The Hartford owns the land and buildings comprising its Hartford location and other properties within the greater Hartford, Connecticut area which total approximately 1.9 million of the 2.2 million square feet owned. In addition, The Hartford leases approximately 5.3 million square feet throughout the United States and approximately 130 thousand square feet in other countries. All of the properties owned or leased are used by one or more of all eight operating segments, depending on the location. (For more information on operating segments see Part 1, Item 1, Business of The Hartford - Reporting Segments.) The Company believes its properties and facilities are suitable and adequate for current operations.
2001 includes a $91 reduction in premiums from reinsurance cessions related to September 11.
2001 includes the impact of September 11. Before the impact of September 11, the 2001 combined ratio was 101.7.
Life includes four reportable operating segments: Retail Products Group, Institutional Solutions Group, Individual Life and Group Benefits. Through Life the Company provides investment and retirement products such as variable and fixed annuities, mutual funds and retirement plan services; other institutional investment products; structured settlements; private placement life insurance; individual life insurance products including variable universal life, universal life, interest sensitive whole life and term life; and group benefit products, such as group life and group disability insurance.
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. Through Property & Casualty the Company provides a number of coverages, as well as insurance-related services, to businesses throughout the United States, including workers’ compensation, property, automobile, liability, umbrella, specialty casualty, marine, agriculture, bond, professional liability and director’s and officer’s liability coverages. Property & Casualty also provides automobile, homeowners, and home-based business coverage to individuals throughout the United States, as well as insurance-related services to businesses.
In June 2004, the Company received a subpoena from the New York Attorney General’s Office in connection with its inquiry into compensation arrangements between brokers and carriers. In mid-September 2004 and subsequently, the Company has received additional subpoenas from the New York Attorney General’s Office, which relate more specifically to possible anti-competitive activity among brokers and insurers. Since the beginning of October 2004, the Company has received subpoenas or other information requests from Attorneys General and regulatory agencies in more than a dozen jurisdictions regarding broker compensation and possible anti-competitive activity. The Company may receive additional subpoenas and other information requests from Attorneys General or other regulatory agencies regarding similar issues. The Company also has received a subpoena from the New York Attorney General’s Office requesting information related to the Company’s underwriting practices with respect to legal professional liability insurance. In addition, the Company has received a request for information from the New York Attorney General’s Office concerning the Company’s compensation arrangements in connection with the administration of workers compensation plans. The Company intends to continue cooperating fully with these investigations, and is conducting an internal review, with the assistance of outside counsel, regarding the issues under investigation.
On October 14, 2004, the New York Attorney General’s Office filed a civil complaint against Marsh & McLennan Companies, Inc., and Marsh, Inc. (collectively, “Marsh”). The complaint alleges, among other things, that certain insurance companies, including the Company, participated with Marsh in arrangements to submit inflated bids for business insurance and paid contingent commissions to ensure that Marsh would direct business to them. The Company is not joined as a defendant in the action. Although no regulatory action has been initiated against the Company in connection with the allegations described in the civil complaint, it is possible that the New York Attorney General’s Office or one or more other regulatory agencies may pursue action against the Company or one or more of its employees in the future. The potential timing of any such action is difficult to predict. If such an action is brought, it could have a material adverse effect on the Company.
A number of companies have announced settlements of enforcement actions with various regulatory agencies, primarily the SEC and the New York Attorney General’s Office, which have included a range of monetary penalties and restitution. While no such action has been initiated against the Company, the SEC, and the New York Attorney General’s Office are likely to take some action at the conclusion of the on-going investigations related to market timing and directed brokerage. The potential timing of any such action is difficult to predict, and the Company’s ultimate liability, if any, from any such action is not reasonably estimable at this time. If such an action is brought, it could have a material adverse effect on the Company’s consolidated results of operations or cash flows in particular quarterly or annual periods.
The preparation of financial statements, in conformity with accounting principles generally accepted in the United States of America (“GAAP”), requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
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: insurance reserves; Life operations deferred policy acquisition costs and present value of future profits; the valuation of investments and derivative instruments and the evaluation of other-than-temporary impairments; pension and other postretirement benefits; and contingencies. 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, 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 and professional liability. 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 claims and claim adjustment expenses.
The following table shows loss and loss adjustment expense reserves by line of business and by operating segment as of December 31, 2004, net of reinsurance:
Reserves are set by line of business within the various operating segments. As indicated in the above table, a single line of business may be written in one or more of the segments. Case reserves are established by a claims handler on each individual claim and are adjusted as new information becomes known during the course of handling the claim. Lines of business for which loss data (e.g. paid losses and case reserves) emerge (i.e. is reported) over a long period of time are referred to as long-tail lines of business. Lines of business for which loss data emerge more quickly are referred to as short-tail lines of business. Within the Company’s Ongoing Operations the shortest-tail lines of business are property and auto physical damage. The longest tail lines of business within Ongoing Operations include workers’ compensation, general liability, and professional liability. HartRe assumed reinsurance, which is within Other Operations, is also long-tail business.
Company actuaries regularly review reserves for both current and prior accident years using the most current claim data. These quarterly reserve reviews incorporate a variety of actuarial methods and judgments and involve rigorous analysis. 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 from claims personnel, pricing actuaries and operating management on reported loss cost trends and other factors that could affect the reserve estimates.
Based on the results of the quarterly reserve reviews, the Company will determine the appropriate reserve adjustments, if any, to record. Recorded reserve estimates are changed after consideration of numerous factors, including but not limited to, the magnitude of the difference between the actuarial indication and the recorded reserves, improvement or deterioration of actuarial indications in the period, the maturity of the accident year, trends observed over the recent past and the level of volatility within a particular line of business. In general, changes are made more quickly to more mature accident years and less volatile lines of business. At year-end 2004, total recorded reserves excluding asbestos and environmental were within 0.2% of the actuarial indication. Annually, as part of the statutory reporting requirements, IBNR is allocated to accident year by statutory line of business. This work forms the basis for the loss development table and reserve re-estimates table shown in the “Business” section.
During 2004 there were numerous changes to reserve estimates. Among other loss developments in 2004, these changes included a reduction in estimated ultimate losses associated with September 11 and increases in estimated ultimate losses associated with construction defect claims and HartRe assumed reinsurance. Changes in 2004 also included increases in the estimated ultimate losses for auto liability and package business in Business Insurance, as well as a reduction in the expected loss ratio for accident year 2004 for Bond within Specialty Commercial. See “Reserves” within the Property and Casualty MD&A for further discussion of reserve developments.
Recorded reserves for auto liability, net of reinsurance, are $2.1 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 estimate 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%. A 2.5 point change in assumed annual severity for the two most recent accident years would change the estimated net reserve need by $60, in either direction.
Recorded reserves for general liability, net of reinsurance, are $1.8 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 7%, a change that is within historical variation, the estimated net reserve need would change by $200, in either direction.
The Hartford continues to receive claims that assert damages from asbestos-related and environmental-related exposures. Asbestos claims relate primarily to bodily injuries asserted by those who came in contact with asbestos or products containing asbestos. Environmental claims relate primarily to pollution and related clean-up costs.
Evaluation of both the insured’s estimated liability and The Hartford’s exposure to the insured depends heavily on an analysis of the relevant legal issues and litigation environment. This analysis is conducted by the Company’s lawyers and is subject to applicable privileges.
For both asbestos and environmental reserves, The Hartford also compares its historical direct net loss and expense paid and incurred experience, and net loss and expense paid and incurred experience year by year, to assess any emerging trends, fluctuations or characteristics suggested by the aggregate paid and incurred activity.
Once the gross ultimate exposure for indemnity and allocated claim adjustment expense is determined for each insured by each policy year, The Hartford calculates its ceded reinsurance projection based on any applicable facultative and treaty reinsurance and the Company’s experience with reinsurance collections.
With regard to both environmental and particularly asbestos claims, significant uncertainty limits the ability of insurers and reinsurers to estimate the ultimate reserves necessary for unpaid losses and related expenses. Traditional actuarial reserving techniques cannot reasonably estimate the ultimate cost of these claims, particularly during periods where theories of law are in flux. The degree of variability of reserve estimates for these exposures is significantly greater than for other more traditional exposures. In particular, The Hartford believes there is a high degree of uncertainty inherent in the estimation of asbestos loss reserves.
The variability of estimates for asbestos and environmental reserves is affected by a number of factors including assumptions with respect to the frequency of claims, the average severity of those claims settled with payment, the dismissal rate of claims with no payment and the expense to indemnity ratio. The uncertainty with respect to the underlying reserve assumptions for asbestos and
In the opinion of management, based upon the known facts and current law, the reserves recorded for The Hartford’s property and casualty businesses at December 31, 2004 represent the Company’s best estimate of its ultimate liability for claims and claim adjustment expenses related to losses covered by policies written by the Company. However, because of the significant uncertainties surrounding environmental, and particularly asbestos exposures, it is possible that management’s estimate of the ultimate liabilities for these claims may change and that the required adjustment to recorded reserves could exceed the currently recorded reserves by an amount that could be material to The Hartford’s results of operations, financial condition and liquidity.
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” as defined in Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 115”). Accordingly, these securities are carried at fair value with the after-tax difference from 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, reflected in stockholders’ equity as a component of accumulated other comprehensive income (“AOCI”). The equity investments associated with the variable annuity products offered in Japan are recorded at fair value and are classified as “trading” as defined in SFAS No. 115, with changes in fair value recorded in net investment income. Policy loans are carried at outstanding balance, which approximates fair value. Other investments primarily consist of limited partnership interests, derivatives and mortgage loans. The limited partnerships are accounted for under the equity method and accordingly the Company’s share of partnership earnings are included in net investment income. Derivatives are carried at fair value and 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.
[2] Effective January 1, 2004, guaranteed separate account assets were included with general account assets as a result of adopting SOP 03-1.
One of the significant estimations inherent in the valuation of investments is the evaluation of other-than-temporary impairments. 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’s accounting policy requires that a decline in the value of a security below its amortized cost basis be assessed to determine if the decline is other-than-temporary. If the security is deemed to be other-than-temporarily impaired, a charge is recorded in net realized capital losses equal to the difference between the fair value and amortized cost basis of the security. In addition, for securities expected to be sold, an other-than-temporary impairment charge is recognized if the Company does not expect the fair value of a security to recover to amortized cost prior to the expected date of sale. The fair value of the other-than-temporarily impaired investment becomes its new cost basis. 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.
Securities not subject to Emerging Issues Task Force (“EITF”) Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets” (“non-EITF Issue No. 99-20 securities”), that are in an unrealized loss position, are reviewed at least quarterly to determine if an other-than-temporary impairment is present based on certain quantitative and qualitative factors. The primary factors considered in evaluating whether a decline in value for non-EITF Issue No. 99-20 securities is other-than-temporary include: (a) the length of time and the extent to which the fair value has been less than cost, (b) the financial condition, credit rating and near-term prospects of the issuer, (c) whether the debtor is current on contractually obligated interest and principal payments and (d) the intent and ability of the Company to retain the investment for a period of time sufficient to allow for recovery. Non-EITF Issue No. 99-20 securities depressed by twenty percent or more for six months are presumed to be other-than-temporarily impaired unless significant objective verifiable evidence supports that the security price is temporarily depressed and is expected to recover within a reasonable period of time. The evaluation of non-EITF Issue No. 99-20 securities depressed more than ten percent is documented and discussed quarterly by the committee.
Once an impairment charge has been recorded, the Company continues to review the other-than-temporarily impaired securities for additional other-than-temporary impairments. As discussed in Note 1 of the Notes to Consolidated Financial Statements, the Financial Accounting Standards Board (“FASB”) voted to delay the implementation of the impairment measurement and recognition guidance contained in paragraphs 10-20 of EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairments and Its Application to Certain Investments” (“EITF Issue No. 03-1”), in order to redeliberate certain aspects of the consensus. The ultimate completion of EITF Issue No. 03-1 may impact the Company’s current other-than-temporary impairment evaluation process.
An embedded derivative instrument is reported at fair value based upon internally established valuations that are consistent with external valuation models, quotations furnished by dealers in such instruments or market quotations. The Company has calculated the fair value of the guaranteed minimum withdrawal benefit (“GMWB”) embedded derivative based on actuarial assumptions related to the projected cash flows, including benefits and related contract charges, over the lives of the contracts, incorporating expectations concerning policyholder behavior. Because of the dynamic and complex nature of these cash flows, stochastic techniques under a variety of market return scenarios and other best estimate assumptions are used. Estimating these cash flows involves numerous estimates and subjective judgments including those regarding expected market rates of return, market volatility, correlations of market returns and discount rates. At each valuation date, the Company assumes expected returns based on risk-free rates as represented by the current LIBOR forward curve rates; market volatility assumptions for each underlying index based on a blend of observed market
Additionally, Life continues to perform analyses with respect to the potential impact of a revision to future EGPs. If such a revision to EGPs were deemed necessary, Life would adjust, as appropriate, all of its assumptions for products accounted for in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments”, and reproject its future EGPs based on current account values at the end of the quarter in which a revision is deemed to be necessary. To illustrate the effects of this process, assume Life had concluded that a revision of Life’s EGPs was required at December 31, 2004. If Life assumed a 9% average long-term rate of growth from December 31, 2004 forward along with other appropriate assumption changes in determining the revised EGPs, Life estimates the cumulative decrease to amortization would be approximately $60-$65, after-tax. If instead Life were to assume a long-term growth rate of 8% in determining the revised EGPs, the adjustment would be approximately $20-$25, after-tax. Any such adjustment would not affect statutory income or surplus, due to the prescribed accounting for such amounts that is discussed above.
Aside from absolute levels and timing of market performance assumptions, additional factors that will influence this determination include the degree of volatility in separate account fund performance and shifts in asset allocation within the separate account made by policyholders. The overall 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. Life’s overall separate account fund performance has been reasonably correlated to the overall performance of the S&P 500 Index (which closed at 1,212 on December 31, 2004), although no assurance can be provided that this correlation will continue in the future.
The overall recoverability of the DAC asset is dependent on the future profitability of the business. Life tests the aggregate recoverability of the DAC asset by comparing the amounts deferred to the present value of total EGPs. In addition, Life routinely
To illustrate the impact of these assumptions on annual pension expense for 2005 and going forward, a 25 basis point change in the discount rate will increase/decrease pension expense by approximately $13 and a 25 basis point change in the long-term asset return assumption will increase/decrease pension expense by approximately $6.
2004 Compared to 2003 - Net income for the year ended December 31, 2004 increased $2.2 billion, compared to the prior year which reflected a $1.7 billion after-tax charge to strengthen net asbestos reserves based on a ground up study. Also contributing to the increase was a $216 tax benefit, of which $190 was recorded in Life and $26 was recorded in Property & Casualty, primarily consisting of the benefit related to the separate account dividends-received deduction (“DRD”) and interest. For further discussion, see Note 12 of Notes to Consolidated Financial Statements. Also contributing to the change in net income was growth in all of Life’s segments and improved underwriting results in the Business Insurance segment. Offsetting these increases were increased Property & Casualty catastrophe losses, primarily related to hurricanes Charley, Frances, Ivan and Jeanne.
2003 Compared to 2002 - Revenues for the year ended December 31, 2003 increased $2.3 billion over the comparable 2002 period. Revenues increased due to earned premium growth within the Business Insurance, Specialty Commercial and Personal Lines segments, primarily as a result of earned pricing increases, higher earned premiums and net investment income in the Retail Products segment and net realized capital gains in 2003 as compared to net realized capital losses in 2002.
The effective tax rate for 2004, 2003 and 2002 was 15%, 83% and 6%, respectively. The principal causes of the difference between the effective rates and the U.S. statutory rate of 35% were tax-exempt interest earned on invested assets, the dividends-received deduction, the tax benefit associated with the settlement of the 1998-2001 IRS audit in 2004 and the tax benefit associated with the settlement of the 1996-1997 IRS audit in 2002. Income taxes paid (received) in 2004, 2003 and 2002 were $32, ($107) and ($102) respectively. For additional information, see Note 13 of Notes to Consolidated Financial Statements.
[1] As a result of the net loss for the year ended December 31, 2003, SFAS No. 128, “Earnings Per Share”, requires the Company to use basic weighted average common shares outstanding in the calculation of the year ended December 31, 2003 diluted earnings (loss) per share, since the inclusion of options of 1.8 would have been antidilutive to the earnings per share calculation. In the absence of the net loss, weighted average common shares outstanding and dilutive potential common shares would have totaled 274.2.
The Company provides investment and retirement products such as variable and fixed annuities, mutual funds and retirement plan services and other institutional products; individual and corporate owned life insurance; and, group benefit products, such as group life and group disability insurance.
The Company derives its revenues principally from: (a) fee income, including asset management fees, on separate account and mutual fund assets and mortality and expense fees, as well as cost of insurance charges; (b) net investment income on general account assets; (c) fully insured premiums; and (d) certain other fees. Asset management fees and mortality and expense fees are primarily generated from separate account assets, which are deposited with the Company through the sale of variable annuity and variable universal life products and from mutual funds. Cost of insurance charges are assessed on the net amount at risk for investment-oriented life insurance products. Premium revenues are derived primarily from the sale of group life, and group disability and individual term insurance products.
The Company’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 on 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, for instance, variable annuity contracts. In the mutual fund business, net flows are known as net sales. Net sales are comprised of new sales less redemptions of mutual fund customers. The Company 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. Thus, a prolonged downturn in the financial markets could reduce revenues and potentially raise the possibility of a charge against deferred policy acquisition costs.
The Company’s profitability in its individual life insurance and group benefits businesses depends largely on the size of its in force block, the adequacy of product pricing and underwriting discipline, actual mortality and morbidity experience, and the efficiency of its claims and expense management.
The significant increase in net investment income and interest credited in the Retail Products Group segment and Other and, to a lesser extent Individual Life segment was largely the result of the adoption of SOP 03-1. The adoption of SOP 03-1 resulted in certain changes in presentation in the Company’s financial statements, including reporting of the spreads on the Company’s MVA fixed annuities and variable annuity products offered in Japan on a gross basis in net investment income and interest credited. The increase in net investment income for the Group Benefits segment was primarily due to the acquisition of the group benefits business of CNA at December 31, 2003.
As discussed above, traditional insurance type products collect premiums from policyholders in exchange for financial protection of the policy holder from a specified insurable loss, such as death or disability. These premiums together with net investment income earned from the overall investment strategy are used to pay the contractual obligations under these insurance contracts. Two major factors, new sales and persistency, impact premium growth. Sales can increase or decrease in a given year based on a number of factors, including but not limited to, customer demand for the Company’s product offerings, pricing competition, distribution channels and the Company’s reputation and ratings. A majority of sales correspond with the open enrollment periods of employers’ benefits, typically January 1 or July 1. Persistency is a measure of business retention during a renewal period.
The increase in the expense ratio for the Group Benefits segment in 2004 compared to 2003 is the result of the CNA Acquisition. As part of the CNA Acquisition, a larger block of affinity business is now included in the Group Benefits segment and this business typically has lower expected loss ratios and higher expected commission ratios than other products within the business.
Life changed its reportable operating segments in 2004 from Investment Products, Individual Life, Group Benefits and Corporate Owned Life Insurance (“COLI”) to Retail Products Group (“Retail”), Institutional Solutions Group (“Institutional”), Individual Life and Group Benefits. Retail offers individual variable and fixed annuities, mutual funds, retirement plan products and services to corporations under Section 401(k) plans and other investment products. Institutional primarily offers retirement plan products and services to municipalities under Section 457 plans, other institutional investment products, structured settlements, and private placement life insurance. Individual Life sells a variety of life insurance products, including variable universal life, universal life, interest sensitive whole life and term life insurance. Group Benefits sells group insurance products, including group life and group disability insurance as well as other products, including medical stop loss and supplementary medical coverages to employers and employer sponsored plans, accidental death and dismemberment, travel accident and other special risk coverages to employers and associations. Life also includes, in an Other category, its international operations, which are primarily located in Japan and Brazil; net realized capital gains and losses other than periodic net coupon settlements on non-qualifying derivatives and net realized capital gains and losses related to guaranteed minimum withdrawal benefits; corporate items not directly allocated to any of its reportable operating segments; and intersegment eliminations. Periodic net coupon settlements on non-qualifying derivatives and net realized capital gains
2004 Compared to 2003 - Life’s net income increased due primarily to business growth in virtually all lines of business as discussed below, a lower effective income tax rate, and higher net realized capital gains. (See the Investments section for further discussion of investment results and related realized capital gains.) During the third quarter of 2004, the Internal Revenue Service completed its examination of the 1998-2001 tax years. (For further discussion see Note 12 of Notes to Consolidated Financial Statements under Tax Matters). Life recorded in the third quarter of 2004 a tax benefit of $190, consisting primarily of a change in estimate of the dividends-received deduction (“DRD”) tax benefit reported during 2003 and prior years and interest, and changed the estimate of the after-tax benefit for the DRD benefit related to the 2004 tax year.
A description of each segment as well as an analysis of the operating results summarized above is included on the following pages.
Partially offsetting the positive earnings drivers discussed above were higher DAC amortization costs, lower income from the fixed annuity business and the cumulative effect of accounting change from the Company’s adoption of SOP 03-1. DAC amortization was higher in the current year as compared to the prior year due to higher subsequent deposit activity, primarily in individual annuity. The decrease in net income in the fixed annuity business in 2004 compared to 2003 was principally due to lower investment spread from the market value adjusted (“MVA”) product. With the adoption of SOP 03-1, the Company includes the investment return from the fixed annuity product in net investment income and includes interest credited to contract holders in the benefits, claims and expenses line on the income statement rather than reporting the net spread in fee income and other. Additionally, income tax expense was higher for the current year due primarily to higher income earned by the segment. This increase was largely offset by a higher DRD
2003 Compared to 2002 - Net income was higher driven by an increase in revenues in the individual annuity and other retail product operations as a result of the strong net flows and growth in the equity markets during 2003 and strong expense management. Net income increased due to an increase in fee income in Retail. Fee income in Retail was higher in 2003 compared to 2002, as a result of higher average account values, specifically in individual annuities and mutual fund businesses, due primarily to stronger variable annuity sales and the higher equity market values compared to the prior year. Net investment income increased due to higher general account assets. General account assets for the individual annuity business were $9.4 billion as of December 31, 2003, an increase of approximately $800 or 9% from 2002, due primarily to an increase in individual annuity sales, with the majority of those new sales electing to use the dollar cost averaging (“DCA”) feature. The DCA feature allows policyholders to earn a credited interest rate in the general account for a defined period of time as their invested assets are systematically invested into the separate account funds. Additionally, there was increased interest credited in the individual annuity operation as a result of higher general account asset levels and an increase in amortization of deferred policy acquisition costs related to the individual annuity business due to higher gross profits.
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, the Company may experience stronger sales 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 the Company of individual annuities, such as guaranteed minimum death benefits (“GMDB”) and GMWB benefits. Conversely, weak equity markets may dampen sales 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 the Company of GMDB and GMWB benefits associated with individual annuities. The Company 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 the Company will be affected by the effectiveness of the risk management strategies the Company 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 Retail 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 where the contract holder’s rate guarantee expires in the upcoming year, and the future interest rate environment.
The Institutional Solutions Group primarily offers customized wealth creation and financial protection for institutions, corporate and government employers and high net worth individuals through its three business units: Government, Institutional Investment Products (“IIP”) and private placement life insurance (“PPLI”) (formerly Corporate Owned Life Insurance or “COLI”).
Partially offsetting increases in segment net income for the current year was lower income from the IIP and PPLI businesses, excluding the settlement of the Bancorp litigation. For a discussion of the Bancorp litigation, see Note 12 of Notes to Consolidated Financial Statements. The decrease in net income in the IIP was due primarily to lower spread income and slightly higher insurance operating costs for the year ended December 31, 2004 as compared to 2003. In addition, the IIP reported lower earnings for the current year compared to the prior year due to favorable mortality experience in 2003. PPLI also experienced lower earnings for the year ended December 31, 2004 as compared to 2003 due to lower average leveraged COLI account values.
Excluding the expenses associated with the Bancorp litigation, net income increased $4 or 9%, primarily due to higher income in the institutional investment products business as a result of favorable mortality experience and growth in average assets over the last twelve months. General account assets under management related to the IIP increased 32% since December 31, 2002, to $9.9 billion as of December 31, 2003. The increase in general account assets was primarily due to higher net flows and market appreciation related to institutional annuities and structured settlement products. Partially offsetting the increase in earnings in the IIP was lower PPLI income due to the decline in leveraged COLI account values as a result of surrender activity and lower sales volume of PPLI products in 2003 as compared to the prior year. In addition, amortization of deferred policy acquisition costs increased as a result of higher sales in the institutional investment products business.
2003 Compared to 2002 - Net income increased due to increases in fee income. Fees increased primarily due to increased cost of insurance charges as life insurance inforce grew and aged, and variable universal life account values increased 30%, driven by the growth in the equity markets in 2003. Also contributing to the increase in net income was a decrease in benefit costs in 2003 as
expenses due to the premium growth previously described and continued investments in technology, service and distribution. The segment’s ratio of insurance operating costs and other expenses to premiums and other considerations (excluding buyouts) was 25%, increasing slightly from 23% in 2002.
Following the majority of the integration effort of the acquired group life and accident, and short-term and long-term disability businesses of CNA Financial Corporation, the Company anticipates the increased scale of the group life and disability operations and the expanded distribution network for its products and services will generate low double digit sales growth in 2005. Sales, however, may be negatively affected by the competitive pricing environment in the marketplace. Management is committed to selling competitively priced products that meet the Company’s internal rate of return guidelines. The two significant factors in evaluating this business are the loss ratio and the expense ratio. Based on historical experience trends and variability in the Group Benefits business, management expects the loss ratio in future periods to be in the range of 73% to 76% and the expense ratio to be in the range of 27% to 29%.
Underwriting profitability over time is also greatly influenced by the Company’s underwriting discipline which seeks to manage exposure to loss through favorable risk selection and diversification and by its ability to manage its expense ratio which it accomplishes through economies of scale and its management of acquisition costs and other underwriting expenses.
Through its Other Operations segment, Property & Casualty is responsible for managing operations of The Hartford that have discontinued writing new or renewal business as well as managing the claims related to asbestos and environmental exposures. As such, the underwriting loss in Other Operations is principally related to claim and claim adjustment expense development.
Policies in force represent the number of policies with coverage in effect as of the end of the period. In both automobile and homeowners, the policy in force count in 2004 has increased as a result of the new Dimensions class plan rolled out in the latter part of 2003 and through the remainder of 2004. The increase is also attributable to continued growth in AARP business, reflecting growth in the size of the AARP target market and direct marketing programs to increase premium writings. The policy in force count is a reflection of both the increase in new business and strong policy renewal retention of prior year business. The Company expects the number of policies in force to continue to increase for both automobile and homeowners in 2005.
Within Personal Lines auto, our overall assumption for the line of business is that frequency in the 2005 accident year will be generally flat and that severity will continue to increase. This represents a change in frequency from the recent past, where claim frequency had declined. Within Personal Lines homeowners, we expect frequency to decrease slightly, compared to a more significant decrease in recent years, and severity to continue to increase. Within Business Insurance, expectations are generally for frequency to be flat, although we expect frequency to continue to decline, albeit moderately, in workers’ compensation. As in Personal Lines, recent history in Business Insurance has shown more significant declines in frequency, so this assumption is an unfavorable change from recent years. Consistent with recent experience, severity within Business Insurance is expected to increase across all coverages. For long-tailed lines of business such as workers’ compensation and general liability, estimates of severity are subject to the same inherent uncertainty as estimates of loss reserves. Within the Specialty Commercial lines of business, the base assumptions for frequency and severity are similar to the assumptions for Business Insurance, but adjustments are made for the unique lines of business and for the individual risks or transactions being priced within Specialty Commercial.
[1] Included in both the prior year loss and loss adjustment expense ratio and the catastrophe ratio is prior accident development on catastrophe losses, including, in 2004, the net reserve release of (3.1) points related to September 11.
Because the Company earns premiums over the 6 to 12 month term of the policies, earned pricing increases (decreases) lag written pricing increases (decreases) by 6 to 12 months. As of December 31, 2004, approximately 67% of Personal Lines Agency Auto policies in force were 6 month policies. Substantially all other policies in force for Property and Casualty at that date were 12 month policies. In 2004, earned pricing increases have moderated as written pricing increases over the prior 6 to 12 months have declined.
Management does not expect claim frequency for property coverages to continue to be as favorable in the future. In 2005, management expects the current accident year loss and loss adjustment expense ratio to increase modestly as earned pricing increases moderate. Management expects claim frequency to remain relatively flat and expects claim severity to increase as a result of inflation in claim settlement costs, driven principally by medical cost inflation, property value increases and other indemnity cost increases. Expected increases in total loss costs, however, are expected to be partially offset by reductions in loss adjustment expenses per claim.
Reserve estimates, including reserves for catastrophe claims, are inherently uncertain. While the Company believes its recorded reserves are established at a level to meet the ultimate cost of unpaid claims, reserve estimates may change in the future based on information or trends that are not currently known. See “Reserves” below for a discussion of prior accident year loss development and “Critical Accounting Estimates” for a discussion of current trends contributing to reserve uncertainty and the impact of changes in key assumptions on reserve volatility.
The expense ratio is the ratio of underwriting expenses, excluding bad debt expense, to earned premiums. Underwriting expenses include the amortization of deferred policy acquisition costs and insurance operating costs and expenses. Deferred policy acquisition costs include commissions, taxes, licenses and fees and other underwriting expenses and are amortized over the policy term. While changes in the expense ratio vary by segment, the overall expense ratio for Ongoing segments
The catastrophe ratio (a component of the loss and loss adjustment expense ratio) represents the ratio of catastrophe losses (net of reinsurance) to earned premiums. A catastrophe is an event that causes $25 or more in industry insured property losses and affects a significant number of property and casualty policyholders and insurers. By their nature, catastrophe losses vary dramatically from year to year. Based on the mix and geographic dispersion of premium written and estimates derived from various catastrophe loss models, the Company’s expected catastrophe ratio over the long-term is 3.0 points. Before considering the reduction in Ongoing Operation’s catastrophe reserves related to September 11 of $298 in 2004, the catastrophe ratio in 2004 was 5.3 points. See “Risk Management Strategy” below for a discussion of the Company’s property catastrophe risk management program that serves to mitigate the Company’s net exposure to catastrophe losses.
The combined ratio before catastrophes and prior accident year development represents the combined ratio for the current accident year, excluding the impact of catastrophes. The Company believes this ratio is an important measure of the trend in profitability since it removes the impact of volatile and unpredictable catastrophe losses and prior accident year reserve development. Before considering catastrophes, the combined ratio related to current accident year business has improved from 2002 to 2004 principally due to earned pricing increases and favorable claim frequency.
The investment return, or yield, on Property & Casualty’s invested assets is an important element of the Company’s earnings since insurance products are priced with the assumption that premiums received can be invested for a period of time before loss and loss adjustment expenses are paid. For longer tail lines, such as workers’ compensation and general liability, claims are paid over several years and, therefore, the premiums received for these lines of business can generate significant investment income.
backed securities and asset-backed securities. As of both December 31, 2004 and 2003, approximately 96% of Property & Casualty’s invested assets were held in fixed maturities.
The Hartford’s property and casualty operations have well-developed processes to manage catastrophic risk exposures to natural catastrophes, such as hurricanes and earthquakes, and other perils, such as terrorism. These processes involve establishing underwriting guidelines for both individual risks and in aggregate including individual policy limits and aggregate exposure limits by geographic zone and peril. The Company establishes exposure limits and actively monitors the risk exposures as a percent of Property and Casualty surplus. Generally the Company limits its exposure to natural catastrophes from a single 250-year event to less than 30% of property and casualty statutory surplus for losses prior to reinsurance and to less than 15% of property and casualty statutory surplus for losses net of reinsurance. In specifically identified locations, the Company manages aggregate terrorism exposures including exposures resulting from the Company’s Group Life operations. The aggregate terrorism exposure in these locations, as measured by specific loss scenarios, is generally limited to an amount equivalent to approximately 7% of the combined statutory surplus of the life and property and casualty operations. The Company monitors exposures monthly and employs both internally developed and externally purchased loss modeling tools.
The Hartford utilizes reinsurance to manage risk and transfer exposures to well-established and financially secure reinsurers. Reinsurance is used to manage aggregate exposures as well as specific risks based on accumulated property and casualty liabilities in certain geographic zones. All treaty purchases related to the Company’s property and casualty operations are administered by a centralized function to support a consistent strategy and ensure that the reinsurance activities are fully integrated into the organization’s risk management processes.
government and all insurers of $100 billion. If an act of terrorism or acts of terrorism result in covered losses exceeding the $100 billion annual limit, insurers with losses exceeding their deductibles will not be responsible for additional losses.
[2] Includes the impact of 2003 asbestos reserve addition of $2,604.
[4] Net prior year incurred losses includes reserve strengthening for construction defects claims of $190, a reduction in net reinsurance recoverable asset of $181, environmental reserve strengthening of $75, an increase in reserves of $170 for HartRe assumed reinsurance, partially offset by the net reserve release of $395 related to September 11.
[6] Includes $26 tax benefit related to tax years prior to 2004.
[8] Ratios do not include the effects of Other Operations. Refer to the “Ratios” section below for definitions of the underwriting ratios.
2004 Compared to 2003 - Total revenues for Property & Casualty increased $653 for the year ended December 31, 2004. The increase was due primarily to earned premium growth of $689 and an increase in investment income of $76, partially offset by a decrease in realized capital gains of $120. The increase in earned premiums in the Business Insurance, Personal Lines and Specialty Commercial segments was due to earned pricing increases and growth in new business premiums outpacing non-renewals for Personal Lines and Business Insurance. Additionally, earned premium growth was partially offset by a $90 decrease reflecting a reduction in estimated earned premium under retrospectively-rated policies. The increase in investment income of $76 is primarily driven by an increase in underwriting cash flow, partially offset by a decrease in the after-tax investment yield.
Net income for the year ended December 31, 2004 increased $1.7 billion, primarily due to the net asbestos reserve strengthening of $1.7 billion, after-tax, in the first quarter of 2003, a decrease in after-tax catastrophe losses related to September 11 of $257 and an improved combined ratio before catastrophes and prior accident year development in Business Insurance, Personal Lines and Specialty Commercial. The increase in net income is partially offset by an increase in after-tax catastrophe losses of $159 before considering the September 11 reserve release, a decrease in after-tax realized capital gains of $78, and an increase in after-tax prior
accident year development of $383 before considering both the September 11 reserve release and the 2003 net asbestos reserve strengthening. Before the September 11 reserve release, after-tax catastrophe losses in 2004 of $330 includes after-tax losses of $76 from Hurricane Charley, $69 from Hurricane Frances, $54 from Hurricane Ivan and $60 from Hurricane Jeanne. Before the September 11 reserve release, 2004 prior accident year development of $526, after-tax, includes, among other movements, a $124 after-tax reserve strengthening for construction defect claims, a $118 after-tax provision related to a reduction in the reinsurance recoverable asset on older, long-term casualty liabilities, a $111 after-tax increased in assumed casualty reinsurance reserves, and a $49 after-tax increase in environmental reserves. The combined ratio before catastrophes and prior accident year development for Ongoing Operations improved by 3.1 points, from 92.8 in 2003 to 89.7 in 2004. Strong earned pricing and favorable claim frequency contributed to the improvement across Business Insurance, Personal Lines and Specialty Commercial.
2003 Compared to 2002 - Revenues for Property & Casualty increased $1.2 billion for the year ended December 31, 2003. The improvement was due primarily to earned premium growth in the Business Insurance, Specialty Commercial and Personal Lines segments, primarily as a result of earned pricing increases, as well as an increase in net realized capital gains of $321, and an increase in net investment income of $112. Partially offsetting the increase was a $412 earned premium decline in the Other Operations segment primarily as a result of the Company’s decision to withdraw from the assumed reinsurance business as discussed more fully below.
On May 16, 2003, as part of the Company’s decision to withdraw from the assumed reinsurance business, the Company entered into a quota share and purchase agreement with Endurance Reinsurance Corporation of America (“Endurance”) whereby HartRe assumed reinsurance retroceded the majority of its domestic inforce book of business as of April 1, 2003 and sold renewal rights to Endurance. Under the quota share agreement, Endurance reinsured most of the segment’s assumed reinsurance contracts that were written on or after January 1, 2002 and that had unearned premium as of April 1, 2003. In consideration for Endurance reinsuring the unearned premium as of April 1, 2003, the Company paid Endurance an amount equal to unearned premiums less the related unamortized commissions/deferred acquisition costs. Under the quota share agreement, Endurance pays an override commission based on a percentage of all ceded premium and a profit sharing commission based on the performance of property treaty, property catastrophe and aviation pool unearned premium. Both the override commission and the profit sharing commission are recognized as income over the period the ceded contracts are in force. Under the purchase agreement, Endurance will pay a renewal rights fee, subject to a guaranteed minimum of $15, based on the level of renewal premium on the reinsured contracts over the two year period following the agreement. Given that the Company did not have a continuing obligation with respect to the renewal rights, the guaranteed minimum was recorded in income during the second quarter of 2003, when the purchase agreement was entered. During the first quarter of 2004, the Company fully transferred HartRe assumed reinsurance to its Other Operations segment, where it remains subject to ongoing reserve development relating to all retained business.
Net income decreased $1.3 billion for the year ended December 31, 2003 primarily due to the net asbestos reserve strengthening of $1.7 billion, after-tax, in the first quarter of 2003. Results for the year were favorably impacted by an increase in net realized capital gains (losses) and improved underwriting results in the Personal Lines and Business Insurance segments. Strong earned pricing and favorable claim frequency resulted in an increase in underwriting results in both the Personal Lines and Business Insurance segments. In addition, net investment income, after-tax, rose $69 for the year ended December 31, 2003 due to higher invested assets, primarily from strong cash flows and additional capital raised during the second quarter of 2003.
Substantially all of the net reserve balance is incurred but not reported (“IBNR”) and the majority of the balance is related to workers’ compensation exposures.
The Company has exposure to losses from construction defects, particularly from contractors in California. The Company’s exposure to losses from construction defects relates primarily to years prior to 2000. The Company has been evaluating and closely monitoring these reserves. Based on the Company’s 2004 reserve study that used various predictive models and reflected the increasing severity of construction defect claims, the Company concluded an increase in reserves of $190 was required. This increase consisted of $23 for Business Insurance and $167 for Specialty Commercial and is included in the general liability line of business. As of December 31, 2004, reserves for Specialty Commercial general liability, net of reinsurance, were $1,125. The $167 strengthening related to Specialty Commercial represents 15% of the net reserves.
In addition to the foregoing reserve adjustments, within the Specialty Commercial segment there were other offsetting positive and negative adjustments. The principal offsetting adjustments related to a strengthening in specialty large deductible workers’ compensation reserves and a release in other liability reserves, each approximately $150.
Reserves and reserve activity in the Other Operations segment are categorized and reported as asbestos, environmental or “all other” activity. Total net reserve strengthening for Other Operations was $409 in 2004, including $262 of strengthening for asbestos and environmental reserves. The asbestos and environmental strengthening primarily includes a $75 increase in environmental reserves and a $181 reduction in the reinsurance recoverable asset associated with older, long-term casualty liabilities, including asbestos liabilities. These actions are further discussed in the Other Operations segment MD&A discussion.
The Company has been evaluating and closely monitoring assumed reinsurance reserves in Other Operations. During 2003 and 2002, the Company booked unfavorable reserve development of $129 and $77, respectively. Unfavorable trends continued during 2004 and, as a result, the Company increased reserves by $170. The majority of the $170 increase was for assumed casualty treaty reinsurance for the 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 claims above previous expectations and this increase in reported claims contributed to the reserve re-estimates.
As noted in the Ongoing Operations discussion, the Company continued to observe favorable developments with respect to reserves related to September 11. Particularly for Other Operations, these favorable trends included a lack of significant additional loss notices on assumed reinsurance property treaties. The reduction in net reserves for September 11 for Other Operations was $97. As of December 31, 2004, gross reserves and net reserves remaining in Other Operations related to September 11 were $171 and $68, respectively. All September 11 reserves within Other Operations relate to HartRe assumed reinsurance exposures, both property and casualty.
[1] Represents the transfer of reserves pursuant to the MacArthur settlement.
[2] The “loss and loss expense paid ratio” represents the ratio of paid claims and claim adjustment expenses to earned premiums.
There was no significant reserve strengthening or release in the Business Insurance and Personal Lines segments for the year ended December 31, 2003. Specialty Commercial strengthened prior accident year reserves by $52 for the year ended December 31, 2003 primarily as a result of losses in the bond and professional liability lines of business. The bond reserve strengthening was isolated to a few severe contract surety claims related to accident year 2002. The professional liability reserve strengthening involved a provision for anticipated settlements of reinsurance obligations for contracts outstanding at the time of the original acquisition of Reliance Group Holdings’ auto residual value portfolio in the third quarter of 2000.
As further discussed in the segment section, the Company recorded net asbestos reserve strengthening of $2.6 billion during the first quarter of 2003. In addition, strengthening of assumed reinsurance reserves of $129 in 2003 occurred across multiple accident years, primarily 1997 through 2000, and principally in the casualty line of HartRe assumed reinsurance.
As explained in connection with the Company’s discussion of Critical Accounting Estimates, the establishment of Property and Casualty reserves is an estimation process, using a variety of methods, assumptions and data elements. Ultimate losses may vary significantly from the current estimates. Many factors can contribute to these variations and the need to change the previous estimate of required reserve levels. Subsequent changes can generally be thought of as being the result of the emergence of additional facts that were not known or anticipated at the time of the prior reserve estimate and/or changes in interpretations of information and trends.
The table below shows the range of annual reserve re-estimates experienced by The Hartford over the past four 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 four 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.
[1] Bracketed prior accident year development indicates favorable development. Unbracketed amounts represent unfavorable development.
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 $374 and $381 as of December 31, 2004 and December 31, 2003, respectively. The allowance for uncollectible reinsurance is based on an assessment of the credit quality of the Company’s reinsurers as well as an estimate of the cost of resolution of reinsurer disputes.
The Company completed an evaluation of the reinsurance recoverable asset associated with older, long-term casualty liabilities, including asbestos liabilities, reported in the Other Operations segment. As a result of this evaluation, the Company reduced its net reinsurance recoverable by $181. The after-tax income effect of this action was $118. The $181 primarily related to a reduction of the amount of liabilities, principally asbestos, that the Company expects to cede to reinsurers and, to a lesser extent, an increase in the allowance for uncollectible reinsurance recoverables.
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. The following segment discussions for the years ended December 31, 2004, 2003 and 2002, respectively, include the presentation of written premiums in addition to earned premiums. Management believes that this performance measure is useful to investors as it reflects current trends in the Company’s sale of property and casualty insurance products, as compared to earned premium. Reinstatement premium represents additional ceded premium paid for the reinstatement of the amount of reinsurance coverage that was reduced as a result of a reinsurance loss payment.
New business written premium for the year ended December 31, 2004 of $1,148 was up from $1,038 for the year ended December 31, 2003, due to an increase in new business written premium for small commercial of $172, partially offset by a decrease in new business written premium for middle market of $61. The new business premium growth in Small Commercial was due primarily to growth from the Select Xpand product and growth from an increase in the number of agents, partially offset by the moderation in written pricing increases.
2003 Compared to 2002 - Earned premiums for the segment increased by $570 for the year ended December 31, 2003, primarily due to earned pricing increases of 12% and new business growth outpacing non-renewals. As substantially all premiums in the segment are earned over a 12 month policy period, earned pricing increases in 2003 were primarily driven by written pricing increases of 14% in the last six months of 2002 and 9% during 2003. New business growth of 17% in 2003 was primarily driven by growth in middle market business. Premium renewal retention for the year ended December 31, 2003 remained strong at 87% compared to 89% in 2002.
Underwriting results improved $64, with a corresponding 1.3 point decrease in the combined ratio, for the year ended December 31, 2003, despite a significant increase in catastrophe losses due largely to Hurricane Isabel and severe tornadoes in the Midwest. Before catastrophes, underwriting results improved $140, or 119%, with a corresponding 3.2 point decrease in the combined ratio. The improvement was driven by a decrease in the loss and loss expense ratio before catastrophes for both small commercial and middle market, primarily due to improved claim frequency and double-digit earned pricing increases. In addition, double-digit earned pricing increases and prudent expense management favorably impacted the expense ratio for the year ended December 31, 2003.
Management expects the Business Insurance segment to continue to deliver strong results in 2005. Although some price decreases within many markets of the commercial industry are expected, the Company expects to achieve mid- to high-single-digit written premium growth due, in part, to implementing continued strategic actions. These actions include working with distribution channels to expand market share in targeted states, improving pricing opportunities through better segmentation of the market, offering flexible products that allow agents to tailor offerings to each customer, maintaining disciplined renewal underwriting and enhancing agency technology, including e-submission capability. Loss costs are expected to increase due to less favorable trends in claim frequency and continuing trends of increasing claim severity. As a result of the anticipated slight decrease in written pricing and increase in loss costs, management expects the loss and loss expense ratio to increase moderately in 2005. Competition in middle market is challenging, but largely rational, with some classes of business experiencing more aggressive price competition. Written pricing in the small commercial market will also continue to be impacted by increasing competition as more national carriers enter the market. Nonetheless, we anticipate continued new business growth in the small commercial segment through execution of strategic initiatives and the continued growth of our Select Xpand product sales.
[1] The difference between written premiums and earned premiums is attributable to the change in unearned premium reserve.
Personal Lines provides automobile, homeowners’ and home-based business coverages to the members of AARP through a direct marketing operation; to individuals who prefer local agent involvement through a network of independent agents in the standard personal lines market (“Standard”) and in the non-standard automobile market through the Company’s Omni Insurance Group, Inc. (“Omni”) subsidiary. Personal Lines also operates a member contact center for health insurance products offered through AARP’s Health Care Options. The Hartford’s exclusive licensing arrangement with AARP continues through January 1, 2010 for automobile, homeowners and home-based business. The Health Care Options agreement continues through 2007.
2004. AARP and Agency earned premium increased $190 and $100, respectively, for the year ended December 31, 2004, primarily because new business growth over the prior 6 to 12 months has exceeded non-renewals. Both AARP and Agency have experienced increased earned premiums in both automobile and homeowners business. The growth in Agency earned premium is due, in part, to the new Dimensions automobile and homeowners class plans, which allows the Company to write a broader class of risks. The growth in AARP reflects growth in the size of the AARP target market and direct marketing programs to increase premium writings.
The new Dimensions auto class plan has been rolled out to an additional six states in 2004, bringing the total number of states to 37. The new Dimensions homeowners’ class plan was introduced in the first quarter of 2004 and has been rolled out to 28 states through December 31, 2004. As a result of the new Dimensions class plan initiative and other actions taken to increase growth, the number of policies in force at year end increased in auto and homeowners from 2,058,825 and 1,319,629, respectively, as of December 31, 2003, to 2,166,922 and 1,348,573, respectively, as of December 31, 2004. The growth in policies in force does not correspond directly with the growth in earned premium due to the impact of earned pricing increases and because policy in force counts are as of a point in time rather than over a period of time. Most of the growth in homeowners policies in force was generated by Agency while for auto policies in force, growth in both AARP and Agency is partially offset by a decline in Omni. For the year ended December 31, 2004, new business premiums for both automobile and homeowners in AARP and Agency were $311 and $167, respectively, which was up from $226 and $105, respectively, for the year ended December 31, 2003.
Premium renewal retention for automobile decreased from 91% for the year ended December 31, 2003 to 89% for the year ended December 31, 2004. The decrease in premium renewal retention for automobile is driven largely by the impact of declining written pricing increases. Premium renewal retention for homeowners decreased from 101% for the year ended December 31, 2003 to 100% for the year ended December 31, 2004, also due to declining written pricing increases.
2003 Compared to 2002 - Earned premiums increased $197 in 2003 due to growth in both the automobile and homeowners lines, primarily in AARP business, which grew by $209, or 12%. The increase in automobile earned premium of $132 was primarily due to new business growth in AARP and earned pricing increases of 9% in 2003 up from 6% in 2002. Homeowners earned premium growth of $65 for the year ended December 31, 2003, was largely driven by new business growth in AARP and earned pricing increases of 14% in 2003, up from 7% in 2002. The increase in earned premiums for AARP and Agency is partially offset by the decrease in earned premiums for other affinity business of $29 due to a planned reduction in policy counts as a result of the Company’s strategic decision to de-emphasize other affinity business.
groups. In addition, Specialty Commercial provides third-party administrator services for claims administration, integrated benefits, loss control and performance measurement through Specialty Risk Services.
2004 Compared to 2003 - Earned premiums for the Specialty Commercial segment grew $168 due primarily to earned pricing increases in casualty, bond and professional liability, partially offset by earned pricing decreases in property, a decline in new business growth in all lines except bond and a decrease in renewal retention in all lines. The increase in earned premium for the year ended December 31, 2004 is also offset by a $90 reduction in premiums receivable under retrospectively-rated policies, reflecting a decrease in estimated earned premium under the terms of these policies. As substantially all premiums in the segment are earned over a 12 month policy period, the earned pricing increases in 2004 resulted primarily from written pricing increases over the last 6 months of 2003 and the year ended December 31, 2004.
In professional liability, written premium is up $18 for the year ended December 31, 2004 due to a decrease in the portion of risks ceded to outside reinsurers and earned pricing increases, partially offset by a decrease in renewal retention and new business growth. Earned pricing increases in professional liability were due entirely to written pricing increases in 2003 as prices have declined in 2004.
Within the “other” category, written and earned premiums increased $31 and $41, respectively, for the year ended December 31, 2004 due to increased premiums on internal reinsurance arrangements.
2003 Compared to 2002 - Earned premiums increased $336, or 27%, for the year ended December 31, 2003, primarily due to earned premium growth in the property, casualty and professional liability lines of business as a result of strong earned pricing increases. Written premiums increased $250, or 18%, in 2003, primarily due to double-digit growth in casualty and professional liability. Casualty and professional liability written premiums grew $114, or 21%, and $85, or 36%, respectively, due to strong written pricing increases. Bond growth for the year was negatively impacted by ceded reinstatement premium. While property pricing began to turn negative in the latter half of 2003, written premiums in property increased $35 for the year ended December 31, 2003. Premium renewal retention for casualty, professional liability and bond was flat to slightly higher from year to year, except for a decrease in renewal retention in property due to the decline in pricing.
Specialty Commercial is made up of a diverse group of businesses, each of which operates independently with its own set of business objectives and focuses on the operational dynamics of its specific industry. These businesses, while somewhat interrelated, each have a unique business model and operating cycle. Given pricing declines in some markets, we anticipate negative written premium growth for 2005. Although written price decreases for property and professional liability are expected to continue in 2005, management expects written pricing increases in both casualty and bond. We will continue to write and renew business where pricing and terms and conditions are reasonable. Management will continue to take actions to maintain profitability, including exercising underwriting discipline, maximizing growth in the segment’s most profitable lines, providing innovative new products and expanding non-traditional distribution alternatives. In 2005, both the loss and loss adjustment expense ratio and the expense ratio will be impacted from exiting the MPCI crop insurance business. The MPCI business made up 27.5% of the earned premium in property for 2004 and had a higher loss ratio than the balance of the property business. The MPCI business also had one of the lowest expense ratios in Specialty Commercial because of the reimbursement of expenses from the Federal government under the MPCI program. As a result of exiting the business, there will likely be an unfavorable impact to earned premium growth and the expense ratio, offset by a favorable impact on the loss and loss adjustment expense ratio. In addition, the non-renewal of an alternative markets insured program, representing $225 of earned premium in 2004, will negatively impact casualty earned premium in 2005, but is not expected to have a significant impact on underwriting results.
The Other Operations segment includes operations that are under a single management structure, Heritage Holdings, which is responsible for two related activities. The first activity is the management of certain subsidiaries and operations of The Hartford that have discontinued writing new business. The second is the management of claims (and the associated reserves) related to asbestos and environmental exposures. Effective January 1, 2004, the financial results of HartRe assumed reinsurance are fully reported in Other Operations, and 2003 and 2002 financial results have been restated to include HartRe assumed reinsurance.
2004 Compared to 2003 - Earned premiums continue to decline as a result of the Company’s decision to exit from the HartRe assumed domestic reinsurance business in the second quarter of 2003. Underwriting losses decreased $2.4 billion for the year ended December 31, 2004, primarily due to the impact of $2.6 billion of asbestos reserve strengthening in the first quarter 2003, and a reduction in September 11 reserves of $97 in the first quarter of 2004. These favorable variances were partially offset by the $170 strengthening of assumed reinsurance reserves, the $75 strengthening of environmental reserves in the third quarter of 2004, and the $181 provision associated with the evaluation of the reinsurance recoverable asset in the second quarter of 2004.
2003 Compared to 2002 - The decline in earned premiums was primarily due to the Company’s decision to exit the HartRe assumed domestic reinsurance business. The underwriting loss was driven by the first quarter net asbestos reserve strengthening of $2.6 billion as discussed in the section that follows.
The paragraphs that follow are background information and a discussion of asbestos and environmental claims, the deteriorating trends with respect to asbestos, and a summary of the Company’s detailed study of asbestos reserves.
In the case of the reserves for asbestos exposures, factors contributing to the high degree of uncertainty include inadequate loss development patterns, plaintiffs’ expanding theories of liability, the risks inherent in major litigation, and inconsistent emerging legal doctrines. Furthermore, over time, insurers, including The Hartford, have experienced significant changes in the rate at which asbestos claims are brought, the claims experience of particular insureds, and the value of claims, making predictions of future exposure from past experience uncertain. For example, in the past few years, insurers in general, including The Hartford, have experienced an increase in the number of asbestos-related claims due to, among other things, plaintiffs’ increased focus on new and previously peripheral defendants, and an increase in the number of insureds seeking bankruptcy protection as a result of asbestos-related liabilities. Plaintiffs and insureds have sought to use bankruptcy proceedings, including “pre-packaged” bankruptcies, to accelerate and increase loss payments by insurers. In addition, some policyholders have asserted new classes of claims for so-called “non-products” coverages to which an aggregate limit of liability may not apply. Further uncertainties include insolvencies of other carriers and unanticipated developments pertaining to The Hartford’s ability to recover reinsurance for asbestos and environmental claims. Management believes these issues are not likely to be resolved in the near future.
In the case of the reserves for environmental exposures, factors contributing to the high degree of uncertainty include expanding theories of liabilities and damages; the risks inherent in major litigation; inconsistent decisions concerning the existence and scope of coverage for environmental claims; and uncertainty as to the monetary amount being sought by the claimant from the insured.
The process of estimating asbestos and environmental reserves remains subject to a wide variety of uncertainties, which are detailed in Note 12 of Notes to Consolidated Financial Statements. The Company believes that its current asbestos and environmental reserves are reasonable and appropriate. However, analyses of future developments could cause The Hartford 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.
The Other Operations book of business contains policies written from 1940s to 2003. With the transfer of HartRe assumed reinsurance into Other Operations in both 2002 and 2004, Other Operations has exposure related to more recent assumed casualty reinsurance reserves, particularly for the underwriting years 1997 through 2001. The Hartford’s experience has been that this book of runoff business has over time produced significantly higher claims and losses than were contemplated at inception. The areas of active claim activity have also shifted based on changes in plaintiff focus and the overall litigation environment. A significant portion of the claim reserves of the Other Operations segment relates to exposure to the insurance businesses of other insurers or reinsurers (“whole account” exposure). Many of these whole account exposures arise from reinsurance agreements previously written by The
In December 2002, Halliburton announced its intention to file a pre-packaged bankruptcy plan through one or more subsidiaries and in January 2003, Honeywell announced that it had reached an agreement with the plaintiffs’ bar that would enable it to file a pre-negotiated plan through its former NARCO subsidiary, then already in bankruptcy. In January 2003, Congoleum, a floor tile manufacturer, which previously had defended claims successfully in the tort system, announced its intention to file a pre-packaged plan of reorganization to be funded almost entirely with insurance proceeds. Moreover, prominent members of the plaintiffs’ and policyholders’ bars announced publicly their intention to file many more such plans. These events represented a worsening of conditions the Company observed in 2002.
In the first quarter of 2003, several events occurred that in the Company’s view confirmed the existence of a substantial long-term deterioration in the asbestos litigation environment. For example, in February 2003, Combustion Engineering, long a major asbestos defendant, filed a pre-packaged bankruptcy plan under which it proposed to emerge from bankruptcy within five weeks, before opponents of the plan could have a meaningful opportunity to object, and included many novel features in its plan that its insurers found objectionable.
As a result of these worsening conditions, the Company conducted a comprehensive, ground-up study of its asbestos exposures in the first quarter of 2003 in an effort to project, beginning at the individual account level, the effect of these trends on the Company’s estimated total exposure to asbestos liability. Based on the Company’s evaluation of the deteriorating conditions described above, the Company strengthened its gross and net asbestos reserves by $3.9 billion and $2.6 billion, respectively. The reserve strengthening related primarily to policies effective in 1985 or prior years. The Company had incorporated an absolute asbestos exclusion in most of its general liability policies written after 1985.
During the first quarter of 2004, the Company completed an updated gross asbestos reserve evaluation. As part of this evaluation, the Company 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 required gross asbestos reserves. During the second quarter of 2004, the Company completed an evaluation of the reinsurance recoverables associated with older, long-term casualty liabilities reported in the Other Operations segment, including asbestos liabilities. In conducting its Other Operations reinsurance recoverable review, the Company used its most recent detailed studies of gross asbestos, environmental and all other liabilities reported in the segment, including its estimate of the type and potential timing of future claims, and analyzed the legal entities through which each exposed coverage was written, the reinsurance arrangements in place at each of these legal entities and the years of potential reinsurance available. As part of its Other Operations reinsurance recoverable review, the Company also analyzed 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. As a result of this evaluation, the Company reduced its estimated 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. The after-tax effect of this action was $118. The Company also consolidated within the “all other” category its allowance for insolvencies and disputes that might affect reinsurance coverage associated with Other Operations into a single allowance. As of December 31, 2004, the allowance for uncollectible reinsurance totals $314.
In the third quarter of 2004, The Hartford completed an account-by-account review of its environmental exposures. During the course of this review, the Company found estimates for individual cases changed based upon the particular circumstances of each account, although the review found no apparent overarching cause or change in the claim environment. The net effect of these changes resulted in a $75 before tax increase in gross and net environmental liabilities.
Consistent with the Company’s long-standing reserving practices, The Hartford will continue to review and monitor these reserves regularly and, where future developments indicate, make appropriate adjustments to the reserves. The loss reserving assumptions, drawn from both industry data and the Company’s experience, have been applied over time to all of this business and have resulted in reserve strengthening or reserve releases at various times over the past decade. The Company believes that its current asbestos and environmental reserves are reasonable and appropriate. However, analyses of future developments could cause The Hartford 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. Currently, the Company expects to perform an asbestos study in the second quarter of 2005 and an environmental study in the third quarter of 2005. In addition, the Company currently expects to perform a comprehensive review of Other Operations reinsurance recoverables at least annually. At any time there are significant developments that affect particular exposures, reinsurance arrangements or the financial condition of particular reinsurers, the Company will respond by making adjustments in the portion of liabilities it expects to cede or in its allowance for uncollectible reinsurance.
The following table presents reserve activity, inclusive of estimates for both reported and incurred but not reported claims, net of reinsurance, for Other Operations, categorized by asbestos, environmental and all other claims, for the years ended December 31, 2004, 2003 and 2002. Also included are the remaining asbestos and environmental exposures of Ongoing Operations.
[1] Includes unallocated loss adjustment expense reserves and allowance for uncollectible reinsurance.
[7] The one year and average three year net paid amounts for asbestos claims are $1,202 and $504, respectively, resulting in a one year net survival ratio of 2.1 (15.2 excluding the MacArthur payments) and a three year net survival ratio of 5.0 (16.5 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.
[8] Represents the transfer of reserves pursuant to the MacArthur settlement.
[9] The nature of these reallocations is described in the preceding discussion.
At December 31, 2004, asbestos reserves were $2.5 billion, a decrease of $1.3 billion compared to $3.8 billion as of December 31, 2003. The decrease in asbestos reserves was due primarily to the MacArthur settlement payment made in the first quarter of 2004. At December 31, 2003, asbestos reserves were $3.8 billion, an increase of $2.7 billion compared to $1.1 billion as of December 31, 2002. Net incurred losses and loss adjustment expenses were $2.6 billion for the year ended December 31, 2003. The increase in reserves for 2003 as well as the increase in paid losses reflect asbestos claim and litigation trends.
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 at the reinsurer level reflecting changes in the asbestos tort litigation and direct insurance coverage environments.
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 in April. 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 claim and claim adjustment expenses during the first quarter of 2004.
For the past three years, direct paid loss and expense for environmental claims have declined. The vast majority of these payments have been made under settlement agreements that fully resolve The Hartford’s exposure to these insureds for environmental liabilities.
The following table sets forth, for the three years ended December 31, 2004, paid and incurred loss activity by the three categories of claims for asbestos and environmental.
Paid and Incurred Loss and Loss Adjustment Expense (“LAE”) Development - Asbestos and Environmental
Pursuant to the adoption of SOP 03-1, as discussed in Note 1 of Notes to Consolidated Financial Statements, on January 1, 2004, the Company reclassified $18.1 billion of separate account assets to the general account. Of this amount, $11.7 billion was associated with guaranteed separate accounts and was primarily comprised of fixed maturities. These assets are classified as available-for-sale securities with changes in fair value reported in other comprehensive income. In addition, $6.2 billion is primarily comprised of equity securities related to variable annuity products offered in Japan. These assets are classified as trading securities with changes in fair value reported in net investment income. The remaining amount of $200 related to policy loans on private placement life insurance products.
Fluctuations in interest rates affect the Company’s return on, and the fair value of, general account fixed maturity investments, which comprised approximately 80% and 93% of the fair value of its invested assets as of December 31, 2004 and 2003, respectively. Other events beyond the Company’s control could also adversely impact the fair value of these investments. Specifically, a downgrade of an issuer’s credit rating or default of payment by an issuer could reduce the Company’s investment return.
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 16% and 17% of the fair value of its invested assets as of December 31, 2004 and 2003, 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. (For a further discussion of the evaluation of other-than-temporary impairments, see the Critical Accounting Estimates section of the MD&A under “Valuation of Investments and Derivative Instruments and Evaluation of Other-Than-Temporary Impairments”.)
Net realized capital gains during 2004 increased by $109 compared to the prior year, primarily the result of lower other-than-temporary impairments. (For further discussion of other-than-temporary impairments, see the Other-Than-Temporary Impairments commentary in this section of the MD&A.)
Net realized capital gains (losses) for 2003 increased by $348 compared to the prior year, primarily as a result of net gains on sales of fixed maturities and a decrease in other-than-temporary impairments on fixed maturities. Sales were the result of normal trading activity and were primarily attributable to the improvement in the corporate credit environment, general economic conditions and operating fundamentals, the decrease in interest rates and improved pricing levels for ABS. (For a further discussion of other-than-temporary impairments, see the Other-Than-Temporary Impairments commentary in this section of the MD&A.)
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 the securities lending program.
2004 Compared to 2003 - Before-tax net investment income increased $76, or 6%, and after-tax net investment income increased $43, or 5%, compared to the prior year. The increases in net investment income were primarily due to income earned on a higher average invested assets base in 2004, as compared to prior year, partially offset by a decrease in the average new invested asset yield and the repositioning of the portfolio into higher quality assets as described below.
In 2004, the yield on average invested assets decreased slightly from prior year as a result of new investment purchases at rates below the average portfolio yield due to the continued low interest rate environment. Since the Company invests primarily in long-term fixed rate debt securities, current period changes in long-term interest rates impact the yield on new asset purchases and, therefore, have a gradual impact on the overall portfolio yield. The weighted average yield on new asset purchases in 2004 of approximately 4.9%, before-tax, continues to be below the average portfolio yield. Property & Casualty expects the average before-tax new investment yields in 2005 to range from 4.8% to 5.0%. If future interest rates differ from the forward rates as of December 31, 2004, the actual average new investment yields may be significantly different from the yields currently expected.
portfolios’ exposure to foreign holdings and realize gains associated with the decline in value of the U.S. dollar against foreign currencies.
2003 Compared to 2002 - Before-tax net investment income increased $112, or 11%, and after-tax net investment income increased $69, or 8%, compared to the prior year. The increases in net investment income were primarily due to income earned on a higher invested asset base partially offset by lower investment yields. Yields on average invested assets decreased from the prior year as a result of lower rates on new investment purchases.
During 2004, HIM issued one and began serving as the collateral asset manager for two additional synthetic collateralized loan obligations (“CLOs”), which invest in senior secured bank loans through total return swaps (“referenced bank loan portfolios”). The notional value of the referenced bank loan portfolios from the three synthetic CLOs as of December 31, 2004 was $1.1 billion. The synthetic CLOs issued approximately $185 of notes and preferred shares (“CLO issuances”), approximately $170 of which was to third party investors. The proceeds from the CLO issuances were invested in collateral accounts consisting of high credit quality securities that were pledged to the referenced bank loan portfolios’ swap counterparties. Investors in the CLO issuances receive the net proceeds from the referenced bank loan portfolios. Any principal losses incurred by the swap counterparties associated with the referenced bank loan portfolios are borne by the CLO issuances investors through the total return swaps.
Pursuant to the requirements of FIN 46R, the Company has concluded that the three synthetic CLOs are variable interest entities (“VIEs”) and for the CLO issued in 2004, the Company is the primary beneficiary and must consolidate this CLO. Accordingly, the Company has recorded in the consolidated balance sheets $65 of cash and invested assets, total return swaps with a fair value of $3 in other assets, which reference a bank loan portfolio with a maximum notional of $400, and $52 in other liabilities related to the CLO issuances. The total return from the referenced bank loan portfolio of $3 was received via the total return swap and recorded in realized capital gains and losses. Income from the fixed maturity collateral account and CLO issuance investor payments were recorded in net investment income in the consolidated statements of operations. The Company’s investment in the consolidated synthetic CLO issuance is $14, which is its maximum exposure to loss. Of the two non-consolidated synthetic CLOs, the Company has a $2 preferred share investment in one of the CLO issuances, which is its maximum exposure to loss. The investors in the three synthetic CLO issuances have recourse only to the VIE assets and not to the general credit of the Company. The collateral management fees earned by HIM for the two non-consolidated synthetic CLOs totaled $3 for the year ended December 31, 2004 and are reported in other income in the consolidated statements of operations.
During 2004 there were no significant other-than-temporary impairments (e.g. $15 or greater) recorded on any single security or issuer. In aggregate, other-than-temporary impairments recorded on ABS primarily relate to the decline in market values of certain previously impaired securities. Other-than-temporary impairments recorded on equity securities primarily related to variable rate perpetual preferred securities issued by two highly rated financial services companies. These securities are variable rate securities with unique structural interest rate reset characteristics that have sustained a decline in market value for an extended period of time primarily as a result of the increase in short-term interest rates after the security’s interest rate reset period. As of December 31, 2004, the Company did not hold other perpetual preferred securities in an unrealized loss position with similar interest rate reset characteristics.
• The $31 of CDO other-than-temporary impairments consisted of approximately ten securities, the majority of which were interests in the lower tranches of securities backed by high yield corporate debt. These impairments were primarily the result of continued high default rates in 2003 and lower recovery rates on the CDO’s underlying collateral.
• The $30 of the other-than-temporary impairments recorded on equity securities primarily related to various diversified mutual funds. The market values of these funds had fallen since the date of purchase due to declines in primarily the equity markets and were not expected to recover within a reasonable period of time. Due to the severity of the price depression and length of time the holdings were in an unrealized loss position, these securities were deemed to be other-than-temporarily impaired.
In addition to the impairments described above, fixed maturity and equity securities were sold at losses during 2003, with no single security sold at a loss in excess of $10.
During 2002, other-than-temporary impairments on ABS were primarily driven by collateral deterioration associated with securities backed by aircraft lease receivables and high yield debt. Impairments recognized on corporate fixed maturities were concentrated in the technology and communications sector and were primarily driven by weakening economic conditions and operating fundamentals in the sector. Other-than-temporary impairments were also recorded on equity securities, the majority of which related to various diversified mutual funds. The market values of these funds had fallen since the date of purchase due to declines in the bond and equity markets and were not expected to recover within a reasonable period of time. Due to severity of the price depression and length of time the holdings were in an unrealized loss position, these securities were deemed to be other-than-temporarily impaired. During 2002, there were 8 securities for which a significant (e.g. $15 or greater) other-than-temporary impairment was recorded which are discussed in more detail below.
• Of the technology and communications sector impairments, $110 related to securities issued by WorldCom and its subsidiary MCI, which filed for Chapter 11 bankruptcy protection in July 2002 as a result of liquidity problems driven by economic and operating weakness in this sector, and specific issues related to accounting fraud.
• Of the $84 of impairments relating to ABS backed by aircraft lease receivables, $41 related to investments in the lower tranches of one transaction that experienced a steep decline in fair value as a result of a significant decrease in aircraft lease payments and lower appraised values on the underlying collateral. This transaction was primarily supported by lower quality aircraft and was significantly impacted by the decline in airline travel and numerous airline bankruptcies resulting from the catastrophic events of September 11, 2001. The remaining $43 of impairments on aircraft lease receivables were primarily related to two other transactions that were also adversely impacted by similar circumstances surrounding the airline industry in 2002.
• In the technology and telecommunications sector, $32 of impairments were recognized on fixed maturity securities issued by a major U.S. telecom equipment manufacturer. This issuer had amassed high levels of debt to acquire assets and subsequently experienced liquidity difficulties due to the downturn in demand and economic conditions within the technology and telecommunications sector. As a result, this issuer initiated a debt restructuring in 2002.
• Of the impairments recognized on ABS securities backed by MH receivables, $21 related to three securities issued by the same transaction. These securities were backed by the transaction sponsor who ultimately filed for Chapter 11 bankruptcy protection as a result of numerous defaults on the underlying loans. The manufactured housing sector experienced above average default rates in 2002 primarily due to weak underwriting practices and loan originators extending credit to sub-prime borrowers.
• Another $15 of impairments in the technology and communications sector related to a Canada based local and long-distance communications carrier. As a result of excess capacity and margin erosion within the long-distance sector, this issuer began to experience liquidity problems and eventually filed for bankruptcy in 2002.
As of December 31, 2004 and 2003, the notional value of total return and credit default swaps totaled $2.2 billion and $1.0 billion, respectively, and the swap fair value totaled $8 and $(33), respectively.
The following table identifies fixed maturity securities by type on a consolidated basis as of December 31, 2004 and 2003.
The Company’s fixed maturity portfolio gross unrealized gains and losses as of December 31, 2004 in comparison to December 31, 2003 were primarily impacted by changes in interest rates, foreign currency exchange rates, credit spreads and security sales. The Company’s fixed maturity gross unrealized gains decreased $107 from December 31, 2003 to December 31, 2004 primarily due to sales of securities in a gain position and the increase in interest rates (e.g. short-term through five-year rates) offset by credit spread tightening and changes in foreign currency exchange rates. The gross unrealized loss amount decreased by $97 from December 31, 2003 to December 31, 2004 primarily due to credit spread tightening, improved pricing levels for certain CDOs and ABS, security sales and, to a lesser extent, other-than-temporary impairments, offset by interest rate increases.
As of December 31, 2004 and 2003, 18% of the fixed maturities were invested in private placement securities, including 11% of Rule 144A offerings to qualified institutional buyers. Private placement securities are generally less liquid than public securities. Most of the private placement securities are rated by nationally recognized rating agencies.
The following table identifies fixed maturities by credit quality on a consolidated basis as of December 31, 2004 and 2003. 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 following table presents the BIG fixed maturities by type as of December 31, 2004 and 2003.
The following table presents the Company’s unrealized loss aging for total fixed maturity and equity securities classified as available-for-sale on a consolidated basis, as of December 31, 2004 and 2003, by length of time the security was in an unrealized loss position.
Financial services - As of December 31, 2004, the Company held approximately 110 different securities in the financial services sector that had been in an unrealized loss position for greater than six months. Substantially all of these securities are investment grade securities priced at or greater than 90% of amortized cost as of December 31, 2004. These positions are a mixture of fixed and variable rate 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 interest rates.
Such estimates are derived from prepayment speeds previously experienced at the interest rate levels projected for the underlying collateral. Actual prepayment experience may vary from these estimates.
The Company believes that an increase in interest rates from the current levels is generally a favorable development for the Company. Rate increases are expected to provide additional net investment income, increase sales of fixed rate Life investment products, reduce the cost of the GMWB hedging program, limit the potential risk of margin erosion due to minimum guaranteed crediting rates in certain Life products and, if sustained, could reduce the Company’s prospective pension expense. Conversely, a rise in interest rates will reduce the net unrealized gain position of the investment portfolio, increase interest expense on the Company’s variable rate debt obligations and, if long-term interest rates rise dramatically within a six to twelve month time period, certain Life businesses may be exposed to disintermediation risk. Disintermediation risk refers to the risk that policyholders will surrender their contracts in a rising interest rate environment requiring the Company to liquidate assets in an unrealized loss position. In conjunction with the interest rate risk measurement and management techniques, significant portions of Life’s fixed income product offerings have market value adjustment provisions at contract surrender.
Life is responsible for maximizing after-tax returns within acceptable risk parameters, including the management of the interest rate sensitivity of invested assets and the generation of sufficient liquidity to support policyholder and corporate obligations. Life’s fixed maturity portfolios and certain investment contract and insurance product liabilities have material market exposure to interest rate risk. In addition, Life’s operations are significantly influenced by changes in the equity markets. Life’s profitability depends largely on the amount of assets under management, which is primarily driven by the level of sales, equity market appreciation and depreciation and the persistency of the in-force block of business. Life’s foreign currency exposure is primarily related to non-U.S. dollar denominated fixed income securities, the investment in the Japanese Life operation and certain foreign currency based individual fixed annuity contracts, and to a lesser extent, its GMDB and GMIB benefits associated with its Japanese variable annuities.
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-to-intermediate term.
At December 31, 2004 and 2003, notional amounts pertaining to derivatives utilized to manage interest rate risk totaled $9.9 billion and $9.5 billion, respectively ($7.7 billion and $7.8 billion, respectively related to insurance investments and $2.2 billion and $1.7 billion, respectively related to life insurance liabilities). The fair value of these derivatives as reflected on the consolidated balance sheets was $41 and $142 as of December 31, 2004 and 2003, respectively.
The after-tax change in fair value of the general account invested asset portfolios that support certain universal life-type contracts and other insurance contracts that possess significant mortality risk are shown in the following table. The cash flows associated with these liabilities are less predictable than fixed liabilities. The Company identifies the most appropriate investment strategy based upon the expected policyholder behavior and liability crediting needs. The hypothetical calculation of the estimated change in fair value below assumes a 100 basis point upward and downward parallel shift in the yield curve.
The Company’s operations are significantly influenced by changes in the equity markets. The Company’s profitability depends largely on the amount of assets under management, which is primarily driven by the level of sales, equity market appreciation and depreciation and the persistency of the in-force block of business. Prolonged and precipitous declines in the equity markets can have a significant impact on the Company’s operations, as sales of variable products may decline and surrender activity may increase, as customer sentiment towards the equity market turns negative. Lower assets under management will have a negative impact on the Company’s financial results, primarily due to lower fee income related to the Retail Products Group and Institutional Solutions Group and, to a lesser extent, the Individual Life segments, where a heavy concentration of equity linked products are administered and sold. Furthermore, the Company may experience a reduction in profit margins if a significant portion of the assets held in the variable annuity separate accounts move to the general account and the Company is unable to earn an acceptable investment spread, particularly in light of the low interest rate environment and the presence of contractually guaranteed minimum interest credited rates, which for the most part are at a 3% rate.
The Company sells variable annuity contracts that offer various guaranteed death and income benefits. The Company maintains a liability for the death and income benefit costs, net of
reinsurance, of $138, as of December 31, 2004. 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 Hartford 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 Retail Products Group segment 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.
The net impact of the change in value of the embedded derivative net of the results of the hedging program was an $8 gain before deferred policy acquisition costs and tax effects for the year ended December 31, 2004. As of December 31, 2004, the notional and fair value related to the embedded derivatives, the hedging strategy, and reinsurance was $37.7 billion and $170, respectively.
Currency exchange risk exists with respect to investments in non-U.S. dollar denominated fixed maturities, primarily denominated in Euro, Sterling, Yen and Canadian dollars, as well as Life’s investment in foreign operations, primarily Japan, and the yen based individual fixed annuity product and, to a lesser extent, its GMDB and GMIB benefits associated with its Japanese variable annuities.
The risk associated with the non-U.S. dollar denominated fixed maturities relates to potential decreases in value and income resulting from unfavorable changes in foreign exchange rates. The fair value of the non-U.S. dollar denominated fixed maturities at December 31, 2004 and 2003, were approximately $2.5 billion and $2.0 billion, respectively. In order to manage its currency exposures, Life enters into foreign currency swaps and forwards to hedge the variability in cash flow associated with certain foreign denominated fixed maturities. These foreign currency swap agreements are structured to match the foreign currency cash flows of the hedged foreign denominated securities. At December 31, 2004 and 2003, the derivatives used to hedge currency exchange risk related to non-U.S. dollar denominated fixed maturities had a total notional value of $1.7 billion and $1.4 billion, respectively, and total fair value of $(503) and $(299), 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, 2004 and 2003. Certain financial instruments, such as limited partnerships, have been omitted from the analysis due to the fact the investments are accounted for under the equity method and lack sensitivity to interest rate changes.
In order to manage its currency exposures, Property & Casualty enters into foreign currency swaps and forward contracts to hedge the variability in cash flow associated with certain foreign denominated securities. These foreign currency swap agreements are structured to match the foreign currency cash flows of the hedged foreign denominated securities. At December 31, 2004 and 2003, the derivatives used to hedge currency exchange risk had a total notional value of $370 and $325, respectively, and total fair value of $(70) and $(26), respectively.
Includes current maturities of long-term debt: $250 of 7.75% senior notes in 2004 and $200 of 6.9% senior notes in 2003.
The liquidity requirements of The Hartford have been and will continue to be met by funds from operations as well as the issuance of commercial paper, common stock, debt securities and borrowings from its credit facilities. Current and expected patterns of claim frequency and severity may change from period to period but continue to be within historical norms and, therefore, the Company’s current liquidity position is considered to be sufficient to meet anticipated demands. However, if an unanticipated demand was placed on the Company it is likely that the Company would either sell certain of its investments to fund claims which could result in larger than usual realized capital gains and losses or the Company would enter the capital markets to raise further funds to provide the requisite liquidity. For a discussion and tabular presentation of the Company’s current contractual obligations by period including those related to its Life and Property & Casualty insurance refer to the Off-Balance Sheet and Aggregate Contractual Obligations section below.
The principal sources of operating funds are premiums and investment income, while investing cash flows originate from maturities and sales of invested assets.
The Company’s Japanese life insurance operations are conducted through Hartford Life Insurance K.K. a wholly owned subsidiary of Hartford Life and Accident (“HLA”), one of the Company’s principal statutorily regulated operating subsidiaries. To date, the Company has funded the capital needs of its Japanese operations through investments in the common stock of Hartford Life Insurance K.K. by HLA, an investment that stood at $673 at the end of 2004. This arrangement has generally allowed some portion of the Company’s investment in its Japanese operations to be included as part of the aggregate statutory capital (for the purposes of regulatory and rating agency capital adequacy measures) of HLA.
The Company is currently in the process of evaluating capital structures that it believes in the long-term could result in improved financial flexibility. Certain of these structures would no longer allow a portion of the capital invested in our Japanese operations to be included in the aggregate capital of HLA. This could potentially reduce certain of the capital adequacy measures employed by regulators and rating agencies to assess the capital strength of The Hartford’s domestic life insurance companies. At the current time, the Company believes it has sufficient financial resources to maintain capital adequacy levels consistent with all of its rating objectives.
On December 3, 2003, The Hartford’s shelf registration statement (Registration No. 333-108067) for the potential offering and sale of debt and equity securities in an aggregate amount of up to $3.0 billion was declared effective by the Securities and Exchange Commission. The Registration Statement allows for the following types of securities to be offered: (i) debt securities, preferred stock, common stock, depositary shares, warrants, stock purchase contracts, stock purchase units and junior subordinated deferrable interest debentures of the Company, and (ii) preferred securities of any of one or more capital trusts organized by The Hartford (“The Hartford Trusts”). The Company may enter into guarantees with respect to the preferred securities of any of The Hartford Trusts. In January 2004, the Company issued approximately 6.7 million shares of common stock pursuant to an underwritten offering at a price to the public of $63.25 per share and received net proceeds of $411. On March 9, 2004, the Company issued $200 of 4.75% senior notes due March 1, 2014. As of December 31, 2004, the Company had $2.4 billion remaining on its shelf.
On May 15, 2001, HLI filed with the SEC a shelf registration statement (Registration No. 333-60944) for the potential offering and sale of up to $1.0 billion in debt and preferred securities. The registration statement was declared effective on May 29, 2001. As of December 31, 2004, HLI had $1.0 billion remaining on its shelf.
• 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 will likely 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 2005 do not include payments that will be made on claims incurred in 2005 on policies that were in force as of December 31, 2004. In addition, the table does not include future cash flows related to the receipt of premiums that will be used, in part, to fund loss payments.
[3] Includes contractual principal and interest payments. Payments exclude amounts associated with fair-value hedges of certain of the Company’s long-term debt. All long-term debt obligations have fixed rates of interest. Long-term debt obligations also includes principal and interest payments of $700 and $2.4 billion, respectively, related to junior subordinated debentures which are callable beginning in 2006. See Note 14 of Notes to Consolidated Financial Statements for additional discussion of long-term debt obligations.
[4] Includes $1.4 billion in commitments to purchase investments including $330 of limited partnerships and $299 of mortgage loans. Outstanding commitments under these limited partnerships and mortgage loans are included in payments due in less than 1 year since the timing of funding these commitments cannot be estimated. The remaining $759 relates to payables for securities purchased which are reflected on the Company’s consolidated balance sheet.
The Company made voluntary contributions of $317, $306 and $0 in 2004, 2003 and 2002, respectively, to its defined benefit pension plans. Pension expense reflected in the Company’s net income was $104, $120 and $67 in 2004, 2003 and 2002, respectively. The Company estimates its 2005 pension expense will be approximately $133, based on current assumptions provided below. The assumptions that primarily impact the amount of the Company’s pension obligations and periodic pension expense are the weighted-average discount rate and the Plan asset portfolio’s expected long-term rate of return.
In determining the discount rate assumption, the Company utilizes current market information provided by its plan actuaries, including a discounted cash flow analysis of the Company’s pension obligation and general movements in the current market environment. In particular, the Company uses an interest rate yield curve developed by its plan actuaries to make judgments pursuant to EITF Topic No. D-36, “Selection of Discount Rates Used for Measuring Defined Benefit Pension Obligations and Obligations of Postretirement Benefit Plans Other Than Pensions”. The yield curve is comprised of bonds rated AA or higher with maturities primarily between zero and thirty years. Based upon all available information, it was determined that 5.75% was the appropriate discount rate as of December 31, 2004 to calculate the Company’s accrued benefit liability. Accordingly, as prescribed by SFAS No. 87, “Employers’ Accounting for Pensions”, the 5.75% discount rate will also be used to determine the Company’s 2005 pension expense. At December 31, 2003, the discount rate was 6.25%.
The Company determines the long-term rate of return assumption for the Plan’s asset portfolio based on analysis of the portfolio’s historical compound rates of return since 1979 (the earliest date for which comparable portfolio data is available) and over rolling 5 year, 10 year and 20 year periods, balanced along with future long-term return expectations. 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. While the historical return of the Plan’s portfolio has been 11.16% since 1979, management maintained its long-term rate of return assumption at 8.50% as of December 31, 2004 based on its long-term outlook with respect to the markets.
As provided for under SFAS No. 87, the Company uses a five-year averaging method to determine the market-related value of Plan assets, which is used to determine the expected return component of pension expense. Under this methodology, asset gains/losses that result from returns that differ from the Company’s long-term rate of return assumption are recognized in the market-related value of assets on a level basis over a five year period. The actual asset returns for the Plan of $289 and $334 for the years ended December 31, 2004 and 2003, respectively, reflect improved equity market performance, as compared to expected returns of $201 and $184 for the years ended December 31, 2004 and 2003, respectively. These differentials will be fully reflected in the market-related value of Plan assets over the next five years using the methodology described above. Despite the favorable 2004 actual asset return, the level of unrecognized net losses continues to exceed the allowable amortization corridor as defined under SFAS No. 87. Based on the selected 2005 discount rate of 5.75% and taking into account estimated future minimum funding, the differential between actual and expected performance in 2004 will decrease annual pension expense in future years by approximately $4 in 2005 and by approximately $22 in 2009.
The Company presently anticipates contributing approximately $200 to its pension plans in 2005, 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’s 2005 required minimum funding contributions are estimated to be approximately $1.
The capital structure of The Hartford as of December 31, 2004 and 2003 consisted of debt and equity, summarized as follows:
The following discussion describes the Company’s debt financing activities for 2004.
For the year ended December 31, 2004, the Company repaid $477 of commercial paper utilizing the proceeds from the equity offering and internal sources.
Issuance of Common Stock - On January 22, 2004, The Hartford issued approximately 6.3 million shares of common stock pursuant to an underwritten offering at a price to the public of $63.25 per share and received net proceeds of $388. Subsequently, on January 30, 2004, The Hartford issued approximately 377 thousand shares of common stock pursuant to an underwritten offering at a price to the public of $63.25 per share and received net proceeds of $23. The Company used the proceeds from these issuances to repay $411 of commercial paper issued in connection with the CNA Acquisition.
The Hartford declared $331 and paid $325 in dividends to shareholders in 2004, declared $300 and paid $291 in dividends to shareholders in 2003, declared $262 and paid $257 in 2002.
AOCI - AOCI increased by $179 as of December 31, 2004 compared with December 31, 2003. The increase in AOCI is primarily the result of Life’s adoption of SOP 03-1, which resulted in a $292 cumulative effect for unrealized gains on securities in the first quarter of 2004 related to the reclassification of investments from separate account assets to general account assets, partially offset by net unrealized losses on cash-flow hedging instruments.
The funded status of the Company’s pension and postretirement plans is dependent upon many factors, including returns on invested assets and the level of market interest rates. Declines in the value of securities traded in equity markets coupled with declines in long-term interest rates have had a negative impact on the funded status of the plans. As a result, the Company recorded a minimum pension liability as of December 31, 2004, and 2003, which resulted in an after-tax reduction of stockholders’ equity of $480 and $375 respectively. This minimum pension liability did not affect the Company’s results of operations.
Since the announcement of the suit filed by the New York Attorney General’s Office against Marsh & McLennan Companies, Inc., and Marsh, Inc. on October 14, 2004, the major independent ratings agencies have indicated that they continue to monitor developments relating to the suit. On October 22, 2004, Standard & Poor’s revised its outlook on the U.S. property/casualty commercial lines sector to negative from stable. On November 23, 2004, Standard & Poor’s revised its outlook on the financial strength and credit ratings of the property-casualty insurance subsidiaries to negative from stable. The outlook on the life insurance subsidiaries and corporate debt was unaffected.
The following table summarizes The Hartford’s significant United States member companies’ financial ratings from the major independent rating organizations as of February 25, 2005.
The table below sets forth statutory surplus for the Company’s insurance companies.
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. 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, 2004, 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.
The Terrorism Risk Insurance Act of 2002 established a program that will run through 2005 that provides a backstop for insurance-related losses resulting from any “act of terrorism” certified by the Secretary of the Treasury, in concurrence with the Secretary of State and Attorney General. Under the program, the federal government would pay 90% of covered losses after an insurer’s losses exceed 15% of the Company’s direct commercial earned premiums in 2004, up to a combined annual aggregate limit for the federal government and all insurers of $100 billion. If an act of terrorism or acts of terrorism result in covered losses exceeding the $100 billion annual limit, insurers with losses exceeding their deductibles will not be responsible for additional losses. The statutory formula for determining a company’s deductible for each year is based on the company’s direct commercial earned premiums for the prior calendar year multiplied by a specified percentage. The specified percentage is 15% for 2005.
Regulatory Developments - For a discussion regarding contingencies related to regulatory developments that affect The Hartford, please see “Overview-Regulatory Developments” above.
The new reserve methodologies and SMR standards would only apply to capital requirements for Japanese regulatory purposes, and are not directly related to results under accounting principles generally accepted in the United States. At this time, the Company has decided to adopt the Standard methodology. While management is still evaluating the impact of the regulations on the Company’s Japanese operations, at this time, based on the Company’s assessment, the Standard methodology would require $400 - $650 of additional capital during 2005. This estimate assumes that the Company will successfully employ various capital management strategies within its discretion and control, which may include, but are not limited to, product re-filing. The Company also is currently evaluating certain reinsurance strategies which have the potential to reduce the additional capital required to $100. These reinsurance strategies would be subject to regulatory approval, which may not be granted.
On July 10, 2003, the Senate Judiciary Committee approved legislation that would have provided for the creation of a Federal asbestos trust fund in place of the current tort system for determining asbestos liabilities. The 108th Congress concluded without further action on the proposal. Although Judiciary Committee chair Arlen Specter may likely pursue reform legislation in the current Congress, the prospects for enactment and the ultimate details of any legislation creating a Federal asbestos trust fund are uncertain. Therefore, any potential effect on the Company’s financial condition or results of operations cannot be reasonably estimated at this time.
In all states, insurers licensed to transact certain classes of insurance are required to become members of a guaranty fund. In most states, in the event of the insolvency of an insurer writing any such class of insurance in the state, members of the fund are assessed to pay certain claims of the insolvent insurer. A particular state’s fund assesses its members based on their respective written premiums in the state for the classes of insurance in which the insolvent insurer is engaged. Assessments are generally limited for any year to one or two percent of premiums written per year depending on the state. Such assessments paid by The Hartford approximated $23 in 2004, $26 in 2003 and $26 in 2002.
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 entity 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, 2004 and 2003, the liability balance was $215 and $181, respectively. As of December 31, 2004 and 2003, included in other assets was $14 of related assets for premium tax offsets.