwriting results before catastrophes for casualty decreased, primarily due to a higher loss and loss adjustment expense ratio. Before considering the decrease in catastrophe treaty reinstatement premium, current accident year underwriting results before catastrophes for property also decreased, primarily due to a decrease in earned premium, partially offset by the effects of lower non-catastrophe property loss costs. For professional liability, fidelity and surety business, current accident year underwriting results before catastrophes were relatively flat as an improvement in fidelity and surety was offset by a decrease in professional liability. For professional liability business, the effect of a higher loss and loss adjustment expense ratio and lower ceding commissions was partially offset by the effect of earned premium growth. Also contributing to the decrease in Specialty Commercial underwriting results was an increase in the allocation to Specialty Commercial of premiums ceded under the Company’s principal property catastrophe reinsurance program.
Underwriting results decreased by $112, with a corresponding 6.3 point increase in the combined ratio, to 109.4. The net decrease in underwriting results was principally driven by the following factors:
During 2006, written pricing decreased in casualty and professional liability and increased in property as well as in fidelity and surety. In the latter half of 2006, competition intensified for professional liability business, particularly for directors’ and officers’ insurance coverage. A lower frequency of class action cases in the past couple of years has put downward pressure on rates and this trend could reduce the growth rate of the Company’s professional liability business going forward. During 2007, the Company expects a lower non-catastrophe loss and loss adjustment expense ratio in specialty property due to the growth in earned pricing. Given the anticipated trends in pricing and loss costs in Specialty Commercial, management expects a combined ratio before catastrophes and prior accident year development in the range of 92.0 to 95.0 for 2007. The combined ratio before catastrophes and prior accident year development was 93.0 in 2006.
A combined ratio before catastrophes and prior accident year development of 92.0 to 95.0
Other Operations reported a net loss of $35 in 2006 compared to net income of $71 in 2005, driven by the following:
A $140 decrease in underwriting results, primarily due to a $148 increase in prior year loss development. Reserve development in 2006 included a $243 reduction in net reinsurance recoverables as a result of the agreement with Equitas and the Company’s evaluation of the reinsurance recoverables and allowance for uncollectible reinsurance associated with older, long-term casualty liabilities reported in the Other Operations segment, $43 of environmental reserve strengthening, and $12 of reserve strengthening for assumed reinsurance. In 2005, reserve development included $85 of reserve strengthening for assumed reinsurance, $37 of environmental reserve strengthening, and a $20 increase in the allowance for uncollectible reinsurance.
Other Operations reported net income of $71 in 2005 compared to a net loss of $45 in 2004, driven by the following:
The Company wrote several different categories of insurance contracts that may cover asbestos and environmental claims. First, the Company wrote primary policies providing the first layer of coverage in an insured’s liability program. Second, the Company wrote excess policies providing higher layers of coverage for losses that exhaust the limits of underlying coverage. Third, the Company acted as a reinsurer assuming a portion of those risks assumed by other insurers writing primary, excess and reinsurance coverages. Fourth, subsidiaries of the Company participated in the London Market, writing both direct insurance and assumed reinsurance business.
In addition, within the “all other” category of reserves, Other Operations records its allowance for future reinsurer insolvencies and disputes that might affect reinsurance collectibility associated with asbestos, environmental, and other claims recoverable from reinsurers.
Excludes asbestos and environmental net liabilities reported in Ongoing Operations of $9 and $6, respectively, as of December 31, 2006, $10 and $6, respectively, as of December 31, 2005, and $13 and $9, respectively, as of December 31, 2004. Total net losses and loss adjustment expenses incurred in Ongoing Operations for the years ended December 31, 2006, 2005 and 2004 includes $11, $11 and $13, respectively, related to asbestos and environmental claims. Total net losses and loss adjustment expenses paid in Ongoing Operations for the years ended December 31, 2006, 2005 and 2004 includes $12, $17 and $11, respectively, related to asbestos and environmental claims.
Gross of reinsurance, asbestos and environmental reserves, including liabilities in Ongoing Operations, were $3,242 and $362, respectively, as of December 31, 2006, $3,845 and $432, respectively, as of December 31, 2005, and $4,322 and $501, respectively, as of December 31, 2004.
The one year and average three year net paid amounts for asbestos claims, including Ongoing Operations, were $368 and $595, respectively, resulting in a one year net survival ratio of 6.1 and a three year net survival ratio of 3.8 (9.0 excluding the MacArthur payments). Net survival ratio is the quotient of the net carried reserves divided by the average annual payment amount and is an indication of the number of years that the net carried reserve would last (i.e. survive) if the future annual claim payments were consistent with the calculated historical average.
The Company has been evaluating and closely monitoring assumed reinsurance reserves in Other Operations. With the transfer of certain assumed reinsurance business into Other Operations, the segment has exposure related to more recent assumed casualty reinsurance reserves, particularly for the underwriting years 1997 through 2001. Assumed reinsurance exposures are inherently less predictable than direct insurance exposures because the Company may not receive notice of a reinsurance claim until the underlying direct insurance claim is mature. This causes a delay in the receipt of information from the ceding companies. In recent years, the Company has seen an increase in reported losses above previous expectations and this increase in reported losses contributed to reserve re-estimates.
Gross Environmental Reserves based on the third quarter 2006 environmental reserve study.
During the second quarters of 2006, 2005 and 2004, the Company completed its annual evaluations of the reinsurance recoverables and allowance for uncollectible reinsurance associated with older, long-term casualty liabilities reported in the Other Operations segment. In the second quarter of 2006, the Company entered into an agreement with Equitas and all Lloyd’s syndicates reinsured by Equitas (collectively, “Equitas”) that resolved, with minor exception, all of the Company’s ceded and assumed domestic reinsurance exposures with Equitas, including all of the Company’s reinsurance recoveries from Equitas under the Blanket Casualty Treaty (BCT). As a result of the settlement with Equitas and the 2006 reinsurance recoverable evaluation, the Company reduced its net reinsurance recoverable by $243. As a result of the evaluation in the second quarter of 2005, the Company increased its allowance for uncollectible reinsurance by $20 to reflect deterioration in the credit ratings of certain reinsurers and the Company’s opinion as to the ability of certain reinsurers to pay claims in the future. As a result of the evaluation in the second quarter of 2004, the Company reduced its net reinsurance recoverable by $181, which was comprised of a $126 reduction of ceded amounts and a $55 increase in the allowance for uncollectible reinsurance. In 2004, the Company also consolidated within the “all other” category its allowance for reinsurer credit quality and disputes that might affect reinsurance coverage associated with Other Operations into a single allowance.
In conducting these evaluations of reinsurance recoverables, the Company used its most recent detailed evaluations of ceded liabilities reported in the segment, including its estimate of future claims, the reinsurance arrangements currently in place and the years of potential reinsurance available. The Company also analyzed the overall credit quality of the Company’s reinsurers, recent trends in arbitration and litigation outcomes in disputes between cedants and reinsurers, and recent developments in commutation activity between reinsurers and cedants. In 2006, the Company also considered the effect of the Equitas settlement on the collectibility of amounts due from other upper-layer reinsurers under the BCT. The allowance for uncollectible reinsurance reflects management’s best estimate of reinsurance cessions that may be uncollectible in the future due to reinsurers’ unwillingness or inability to pay.
During the second quarters of 2006 and 2005, the Company completed its annual asbestos reserve evaluations. As part of these evaluations, the Company reviewed all of its open direct domestic insurance accounts exposed to asbestos liability as well as assumed reinsurance. The Company also examined its London Market exposures for both direct insurance and assumed reinsurance. These evaluations resulted in no addition to the Company’s gross and net asbestos reserves. During the first quarter of 2004, the Company completed an updated gross asbestos reserve evaluation. As part of this evaluation, the Company also reviewed all of its open direct domestic insurance accounts exposed to asbestos liability as well as assumed reinsurance accounts and certain closed accounts. The Company also examined its London Market exposures for both direct insurance and assumed reinsurance. The evaluation indicated no change in the overall gross asbestos reserves. The Company currently expects to continue to perform an evaluation of its asbestos liabilities annually.
On December 19, 2003, Hartford Accident and Indemnity Co. (“Hartford A&I”) entered into a settlement agreement with MacArthur Co. and its subsidiary, Western MacArthur Co. Under the settlement agreement, during the first quarter of 2004, Hartford A&I paid $1.15 billion into an escrow account owned by Hartford A&I. The funds were held in the escrow account until conditions precedent to the settlement occurred. On April 22, 2004, the funds were disbursed from the escrow account into a trust established for the benefit of present and future asbestos claimants pursuant to the bankruptcy plan. The settlement payments were accounted for as a reduction in unpaid loss and loss adjustment expenses during the first quarter of 2004.
An account may move between categories from one evaluation to the next. For example, an account with future expected exposure of greater than $2.5 in one evaluation may be reevaluated due to changing conditions and recategorized as less than $2.5 in a subsequent evaluation or vice versa.
An account may move between categories from one evaluation to the next. Reclassifications were made as a result of the reserve evaluation completed in the second quarter of 2006.
For Paid and Incurred Losses and Loss Adjustment Expenses Reporting, the Company classifies its asbestos and environmental reserves into three categories: Direct insurance, Assumed reinsurance and London Market. Direct insurance includes primary and excess coverage. Assumed reinsurance includes both “treaty” reinsurance (covering broad categories of claims or blocks of business) and “facultative” reinsurance (covering specific risks or individual policies of primary or excess insurance companies). London Market business includes the business written by one or more of the Company’s subsidiaries in the United Kingdom, which are no longer active in the insurance or reinsurance business. Such business includes both direct insurance and assumed reinsurance.
The following table sets forth, for the years ended December 31, 2006, 2005 and 2004, paid and incurred loss activity by the three categories of claims for asbestos and environmental.
Excludes asbestos and environmental paid and incurred losses and LAE reported in Ongoing Operations. Total gross losses and loss adjustment expenses paid in Ongoing Operations for the twelve months ended December 31, 2006, 2005, and 2004 includes $12, $23 and $11, respectively, related to asbestos and environmental claims. Total gross losses and loss adjustment expenses incurred in Ongoing Operations for the twelve months ended December 31, 2006, 2005, and 2004 includes $10, $17 and $14, respectively, related to asbestos and environmental claims.
HIMCO portfolio managers may sell securities (except those securities in an unrealized loss position for which the Company has indicated its intent and ability to hold until the price recovers) due to portfolio guidelines or market technicals or trends. For example, the Company may sell securities to manage risk, capture market valuation inefficiencies or relative value opportunities, to remain compliant with internal asset/liability duration matching guidelines, or to modify a portfolio’s duration to capitalize on interest rate levels or the yield curve slope.
The Company invests in private placement securities, mortgage loans and limited partnership arrangements in order to further diversify its investment portfolio. These investment types comprised approximately 21% and 18% of the fair value of its invested assets as of December 31, 2006 and 2005, 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 to compensate for the liquidity risk.
A decrease in the fair value of any investment that is deemed other-than-temporary would result in the Company’s recognition of a net realized capital loss in its financial results prior to the actual sale of the investment. Following the recognition of the other-than-temporary impairment for fixed maturities, the company amortizes the new cost basis to par or to estimated future value over the remaining life of the security based on future estimated cash flows. For a further discussion of the evaluation of other-than-temporary impairments, see the Critical Accounting Estimates section of the MD&A under “Evaluation of Other-Than-Temporary Impairments on Available-for-Sale Securities”.
The Hartford’s investments in fixed maturities, which include bonds, redeemable preferred stock and commercial paper; and certain equity securities, which include common and non-redeemable preferred stocks, are classified as “available-for-sale” and accordingly, are carried at fair value with the after-tax difference from cost or amortized cost, as adjusted for the effect of deducting the life and pension policyholders’ share of the immediate participation guaranteed contracts; and certain life and annuity deferred policy acquisition costs and reserve adjustments, reflected in stockholders’ equity as a component of AOCI. The equity investments associated with the variable annuity products offered in Japan are recorded at fair value and are classified as “trading” with changes in fair value recorded in net investment income. Policy loans are carried at outstanding balance, which approximates fair value. Mortgage loans on real estate are recorded at the outstanding principal balance adjusted for amortization of premiums or discounts and net of valuation allowances, if any. Other investments primarily consist of derivatives, and limited partnership interests and proportionate share limited liability companies (collectively “limited partnerships”). Limited partnerships are reported at their carrying value with the change in carrying value accounted for under the equity method and accordingly the Company’s share of earnings are included in net investment income. Derivatives are carried at fair value.
The fair value for fixed maturity securities is largely determined by one of three primary pricing methods: independent third party pricing service market quotations, independent broker quotations or pricing matrices, which use market data provided by external sources. With the exception of short-term securities for which amortized cost is predominantly used to approximate fair value, security pricing is applied using a hierarchy or “waterfall” approach whereby prices are first sought from independent pricing services with the remaining unpriced securities submitted to brokers for prices or lastly priced via a pricing matrix.
Prices from independent pricing services are often unavailable for securities that are rarely traded or are traded only in privately negotiated transactions. As a result, certain of the Company’s ABS and commercial mortgage-backed securities (“CMBS”) are priced via broker quotations. A pricing matrix is used to price securities for which the Company is unable to obtain either a price from an independent third party service or an independent broker quotation. The pricing matrix begins with current treasury rates and uses credit spreads and issuer-specific yield adjustments received from an independent third party source to determine the market price for the security. The credit spreads, as assigned by a nationally recognized rating agency, incorporate the issuer’s credit rating and a risk premium, if warranted, due to the issuer’s industry and the security’s time to maturity. The issuer-specific yield adjustments, which can be positive or negative, are updated twice annually, as of June 30 and December 31, by an independent third party source and are intended to adjust security prices for issuer-specific factors. The matrix-priced securities at December 31, 2006 and 2005, primarily consisted of non-144A private placements and have an average duration of 5.1 and 5.0 years, respectively.
The following table presents the fair value of fixed maturity securities by pricing source as of December 31, 2006 and 2005.
The following table identifies the invested assets by type held in the general account as of December 31, 2006 and 2005.
The following table summarizes Life’s limited partnerships as of December 31, 2006 and 2005.
Mezzanine debt funds consist of investments in funds whose assets consist of subordinated debt that often times incorporates equity-based options such as warrants and a limited amount of direct equity investments.
The net losses on fixed maturity sales for the year ended December 31, 2006, were primarily the result of rising interest rates from the date of security purchase and, to a lesser extent, credit spread widening on certain issuers that were sold. For further discussion of gross gains and losses, see below.
Net investment income, excluding income on policy loans and equity securities held for trading, increased $164, or 6%, compared to the prior year. The increase in net investment income was primarily due to income earned on a higher average invested assets base as well as higher partnership income. The increase in the average invested assets base, as compared to the prior year, was primarily due to positive operating cash flows, investment contract sales such as retail and institutional notes, and universal life-type product sales such as individual fixed annuity products sold in Japan. The higher partnership income was due to certain of the Company’s partnerships reporting higher market values and the result of certain partnerships liquidating their underlying investment holdings in the favorable market environment.
Higher net realized capital losses in 2005 resulted from rising Japanese interest rates, and in the first half of the year, a decrease in U.S. interest rates. For additional discussion of the Japanese fixed annuity contract hedges see the Capital Markets Risk Management section of the MD&A under “Market Risk-Life” and Note 4 of Notes to Consolidated Financial Statements.
Fixed maturity investments increased $1.8 billion, or 7%, since December 31, 2005, primarily as the result of positive operating cash flows and an increase in the collateral held from increased securities lending activities offset by an increase in interest rates. Mortgage loans increased $189, or 86%, since December 31, 2005, as a result of a decision to continue to increase Property & Casualty’s investment in this asset class primarily due to its attractive yields and diversification opportunities.
Limited partnerships increased by $213, or 90%, during 2006. HIMCO believes investing in limited partnerships provides an opportunity to diversify its portfolio and earn above average returns over the long-term. However, significant price volatility can exist quarter to quarter. Prior to investing, HIMCO performs an extensive due diligence process which attempts to identify funds that have above average return potential and managers with proven track records for results, many of which utilize sophisticated risk management techniques. Due to capital requirements, HIMCO closely monitors the impact of these investments in relationship to the investment portfolio and the overall consolidated balance sheet. HIMCO does not expect investments in limited partnerships to exceed 3% of the fair value of Property & Casualty’s investment portfolio.
The following table summarizes Property & Casualty’s limited partnerships as of December 31, 2006 and 2005.
Hedge funds include investments in funds of funds as well as direct funds. The hedge funds of funds invest in approximately 40 to 90 different hedge funds within a variety of investment styles. In addition, Other Investments includes $384 of hedge funds based investments which are not limited partnerships and therefore, not included in the table above. Examples of hedge fund strategies include long/short equity or credit, event driven strategies and structured credit.
Represents annualized net investment income divided by the monthly weighted average invested assets at cost or amortized cost, as applicable, excluding the collateral received associated with securities lending programs.
Primarily consists of changes in fair value on non-qualifying derivatives and hedge ineffectiveness on qualifying derivatives.
Gross losses on the sale of fixed maturities for the year ended December 31, 2006 were concentrated in the corporate and CMBS sectors with no single security sold at a loss in excess of $4, and an average loss as a percentage of the fixed maturity’s amortized cost of less than 3%, which, under the Company’s impairment policy was deemed to be depressed only to a minor extent.
Net realized capital gains before-tax for 2005 decreased $89 as compared to the prior year primarily due to lower net realized gains on fixed maturity securities, lower periodic net coupon settlements on credit derivatives, as well as net losses on non-qualifying derivatives in 2005 compared to net gains in 2004.
Gross gains on the sale of fixed maturities for the year ended December 31, 2005, were concentrated in the corporate and foreign government sectors and were the result of decisions to reposition the portfolio due to credit spread tightening in certain sectors and changes in foreign currency exchange rates. Certain lower quality corporate securities that had appreciated in value as a result of an improved corporate credit environment were sold to reposition the corporate holdings into higher quality securities. Foreign securities were sold to reduce the foreign currency exposure in the portfolio due to the expected near term volatility in foreign exchange rates. Also, certain foreign government securities appreciated in price and were sold to reposition the portfolio into higher credit quality securities.
Gross losses on the sale of fixed maturities for the year ended December 31, 2005, were primarily within corporate and foreign government securities. Included in the corporate gross losses were losses on sales of securities related to a major automotive manufacturer of $10, before-tax, that primarily occurred during the second quarter. Sales related to actions taken to reduce issuer exposure in light of a downward adjustment in earnings and cash flow guidance primarily due to sluggish sales, rising employee and retiree benefit costs and an increased debt service interest burden, and to reposition the portfolio into higher quality securities. For the year ended December 31, 2005, excluding sales related to the automotive manufacturer noted above, there was no single security sold at a loss in excess of $3, and the average loss as a percentage of the fixed maturity’s amortized cost was less than 2%, which under the Company’s impairment policy was deemed to be depressed only to a minor extent.
The investment objective of Corporate is to raise capital through financing activities to support the Life and Property & Casualty operations of the Company and to maintain sufficient funds to support the cost of those financing activities including the payment of interest for The Hartford Financial Services Group, Inc. (“HFSG”) issued debt and dividends to shareholders of The Hartford’s common stock. As of December 31, 2006 and 2005, Corporate held $404 and $298, respectively, of fixed maturity investments. In addition, Corporate held $55 and $0 of equity securities as of December 31, 2006 and 2005, respectively.
The Company provides collateral management services and earns a fee associated with these structures.
The maximum exposure to loss is the Company’s co-investment in these structures.
The maximum exposure to loss is equal to the carrying value of the investment plus any unfunded commitments.
In addition to the VIEs described above, as of December 31, 2006 and 2005, the Company held variable interest in three CDOs that are managed by HIMCO where the Company is not the primary beneficiary. As a result, these are not consolidated by the Company. These investments have been held by the Company for a period of one to three years. The Company’s maximum exposure to loss from the non-consolidated CDOs (consisting of the Company’s investments) was approximately $20 and $21 as of December 31, 2006 and 2005, respectively.
The Company categorizes impairments as credit related and other. If the Company determines that it is not likely to receive interest or principal amounts based upon the initial expectations of the security or due in accordance with the contractual terms of the security, the impairment is characterized as credit related. The Company may also characterize an impairment as credit related if substantially all of the depression in security value is related to issuer credit spread widening. Company management uses average credit related impairment amounts within Life and Property & Casualty product pricing assumptions. The other-than-temporary impairments recorded in Other are primarily related to securities that had declined in value and for which the Company was uncertain of its intent to retain the investment for a period of time sufficient to allow recovery to cost or amortized cost.
The following discussion provides an analysis of significant other-than-temporary impairments recognized during 2006, 2005 and 2004, the related circumstances giving rise to the other-than-temporary impairments and the potential impact such circumstances may have on other material investments held.
Future other-than-temporary impairment levels will depend primarily on economic fundamentals, political stability, issuer and/or collateral performance and future movements in interest rates. If interest rates continue to increase during 2007 or credit spreads widen, other-than-temporary impairments for 2007 would likely be higher than the 2006 levels. For further discussion of risk factors associated with portfolio sectors with significant unrealized loss positions, see the risk factor commentary under the Consolidated Total Available-for-Sale Securities with Unrealized Loss Greater than Six Months by Type table in the Investment Credit Risk section that follows.
Also included in the corporate securities other-than-temporary impairment amount for 2005 was $9 recorded on securities related to two major automotive manufacturers. The market values of these securities had fallen due to a downward adjustment in earnings and cash flow guidance primarily due to sluggish sales, rising employee and retiree benefit costs and an increased debt
In addition to counterparty credit risk, the Company periodically enters into swap agreements in which the Company assumes credit exposure from or reduces credit exposure to a single entity, referenced index, or asset pool. Summaries of these derivatives are as follows:
Total return swaps and credit spreadlocks involve the periodic exchange of payments with other parties, at specified intervals, calculated using the agreed upon index and notional principal amounts. Generally, no cash or principal payments are exchanged at the inception of the contract. Typically, at the time a swap is entered into, the cash flow streams exchanged by the counterparties are equal in value. As of December 31, 2006 and 2005, the notional value of total return swaps and credit spreadlocks, which exposed the Company to credit risk, totaled $2.7 billion and $1.9 billion, respectively, and the fair value totaled $1 and $5, respectively.
equal to the notional value of the swap contract less the value of the referenced security issuer debt obligation. A credit event is generally defined as default on contractually obligated interest or principal payments or bankruptcy. Certain credit default swaps require an upfront premium to be paid at inception of the contract. During 2006, the Company began using credit default swaps to replicate residual CDO interests. These transactions involve the receipt of cash upon entering into the transaction as well as coupon payments throughout the life of the contract. The upfront cash receipts for positions at December 31, 2006, totaled $201, which represents the original liability value of the credit default swaps. For credit default swaps in which the Company is exposed to credit risk, as of December 31, 2006 and 2005, the notional value totaled $1.8 billion and $700, respectively, and the fair value totaled $(184) and $(4), respectively. As of December 31, 2006, the average S&P rating for these referenced security issuer debt obligations is BBB+. For credit default swaps in which the Company has reduced its credit exposure, as of December 31, 2006 and 2005, the notional value totaled $3.1 billion and $254, respectively, and the fair value totaled $(11) and $2, respectively. As of December 31, 2006, the average S&P rating for these referenced security issuers debt obligations is BBB. The increase in notional value of risk reducing credit default swaps since December 31, 2005, primarily related to negative basis trades. These trades involve the purchase of a cash bond along with credit protection on the issuer through a credit default swap in order to lock in a positive spread to LIBOR.
The following table identifies fixed maturity securities by type on a consolidated basis as of December 31, 2006 and 2005.
The Company’s fixed maturity net unrealized gains decreased $208 from December 31, 2005 to December 31, 2006. The decrease was primarily due to an increase in interest rates and decline in the U.S. dollar in comparison to foreign denominated currencies, partially offset by credit spread compression and other-than-temporary impairments taken during the year. Gross unrealized gains and losses were also reduced by securities sold in a gain or loss position, respectively.
For further discussion of risk factors associated with sectors with significant unrealized loss positions, see the sector risk factor commentary under the Consolidated Total Available-for-Sale Securities with Unrealized Loss Greater than Six Months by Type table in this section of the MD&A.
At the January 2007 Federal Open Market Committee (“FOMC”) meeting, the Federal Reserve maintained the target federal funds rate at 5.25%. The FOMC stated that inflation risks have improved modestly in recent months and inflation pressure was likely to moderate overtime, but maintained the view that upside risk remains. An increase in future interest rates may result in lower fixed maturity valuations, an increase in gross unrealized losses and a decrease in gross unrealized gains.
The following table identifies fixed maturities by credit quality on a consolidated basis as of December 31, 2006 and 2005. The ratings referenced below are based on the ratings of a nationally recognized rating organization or, if not rated, assigned based on the Company’s internal analysis of such securities. The Company held no issuer of a BIG security with a fair value in excess of 4% of the total fair value for BIG securities as of December 31, 2006 and 2005.
The decrease in the unrealized loss amount since December 31, 2005, is primarily the result of asset sales, credit spread compression and other-than-temporary impairments recorded in 2006, offset in part by an increase in interest rates. For further discussion, see the economic commentary under the Consolidated Fixed Maturities by Type table in this section of the MD&A.
The total securities classified as available-for-sale in an unrealized loss position for longer than six months by type as of December 31, 2006 and 2005 are presented in the following table.
Utilities - As of December 31, 2006, the Company held approximately 140 different securities that were in an unrealized loss position for six months or more. Most of these securities are fixed rate, investment grade securities with extended maturity dates, which have been adversely impacted by changes in interest rates after the purchase date. Additional changes in fair value of these securities are primarily dependent on future changes in general market conditions, including interest rates and credit spread movements.
Aircraft lease receivables - The Company’s holdings are asset-backed securities secured by leases to airlines primarily outside of the United States. Based on the current and expected future collateral values of the underlying aircraft, a recent improvement in lease rates and an overall increase in worldwide travel, the Company expects to recover the full amortized cost of these investments. However, future price recovery will depend on continued improvement in economic fundamentals, political stability, airline operating performance and collateral value.
As part of the Company’s ongoing security monitoring process by a committee of investment and accounting professionals, the Company has reviewed its investment portfolio and concluded that there were no additional other-than-temporary impairments as of December 31, 2006 and 2005. Due to the issuers’ continued satisfaction of the securities’ obligations in accordance with their contractual terms and the expectation that they will continue to do so, management’s intent and ability to hold these securities to recovery, as well as the evaluation of the fundamentals of the issuers’ financial condition and other objective evidence, the Company believes that the prices of the securities in the sectors identified above were temporarily depressed.
The Hartford is exposed to market risk, primarily relating to the market price and/or cash flow variability associated with changes in interest rates, equity prices or foreign currency exchange rates.
experienced at the interest rate levels projected for the underlying collateral. Actual prepayment experience may vary from these estimates.
Since the Company matches, and actively manages its assets and liabilities, an interest environment with an inverted yield curve (i.e. short-term interest rates are higher than intermediate-term or long-term interest rates) does not significantly impact the Company’s profits or operations. As noted above, the absolute level of interest rates is more significant than the shape of the yield curve.
The Company does not have significant equity risk exposure from invested assets. The Company’s primary exposure to equity risk relates to the potential for lower earnings associated with certain of the Life’s businesses such as variable annuities where fee income is earned based upon the fair value of the assets under management. In addition, Life offers certain guaranteed benefits, primarily associated with variable annuity products, which increases the Company’s potential benefit exposure as the equity markets decline. For a further discussion, see Life Equity Risk in this section of the MD&A.
The Hartford utilizes a variety of derivative instruments, including swaps, caps, floors, forwards, futures and options, in compliance with Company policy and regulatory requirements to mitigate interest rate, equity market or foreign currency exchange rate risk or volatility.
Derivative activities are monitored by an internal compliance unit and reviewed frequently by senior management. The notional amounts of derivative contracts represent the basis upon which pay or receive amounts are calculated and are not reflective of credit risk. Notional amounts pertaining to derivative instruments used in the management of market risk at December 31, 2006 and 2005, were $78.2 billion and $62.9 billion, respectively. The increase in the derivative notional amount during 2006 was primarily due to the derivatives associated with the GMWB product feature. For further information, see Note 4 of Notes to Consolidated Financial Statements.
Life’s investment portfolios primarily consist of investment grade fixed maturity securities, including corporate bonds, ABS, CMBS, tax-exempt municipal securities and CMOs. The fair value of Life’s fixed maturities was $53.2 billion and $50.8 billion at December 31, 2006 and 2005, respectively. The fair value of Life’s fixed maturities and other invested assets fluctuates depending on the interest rate environment and other general economic conditions. During periods of declining interest rates, paydowns on MBS and CMOs increase as the underlying mortgages are prepaid. During such periods, the Company generally will not be able to re-invest the proceeds of any such prepayments at comparable yields. Conversely, during periods of rising interest rates, the rate of prepayments generally declines, exposing the Company to the possibility of asset/liability cash flow and yield mismatch. The weighted average duration of the fixed maturity portfolio was approximately 5.1 and 5.3 years as of December 31, 2006 and 2005, respectively.
Asset accumulation vehicles primarily require a fixed rate payment, often for a specified period of time. Product examples include fixed rate annuities with a market value adjustment feature and fixed rate guaranteed investment contracts. The duration of these contracts generally range from less than one year to ten years. In addition, certain products such as universal life contracts and the
general account portion of Life’s variable annuity products, credit interest to policyholders subject to market conditions and minimum interest rate guarantees. The duration of these products is short-term to intermediate-term.
At December 31, 2006 and 2005, notional amounts pertaining to derivatives utilized to manage interest rate risk totaled $15.6 billion and $10.6 billion, respectively ($11.4 billion and $7.5 billion, respectively, related to investments and $4.2 billion and $3.1 billion, respectively, related to life liabilities). The fair value of these derivatives was $(42) and $(22) as of December 31, 2006 and 2005, respectively.
The fixed liabilities included above represented approximately 46% and 45% of Life’s general account liabilities as of December 31, 2006 and 2005, respectively. The assets supporting the fixed liabilities are monitored and managed within rigorous duration guidelines using scenario simulation techniques, and are evaluated on an annual basis, in compliance with regulatory requirements.
pressure. Depending on the degree of consumer receptivity and competitor reaction to continuing changes in the Company’s product offerings, the Company’s future level of sales will continue to be subject to uncertainty.
In the U.S., the Company sells variable annuity contracts that offer various guaranteed death benefits. The Company maintains a liability, under SOP 03-1, for the death benefit costs of $475 as of December 31, 2006. Declines in the equity market may increase the Company’s net exposure to death benefits under these contracts. The majority of the contracts with the guaranteed death benefit feature are sold by the Retail Products Group segment. For certain guaranteed death benefits, the Company pays the greater of (1) the account value at death, (2) the sum of all premium payments less prior withdrawals; or (3) the maximum anniversary value of the contract, plus any premium payments since the contract anniversary, minus any withdrawals following the contract anniversary. For certain guaranteed death benefits sold with variable annuity contracts beginning in June 2003, the Company pays the greater of (1) the account value at death, or (2) the maximum anniversary value; not to exceed the account value plus the greater of (a) 25% of premium payments, or (b) 25% of the maximum anniversary value of the contract. The Company currently reinsures a significant portion of these death benefit guarantees associated with its in-force block of business. Under certain of these reinsurance agreements, the reinsurers exposure is subject to an annual cap.
The Company’s total gross exposure (i.e., before reinsurance) to these U.S. guaranteed death benefits as of December 31, 2006 is $5.0 billion. Due to the fact that 83% of this amount is reinsured, the Company’s net exposure is $824. This amount is often referred to as the retained net amount at risk. However, the Company will incur these guaranteed death benefit payments in the future only if the policyholder has an in-the-money guaranteed death benefit at their time of death.
In 2006, the Company entered into an indemnity reinsurance agreement with an unrelated party. Under this agreement, the reinsurer will reimburse the Company for death benefit claims, up to an annual cap, incurred for certain death benefit guarantees associated with an in-force block of variable annuity products offered in Japan with an account value of $2.5 billion as of December 31, 2006.
The Company’s total gross exposure (i.e. before reinsurance) to these guaranteed death benefits and income benefits offered in Japan as of December 31, 2006 is $54. Due to the fact that 65% of this amount is reinsured, the Company’s net exposure is $19. This amount is often referred to as the retained net amount at risk. However, the Company will incur these guaranteed death or income benefits in the future only if the contract holder has an in-the-money guaranteed benefit at either the time of their death or if the account value is insufficient to fund the guaranteed living benefits.
The majority of the Company’s recent U.S. variable annuities are sold with a GMWB living benefit rider, which, as described above, is accounted for under SFAS No. 133. Declines in the equity market may increase the Company’s exposure to benefits under the GMWB contracts. For all contracts in effect through July 6, 2003, the Company entered into a reinsurance arrangement to offset its exposure to the GMWB for the remaining lives of those contracts. Substantially all of the Company’s reinsurance capacity was utilized as of the third quarter of 2003. The remaining capacity was exhausted during the first quarter of 2004. Substantially all U.S. GMWB riders sold since July 2003, are not covered by reinsurance. These unreinsured contracts generate volatility in net income each quarter as the underlying embedded derivative liabilities are recorded at fair value each reporting period, resulting in the recognition of net realized capital gains or losses in response to changes in certain critical factors including capital market conditions and policyholder behavior. In order to minimize the volatility associated with the unreinsured GMWB liabilities, the Company established an alternative risk management strategy. During the third quarter of 2003, the Company began hedging its unreinsured GMWB exposure using interest rate futures, and swaps Standard and Poor’s (“S&P”) 500 and NASDAQ index put options and futures contracts. During the first quarter of 2004, the Company entered into Europe, Australasia and Far East (“EAFE”) Index swaps to hedge GMWB exposure to international equity markets. The hedging program involves a detailed monitoring of policyholder behavior and capital markets conditions on a daily basis and rebalancing of the hedge position as needed. While the Company actively manages this hedge position, hedge ineffectiveness may result due to factors including, but not limited to, policyholder behavior, capital markets dislocation or discontinuity and divergence between the performance of the underlying funds and the hedging indices.
The Company continually seeks to improve its equity risk management strategies. The Company has made considerable investment in analyzing current and potential future market risk exposures arising from a number of factors, including but not limited to, product guarantees (GMDB, GMWB and GMIB), equity market and interest rate risks (in both the U.S. and Japan) and foreign currency exchange rates. The Company evaluates these risks individually and, increasingly, in the aggregate to determine the risk profiles of all of its products and to judge their potential impacts on GAAP net income, statutory capital volatility and other metrics. Utilizing this and future analysis, the Company expects to evolve its risk management strategies over time, modifying its reinsurance, hedging and product design strategies to optimally mitigate its aggregate exposures to market-driven changes in GAAP equity, statutory capital and other economic metrics. Because these strategies could target an optimal reduction of a combination of exposures rather than targeting a single one, it is possible that volatility of GAAP net income would increase, particularly if the Company places an increased relative weight on protection of statutory surplus in future strategies.
Life’s exposure to foreign currency exchange risk exists with respect to non-U.S. dollar denominated investments, Life’s investment in foreign operations, primarily Japan, and non-U.S. dollar denominated liability contracts, including the yen based individual fixed annuity product and its GMDB and GMIB benefits associated with its Japanese variable annuities. A significant portion of the Company’s foreign fixed maturity currency exposure is mitigated through the use of derivatives.
The yen based fixed annuity product is written by Hartford Life Insurance K.K. (“HLIKK”), a wholly-owned Japanese subsidiary of Hartford Life, Inc. (“HLI”), and subsequently reinsured to Hartford Life Insurance Company, a U.S. dollar based wholly-owned indirect subsidiary of HLI. The underlying investment involves investing in U.S. securities markets, which offer favorable credit spreads. The yen denominated fixed annuity product (“yen fixed annuities”) is recorded in the consolidated balance sheets with invested assets denominated in dollars while policyholder liabilities are denominated in yen and converted to U.S. dollars based upon the December 31, yen to U.S. dollar spot rate. The difference between U.S. dollar denominated investments and yen denominated liabilities exposes the Company to currency risk. The Company manages this currency risk associated with the yen fixed annuities primarily with pay variable U.S. dollar and receive fixed yen currency swaps. As of December 31, 2006 and 2005, the notional value and fair value of the currency swaps were $1.9 billion and $1.7 billion, respectively, and $(225) and $(179), respectively. Although economically an effective hedge, a divergence between the yen denominated fixed annuity product liability and the currency swaps exists primarily due to the difference in the basis of accounting between the liability and the derivative instruments (i.e. historical cost versus fair value). The yen denominated fixed annuity product liabilities are recorded on a historical cost basis and are only adjusted for changes in foreign spot rates and accrued income. The currency swaps are recorded at fair value, incorporating changes in value due to changes in forward foreign exchange rates, interest rates and accrued income. An after-tax net gain (loss) of $(11) and $(23) for the years ended December 31, 2006 and 2005, respectively, which includes the changes in value of the currency swaps, excluding net periodic coupon settlements, and the yen fixed annuity contract remeasurement, was recorded in net realized capital gains and losses.
Property & Casualty attempts to maximize economic value while generating appropriate after-tax income and sufficient liquidity to meet policyholder and corporate obligations. Property & Casualty’s investment portfolio has material exposure to interest rates. The Company continually monitors these exposures and makes portfolio adjustments to manage these risks within established limits.
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 4.5 and 4.6 years as of December 31, 2006 and 2005, respectively.
The following table provides an analysis showing the estimated after-tax change in the fair value of Property & Casualty’s fixed income investments and related derivatives, assuming 100 basis point upward and downward parallel shifts in the yield curve as of December 31, 2006 and 2005. Certain financial instruments, such as limited partnerships, have been omitted from the analysis due to the fact that the investments are accounted for under the equity method and generally lack sensitivity to interest rate changes.
Foreign currency exchange risk exists with respect to investments in non-U.S. dollar denominated fixed maturities, primarily euro, sterling and Canadian dollar denominated securities. The risk associated with these securities relates to potential decreases in value resulting from unfavorable changes in foreign exchange rates. The fair value of these fixed maturity securities at December 31, 2006 and 2005 was $1.0 billion and $1.1 billion, respectively.
On September 1, 2005, the stock of HLIKK was transferred from HLA to Hartford Life, Inc. The transfer of the stock was treated as a return of capital for GAAP and statutory accounting purposes for the respective entities. This transaction had no effect on the Company’s consolidated GAAP financial statements. For Statutory, the primary financial effect of the transaction was to reduce the statutory capital of HLA by the amount of the carrying value of HLIKK, which was $963 as of September 1, 2005. In addition, for certain capital adequacy ratios, a corresponding reduction in required capital occurred, which resulted in an improved capital adequacy
ratio. However, as previously disclosed, this action could potentially reduce certain other capital adequacy ratios employed by regulators and rating agencies to assess the capital growth of The Hartford’s life insurance operations. At the current time, taking into consideration the effects of the transaction, the Company believes it has sufficient capital resources to maintain capital solvency ratios consistent with all of its objectives.
The Company’s Board of Directors has authorized the repurchase of outstanding shares of its common stock and equity units from time to time, in an aggregate amount not to exceed $2 billion. On October 19, 2006, the Company announced that it intends to repurchase up to $300 of its common stock over the two to six months following its announcement, under such share repurchase program. On December 11, 2006, the Company announced that it intends to repurchase an additional $500 of its common stock under the existing share repurchase program. Through February 16, 2007, The Hartford had repurchased approximately $363 (3.8 million shares) under this program.
HFSG and HLI are holding companies which rely upon operating cash flow in the form of dividends from their subsidiaries, which enable them to service debt, pay dividends, and pay certain business expenses. Dividends to the Company from its insurance subsidiaries are restricted. The payment of dividends by Connecticut-domiciled insurers is limited under the insurance holding company laws of Connecticut. These laws require notice to and approval by the state insurance commissioner for the declaration or payment of any dividend, which, together with other dividends or distributions made within the preceding twelve months, exceeds the greater of (i) 10% of the insurer’s policyholder surplus as of December 31 of the preceding year or (ii) net income (or net gain from operations, if such company is a life insurance company) for the twelve-month period ending on the thirty-first day of December last preceding, in each case determined under statutory insurance accounting principles. In addition, if any dividend of a Connecticut-domiciled insurer exceeds the insurer’s earned surplus, it requires the prior approval of the Connecticut Insurance Commissioner. The insurance holding company laws of the other jurisdictions in which The Hartford’s insurance subsidiaries are incorporated (or deemed commercially domiciled) generally contain similar (although in certain instances somewhat more restrictive) limitations on the payment of dividends. Dividends paid to HFSG by its insurance subsidiaries are further dependent on cash requirements of HLI and other factors. The Company’s property-casualty insurance subsidiaries are permitted to pay up to a maximum of approximately $1.5 billion in dividends to HFSG in 2007 without prior approval from the applicable insurance commissioner. The Company’s life insurance subsidiaries are permitted to pay up to a maximum of approximately $620 in dividends to HLI in 2007 without prior approval from the applicable insurance commissioner. The aggregate of these amounts, net of amounts required by HLI, is the maximum the insurance subsidiaries could pay to HFSG in 2007. In 2006, HFSG and HLI received a combined total of $609 from their insurance subsidiaries.
The Company has unfunded commitments to purchase investments in limited partnerships, mortgage and construction loans of about $1.4 billion as disclosed in Note 12 of Notes to Consolidated Financial Statements.
The following table identifies the Company’s aggregate contractual obligations as of December 31, 2006 due by payment period:
In estimating the timing of future payments by year, the Company has assumed that its historical payment patterns will continue. However, the actual timing of future payments could vary materially from these estimates due to, among other things, changes in claim reporting and payment patterns and large unanticipated settlements. In particular, there is significant uncertainty over the claim payment patterns of asbestos and environmental claims. Also, estimated payments in 2007 do not include payments that will be made on claims incurred in 2007 on policies that were in force as of December 31, 2006. In addition, the table does not include future cash flows related to the receipt of premiums that may be used, in part, to fund loss payments.
Includes contractual principal and interest payments. All long-term debt obligations have fixed rates of interest. Long-term debt obligations shown above include principal and interest payments. See Note 14 of Notes to Consolidated Financial Statements for additional discussion of long-term debt obligations.
Includes $1.7 billion in commitments to purchase investments including about $1 billion of limited partnership and $333 of mortgage and construction loans. Outstanding commitments under these limited partnerships and mortgage and construction loans are included in payments due in less than 1 year since the timing of funding these commitments cannot be estimated. The remaining $314 relates to payables for securities purchased which are reflected on the Company’s consolidated balance sheet.
As of December 31, 2006, the Company has accepted cash collateral of $2.3 billion in connection with the Company’s securities lending program and derivative instruments. Since the timing of the return of the collateral is uncertain, the return of the collateral has been included in the payments due in less than 1 year.
Includes $42 in collateralized debt obligations (“CDOs”) issued to third-party investors by consolidated investment management entities sponsored by the Company in connection with synthetic CDO transactions. The CDO investors have no recourse to the Company’s assets other than the dedicated assets collateralizing the CDOs. Refer to Note 4 of Notes to Consolidated Financial Statements for additional discussion of CDOs.
Does not include estimated voluntary contribution of $200 to the Company’s pension plan in 2007.
The Company made contributions to its pension plans of $402, $504 and $317 in 2006, 2005 and 2004, respectively. The Company’s 2006 required minimum funding contribution was immaterial. The Company presently anticipates contributing approximately $200 to its pension plans in 2007, based upon certain economic and business assumptions. These assumptions include, but are not limited to, equity market performance, changes in interest rates and the Company’s other capital requirements. The Company does not have a required minimum funding contribution for the U.S. qualified defined benefit pension plan for 2007 and the funding requirements for all of the pension plans is expected to be immaterial.
Pension expense reflected in the Company’s net income was $152, $137 and $104 in 2006, 2005 and 2004, respectively. The Company estimates its 2007 pension expense will be approximately $115, based on current assumptions.
The capital structure of The Hartford as of December 31, 2006 and 2005 consisted of debt and equity, summarized as follows:
Total debt of the Company excludes $258 and $0 of consumer notes as of December 31, 2006 and 2005, respectively.
The following discussion describes the Company’s debt financing activities for 2006.
In August 2006, $330 of senior notes originally issued in September 2002 in connection with the Company’s 6% equity units were remarketed on behalf of the holders of the equity units and the interest rate on the senior notes was reset to 5.663%. See Note 14 of Notes to Consolidated Financial Statements.
On October 3, 2006, the Company issued $400 of 5.25% senior notes due October 15, 2011, $300 of 5.50% senior notes due October 15, 2016, and $300 of 5.95% senior notes due October 15, 2036, and received total net proceeds of approximately $990. The issuance was pursuant to the Company’s existing shelf registration statement.
On October 10, 2006, the Company completed offers to exchange existing senior unsecured notes comprising the $250 of 7.65% notes due 2027 and the $400 of 7.375% notes due 2031 issued by HLI (‘‘HLI notes’’) for up to $650 in new senior unsecured notes of the Company and a cash payment, in order to consolidate debt at the holding company. The new notes have an extended maturity and bear a market interest rate and, together with the cash payment, have a present value not significantly different than the existing notes using the existing notes’ effective interest rates. On October 10, 2006, the Company issued approximately $409 of 6.1% senior notes due October 1, 2041 and paid cash totaling $85 in exchange for $101 of the 7.65% notes due 2027 and $308 of the 7.375% notes due 2031. Cash paid to holders of HLI notes in connection with the exchange offers is reflected on our balance sheet as a reduction of long-term debt. The Company financed the cash payment through available cash.
On December 15, 2006, The Hartford redeemed its $200 7.1% senior notes due 2007 at a price of $202 plus accrued and unpaid interest.
As of December 31, 2006, $258 of Consumer Notes had been issued. These notes have interest rates ranging from 5.0% to 6.0% for fixed notes and consumer price index plus 175 basis points to 225 basis points for variable notes. The aggregate maturities of Consumer Notes are as follows: $230 in 2008, $10 in 2009 and $18 in 2011. For 2006, interest credited to holders of Consumer Notes was $2.
On August 16, 2006, the Company issued approximately 12.1 million shares of common stock in connection with the settlement of purchase contracts originally issued in May 2003 as components of our 7% equity units. The Company received proceeds of approximately $690 from the issuance of common stock in settlement of the purchase contracts.
The after-tax reduction of stockholders’ equity of $526 related to pension and other postretirement plans as of December 31, 2006 reflects the adoption of SFAS No. 158 “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R)” and represents the net actuarial losses and prior service credits related to the Company’s pension and other postretirement plans. As of December 31, 2005, the balance of $620 represented the minimum pension liability adjustment (required for pension plans when the accumulated benefit obligation exceeds the fair value of plan assets).
$135 after-tax increase in AOCI due to favorable experience in pension assumptions which resulted in a gain (increase in the discount rate, actual asset returns exceeding expected asset returns), combined with
$48 after-tax increase in AOCI due to the amortization of actuarial losses into expense.
$113 after-tax decrease in AOCI to recognize the effects of future salary increases into The Hartford’s obligation (the spread between the 2005 PBO and ABO, consistent with the adoption of SFAS 158).
The increase in cash from operating activities was primarily the result of the funding of $1.15 billion in settlement of the MacArthur litigation in 2004 and increased net income as compared to the prior year period. Cash provided by financing activities increased primarily due to higher net receipts from policyholder’s accounts related to investment and universal life contracts and increased proceeds from stock option exercises in 2005 as compared to the prior year period. Also contributing to the increase in cash provided by financing activities was a decrease in debt repayments in 2005 as compared to the prior year period. Net purchases of available-for-sale securities accounted for the majority of cash used for investing activities.
The following table summarizes The Hartford’s significant member companies’ financial ratings from the major independent rating organizations as of February 16, 2007.
The National Association of Insurance Commissioners (“NAIC”) has regulations establishing minimum capitalization requirements based on risk-based capital (“RBC”) formulas for both life and property and casualty companies. The requirements consist of formulas, which identify companies that are undercapitalized and require specific regulatory actions. The RBC formula for life companies establishes capital requirements relating to insurance, business, asset and interest rate risks and effective for 2005, it addresses the equity, interest rate and expense recovery risks associated with variable annuities and group annuities that contain death benefits or certain living benefit. RBC is calculated for property and casualty companies after adjusting capital for certain underwriting, asset, credit and off-balance sheet risks. As of December 31, 2006, each of The Hartford’s insurance subsidiaries within Life and Ongoing Property & Casualty had more than sufficient capital to meet the NAIC’s minimum RBC requirements.
For a discussion regarding contingencies related to the manner in which The Hartford compensates brokers and other producers, please see “Overview-Broker Compensation” above.
On January 22, 2007, the Florida legislature adopted legislation intended to address increasing rates and shrinking capacity for homeowners insurance in the state. The legislation subsequently was signed into law by Governor Crist. The legislation will make significantly more reinsurance capacity available to companies who choose to purchase it. Specifically, the legislation increases the capacity of the Florida Hurricane Catastrophe Fund (the “FHCF”), which provides reinsurance to primary insures for Florida catastrophes at generally below-market rates, from the current level of $16 billion to a potential total of $35 billion. The new Florida legislation includes many other provisions, including steps designed to make Citizens Property Insurance Corporation more competitive with private insures, provisions to provide rate relief to homeowners and requirements that excess profits on residential property business be returned to policyholders. The Hartford is still in the process of analyzing the new legislation to assess the impact on The Hartford.
On August 17, 2006, the President signed into law the Pension Protection Act of 2006, which, among other items, addressed age discrimination in defined benefit pension plans and revised pension plan funding requirements. The Act is not expected to materially affect the Company’s retirement plans.
The Hartford accounts for guaranty fund and other insurance assessments in accordance with Statement of Position No. 97-3, “Accounting by Insurance and Other Enterprises for Insurance-Related Assessments”. Liabilities for guaranty fund and other insurance-related assessments are accrued when an assessment is probable, when it can be reasonably estimated, and when the event obligating the Company to pay an imposed or probable assessment has occurred. Liabilities for guaranty funds and other insurance-related assessments are not discounted and are included as part of other liabilities in the Consolidated Balance Sheets. As of December 31, 2006 and 2005, the liability balance was $149 and $223, respectively. As of December 31, 2006 and 2005, $20 and $20, respectively, related to premium tax offsets were included in other assets.