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 by the Company in the aggregate. In addition, The Hartford leases approximately 5.5 million square feet throughout the United States of America and approximately 292,000 square feet in other countries. All of the properties owned or leased are used by one or more of all eleven reporting segments, depending on the location. For more information on reporting segments, see Part I, Item 1, Business of The Hartford - Reporting Segments. The Company believes its properties and facilities are suitable and adequate for current operations.
In 2007, the Company adopted Financial Accounting Standards Board (“FASB”) Staff Position No. FIN 39-1, “Amendment of FASB Interpretation No. 39” (“FSP FIN 39-1”). The Company recorded the effect of adopting FSP FIN 39-1 as a change in accounting principle through retrospective application. The effect on total assets as of December 31, 2006, 2005, 2004, and 2003 was a decrease of $166, $145, $150 and $86, respectively.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) addresses the financial condition of The Hartford Financial Services Group, Inc. and its subsidiaries (collectively, “The Hartford” or the “Company”) as of December 31, 2007, compared with December 31, 2006, and its results of operations for each of the three years in the period ended December 31, 2007. This discussion should be read in conjunction with the Consolidated Financial Statements and related Notes beginning on page. Certain reclassifications have been made to prior year financial information to conform to the current year presentation.
Life is organized into six reporting segments: Retail Products Group (“Retail”), Retirement Plans, Institutional Solutions Group (“Institutional”), Individual Life, Group Benefits and International. Through Life the Company provides retail and institutional investment products such as variable and fixed annuities, mutual funds, private placement life insurance and retirement plan services, 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. In 2007, Life changed its reporting for realized gains and losses, as
well as credit risk charges previously allocated between Life Other and each of Life’s reporting segments. All segment data for prior reporting periods have been adjusted to reflect the current segment reporting.
Property & Casualty is organized into five reporting segments: the underwriting segments of Personal Lines, Small Commercial, Middle Market 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, livestock, fidelity and surety, 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 2007, Property & Casualty changed its reporting segments to reflect the current manner by which its chief operating decision maker views and manages the business. All segment data for prior reporting periods have been adjusted to reflect the current segment reporting.
reinsurance projection based on the terms of any applicable facultative and treaty reinsurance, including an estimate of how incurred but not reported losses will ultimately be ceded by reinsurance agreement. Accordingly, the Company’s estimate of reinsurance recoverables is subject to similar risks and uncertainties as the estimate of the gross reserve for unpaid losses and loss adjustment expenses.
The following table shows loss and loss adjustment expense reserves by line of business and by reporting segment as of December 31, 2007, net of reinsurance:
Reserves are set by line of business within the various reporting 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. Assumed reinsurance, which is within Other Operations, is also long-tail business.
The actuarial techniques or methods used primarily include paid and reported loss development, frequency / severity, expected loss ratio and Bornhuetter-Ferguson techniques. Within any one line of business, a variety of techniques are used. Within any one line of business, certain methods are generally given more influence in determining the actuarial indication. The methods that are given more influence vary within a line of business based primarily on the maturity of the accident year, the mix of business and the particular internal and external influences impacting the claims experience or the methods. The following is a discussion of the most common methods used; these methods are not used for every line of business or every accident year within a line of business.
Both paid and reported development techniques assume that historical development patterns are predictive of future development patterns.
Frequency / Severity methods. Historical data is used to develop claim count development patterns and those patterns are applied to the number of current reported claims to estimate ultimate claim counts. Estimated ultimate claim counts are multiplied by an estimated average severity (i.e., an average cost per claim) to calculate estimated ultimate losses. Average severity is estimated by fitting historical severity data to a trend line and making assumptions about how the current environment would affect claim severity. In making assumptions about the current environment, industry data is used where such data is available and appropriate.
The advantage of frequency / severity techniques is that frequency estimates are generally easier to predict and external information can be used to supplement internal data in making severity estimates.
The accident period used may vary (e.g., year, quarter, or month)
For ALAE, the Company analyzes ALAE on claims in suit and associated legal expenses separately from ALAE on other claims.
Workers’ Compensation. Workers’ compensation is the Company’s single largest reserve line of business and management does the largest amount of actuarial analysis on this line of business. Methods performed include paid and reported development, variations on expected loss ratio methods, and an in-depth analysis on the largest states. Paid development patterns are historically very stable in the Company’s workers’ compensation business, so paid techniques are preferred for older accident periods. For more recent periods, paid techniques are less predictive of the ultimate liability since such a low percentage of ultimate losses are paid in early periods of
development. Accordingly, for more recent accident periods, the Company generally relies more heavily on a state-by-state analysis and the expected loss ratio approach.
In the Specialty Commercial segment, many lines of insurance, such as excess insurance and large deductible workers’ compensation insurance are “long-tail” lines of insurance. For long-tail lines, the period of time between the incidence of the insured loss and either the reporting of the claim to the insurer, the settlement of the claim, or the payment of the claim can be substantial, and in some cases, several years. As a result of this extended period of time for losses to emerge, reserve estimates for these lines are more uncertain (i.e., more variable) than reserve estimates for shorter-tail lines of insurance. Estimating required reserve levels for large deductible workers’ compensation insurance is further complicated by the uncertainty of whether losses that are attributable to the deductible amount will be paid by the insured; if such losses are not paid by the insured due to financial difficulties, the Company would be contractually liable. Another example of reserve variability relates to reserves for directors and officers insurance. There is potential volatility in the required level of reserves due to the continued uncertainty regarding the number and severity of class action suits, including uncertainty regarding the Company’s exposure to losses arising from the collapse of the sub-prime mortgage market. Additionally, the Company’s exposure to losses under directors and officers insurance policies is in excess layers, making estimates of loss more complex.
The reserve estimation process includes explicit assumptions about a number of factors in the internal and external environment. Across most lines of business, the most important assumptions are future loss development factors applied to paid or reported losses to date. For most lines, the reported loss development factor is most important. In workers’ compensation, paid loss development factors are also important. The trend in loss costs is also a key assumption, particularly in the most recent accident years, where loss development factors are less credible.
Recorded reserves for general liability, net of reinsurance, are $2.4 billion across Small Commercial, Middle Market and Specialty Commercial. Reported loss development patterns are a key assumption for this line of business, particularly for more mature accident years. Historically, assumptions on reported loss development patterns have been impacted by, among other things, emergence of new types of claims (e.g., construction defect claims) or a shift in the mixture between smaller, more routine claims and larger, more complex claims. The Company has reviewed the historical variation in reported loss development patterns. If the reported loss development patterns change by 10%, the estimated net reserve need would change by $350, in either direction. A 10% change in reported loss development patterns is within historical variation, as measured by the variation around the average development factors as reported in statutory accident year reports.
Similar to general liability, assumed casualty reinsurance is affected by reported loss development pattern assumptions. In addition to the items identified above that would affect both direct and reinsurance liability claim development patterns, there is also an impact to assumed reporting patterns for any changes in claim notification from ceding companies to the reinsurer. Recorded net reserves for HartRe assumed reinsurance business, excluding asbestos and environmental liabilities, within Other Operations were $724 as of December 31, 2007. If the reported loss development patterns underlying the Company’s net reserves for HartRe assumed casualty reinsurance change by 10%, the estimated net reserve need would change by $250, in either direction. A 10% change in reported loss
In the opinion of management, based upon the known facts and current law, the reserves recorded for the Company’s property and casualty businesses at December 31, 2007 represent the Company’s best estimate of its ultimate liability for losses and loss adjustment expenses related to losses covered by policies written by the Company. However, because of the significant uncertainties surrounding reserves, 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 Company’s results of operations, financial condition and liquidity.
For most contracts, the Company estimates gross profits over a 20 year horizon as estimated profits emerging subsequent to year 20 are immaterial. The Company uses other amortization bases for amortizing DAC, such as gross costs (net of reinsurance), as a replacement for EGPs when EGPs are expected to be negative for multiple years of the contract’s life. Actual gross profits, in a given reporting period, that vary from management’s initial estimates result in increases or decreases in the rate of amortization, commonly referred to as a “true-up”, which are recorded in the current period. The true-up recorded for the years ended December 31, 2007, 2006, and 2005 was an increase to amortization of $3, $41, and $18, respectively.
Products sold in a particular year are aggregated into cohorts. Future gross profits for each cohort are projected over the estimated lives of the underlying contracts, and are, to a large extent, a function of future account value projections for individual variable annuity products and to a lesser extent for variable universal life products. The projection of future account values requires the use of certain assumptions. The assumptions considered to be important in the projection of future account value, and hence the EGPs, include separate account fund performance, which is impacted by separate account fund mix, less fees assessed against the contract holder’s account balance, surrender and lapse rates, interest margin, mortality, and hedging costs. The assumptions are developed as part of an annual process and are dependent upon the Company’s current best estimates of future events. The Company’s current separate account return assumption is approximately 8% (after fund fees, but before mortality and expense charges) for U.S. products and 5% (after fund fees, but before mortality and expense charges) in aggregate for all Japanese products, but varies from product to product. Beginning in 2007, the Company estimated gross profits using the mean of EGPs derived from a set of stochastic scenarios that have been calibrated to our estimated separate account return as compared to prior years where we used a single deterministic estimation.
In addition to when a comprehensive assumption study is completed, revisions to best estimate assumptions used to estimate future gross profits are necessary when the EGPs in the Company’s models fall outside of an independently determined reasonable range of EGPs. The Company performs a quantitative process each quarter to determine the reasonable range of EGPs. This process involves
During the third quarter of 2007 and the fourth quarter of 2006, the Company completed an annual, comprehensive study of assumptions underlying EGPs, resulting in an “unlock”. The study covered all assumptions, including mortality, lapses, expenses, hedging costs, and separate account returns, in substantially all product lines. The new best estimate assumptions were applied to the current in-force to project future gross profits.
The after-tax impact on the Company’s assets and liabilities as a result of the unlock during the third quarter of 2007 was as follows:
During the third quarter of 2007, the Company estimated gross profits using the mean of EGPs derived from a set of stochastic scenarios that have been calibrated to our estimated separate account return as compared to prior year where we used a single deterministic estimation. The impact of this change in estimation was a benefit of $13, after-tax, for Japan variable annuities and $20, after-tax, for U.S. variable annuities.
The after-tax impact on the Company’s assets and liabilities as a result of the unlock during the fourth quarter of 2006 was as follows:
As a result of the unlock, death benefit reserves, in Retail, increased $294, pre-tax, offset by an increase of $279, pre-tax, in reinsurance recoverables.
In valuing the embedded derivative, the Company attributes to the derivative a portion of fees collected from the contract holder equal to the present value of future GMWB claims (the “Attributed Fees”). Attributed Fees in dollars are determined at the inception of each quarterly cohort by setting the dollars equal to the present value of expected claims. The Attributed Fees, in basis points, are determined by dividing the Attributed Fees in dollars by the present value of account value. The Attributed Fees in basis points are locked-in for each quarterly cohort. Primarily as a result of capital market conditions over the past few years, Attributed Fees for each cohort have historically been significantly below our rider fees, which also vary by product. Capital markets conditions, in particular high equity index volatility and low interest rates, during the last two quarters of 2007, have increased the Attributed Fees for those cohorts to a level close to our rider fees.
Capital market assumptions can significantly change the value of GMWB. For example, independent future decreases in equity market returns, future decreases in interest rates and future increases in equity index volatility will all have the effect of increasing the value of the GMWB embedded derivative liability as of December 31, 2007 resulting in a realized loss in net income. Furthermore, changes in policyholder behavior can also significantly change the value of the GMWB. For example, independent future increases in fund mix towards equity based funds vs. bond funds, future increases in withdrawals, future decreasing mortality, future increasing usage of the step-up feature and decreases in lapses will all have the effect of increasing the value of the GMWB embedded derivative liability as of December 31, 2007 resulting in a realized loss in net income. Independent changes in any one of these assumptions moving in the opposite direction will have the effect of decreasing the value of the GMWB embedded derivative liability as of December 31, 2007 resulting in a realized gain in net income. As markets change, mature and evolve and actual policyholder behavior emerges, management continually evaluates the appropriateness of its assumptions. In addition, management regularly evaluates the valuation model, incorporating emerging valuation techniques where appropriate, including drawing on the expertise of market participants and valuation experts. Upon adoption of Statement of Financial Accounting Standard No. 157, “Fair Value Measurements”, (“SFAS 157”) the Company expects to revise many of the assumptions used to value GMWB. See Note 1 in Notes to Consolidated Financial Statements for a discussion of SFAS 157.
The Hartford’s investments in fixed maturities, which include bonds, redeemable preferred stock and commercial paper; and certain equity securities, which include common and non-redeemable preferred stocks, are classified as “available-for-sale” and accordingly, are carried at fair value with the after-tax difference from cost or amortized cost, as adjusted for the effect of deducting the life and pension policyholders’ share of the immediate participation guaranteed contracts; and certain life and annuity deferred policy acquisition costs and reserve adjustments, reflected in stockholders’ equity as a component of AOCI. The equity investments associated with the variable annuity products offered in Japan are recorded at fair value and are classified as “trading” with changes in fair value recorded in net investment income. Policy loans are carried at outstanding balance, which approximates fair value. Mortgage loans on real estate are recorded at the outstanding principal balance adjusted for amortization of premiums or discounts and net of valuation allowances, if any. Short-term investments are carried at amortized cost, which approximates fair value. Other investments primarily consist of limited partnership and other alternative investments and derivatives instruments. Limited partnerships are reported at their carrying value with the change in carrying value accounted for under the equity method and accordingly the Company’s share of earnings are included in net investment income. Derivatives instruments are carried at fair value.
Prices from third party pricing services are often unavailable for securities that are rarely traded or are traded only in privately negotiated transactions. As a result, certain of the Company’s securities are priced via independent broker quotations which utilize inputs that may be difficult to corroborate with observable market based data. A pricing matrix is used to price securities for which the Company is unable to obtain either a price from a third party pricing service or an independent broker quotation. The pricing matrix begins with current spread levels to determine the market price for the security. The credit spreads, as assigned by a nationally recognized rating agency, incorporate the issuer’s credit rating and a risk premium, if warranted, due to the issuer’s industry and the security’s time to maturity. The issuer-specific yield adjustments, which can be positive or negative, are updated twice annually, as of June 30 and December 31, by an independent third party source and are intended to adjust security prices for issuer-specific factors. The matrix-priced securities at December 31, 2007 and 2006 primarily consisted of non-144A private placements and have an average duration of 4.7 and 5.1 years, respectively. The Company assigns a credit rating to these securities based upon an internal analysis of the issuer’s financial strength.
The following table presents the fair value of fixed maturity securities by pricing source as of December 31, 2007 and 2006.
The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between knowledgeable, unrelated willing parties using inputs, including assumptions and estimates, a market participant would utilize. As such, the estimated fair value of a financial instrument may differ significantly from the amount that could be realized if the security was sold immediately.
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, the effects of changes in interest rates or credit spreads and the recovery period. 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. Based on this evaluation, for the year ended December 31, 2007, the Company concluded $483 of unrealized losses were other-than-temporarily impaired and as of December 31, 2007, the Company’s unrealized losses for fixed maturity and available-for-sale equity securities of $2.8 billion, were temporarily impaired.
Securities not subject to Emerging Issues Task Force (“EITF”) Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continued to Be Held by a Transferor 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 or is expected to be less than cost or amortized 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.
The Company determines the expected long-term rate of return assumption based on an analysis of the Plan portfolio’s historical compound rates of return since 1979 (the earliest date for which comparable portfolio data is available) and over rolling 5 year and 10 year periods, balanced along with future long-term return expectations that generally anticipate an investment mix of 60% fixed income securities, 20% equity securities and 20% alternative assets. The Company selected these periods, as well as shorter durations, to assess the portfolio’s volatility, duration and total returns as they relate to pension obligation characteristics, which are influenced by the Company’s workforce demographics. In addition, the Company also applies market return assumptions, utilized in Life’s DAC analysis, to an investment mix that generally anticipates 60% fixed income securities, 20% equity securities and 20% alternative assets to derive an expected long-term rate of return. Based upon this analysis, the portfolio’s historical rates of return and management’s outlook with respect to market returns and the planned asset mix, management adjusted the long-term rate of return assumption to 7.3% as of December 31, 2007. This assumption is used to determine the Company’s 2008 expense. The long-term rate of return assumption at December 31, 2006 was 8.0%.
Net income increased primarily due to increases in Life of $117 for the year ended December 31, 2007 compared to the year ended December 31, 2006. Additionally, Property & Casualty net income decreased $12 for the year ended December 31, 2007 compared to the year ended December 31, 2006. Also included in the year ended December 31, 2007 is an increase in reserve for regulatory matters of $30, after-tax, of which $21 and $9 relates to Life and Property & Casualty, respectively.
The increase in Life’s net income was due to the following:
Increased income on asset growth in the variable annuity, mutual fund, retirement and institutional businesses.
Partially offsetting the increase in Life’s net income were the following:
Increased DAC amortization in Group Benefits due to the adoption of Statement of Position 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts” (“SOP 05-1”).
Net income increased primarily due to increases in Property & Casualty of $283 and in Life of $237 for the year ended December 31, 2006 compared to the year ended December 31, 2005.
Property & Casualty net income increased $283, as a result of a $389 increase in Ongoing Operations’ net income, partially offset by a decrease in Other Operations’ results from net income of $71 in 2005 to a net loss of $35 in 2006.
Partially offsetting the increase in Life’s net income was a $63, after-tax, charge related to the unlock. See Unlock and Sensitivity Analysis within the Critical Accounting Estimates section of the MD&A for further information on the unlock.
The effective tax rate for 2007, 2006 and 2005 was 26%, 24% and 24%, respectively. The principal causes of the difference between the effective rate and the U.S. statutory rate of 35% for 2007, 2006 and 2005 were tax-exempt interest earned on invested assets and the separate account dividends received deduction (“DRD”). Income taxes paid in 2007, 2006 and 2005 were $451, $179 and $447, respectively. For additional information, see Note 13 of Notes to Consolidated Financial Statements.
The separate account DRD is estimated for the current year using information from the prior year-end, adjusted for current year equity market performance. The estimated DRD is generally updated in the third quarter for the provision-to-filed-return adjustments, and in the fourth quarter based on current year ultimate mutual fund distributions and fee income from the Company’s variable insurance products. The actual current year DRD can vary from estimates based on, but not limited to, changes in eligible dividends received by the mutual funds, amounts of distributions from these mutual funds, amounts of short-term capital gains at the mutual fund level and the Company’s taxable income before the DRD. The Company recorded benefits of $155, $174 and $184 related to the separate account DRD in the years ended December 31, 2007, December 31, 2006 and December 31, 2005, respectively. The 2007 benefit included a tax of $1 related to a true-up of the prior year tax return, the 2006 benefit included a benefit of $6 related to true-ups of prior years’ tax returns and the 2005 benefit included a benefit of $3 related to a true-up of the prior year tax return.
In Revenue Ruling 2007-61, issued on September 25, 2007, the IRS announced its intention to issue regulations with respect to certain computational aspects of DRD on separate account assets held in connection with variable annuity contracts. Revenue Ruling 2007-61 suspended Revenue Ruling 2007-54, issued in August 2007 that purported to change accepted industry and IRS interpretations of the statutes governing these computational questions. Any regulations that the IRS ultimately proposes for issuance in this area will be subject to public notice and comment, at which time insurance companies and other members of the public will have the opportunity to raise legal and practical questions about the content, scope and application of such regulations. As a result, the ultimate timing and substance of any such regulations are unknown, but they could result in the elimination of some or all of the separate account DRD tax benefit that the Company receives. Management believes that it is highly likely that any such regulations would apply prospectively only.
The Company’s unrecognized tax benefits increased by $68 during 2007 as a result of tax positions taken on the Company’s 2006 tax return and expected to be taken on its 2007 tax return, bringing the total unrecognized tax benefits to $76 as of December 31, 2007. This entire amount, if it were recognized, would affect the effective tax rate.
The following table represents earnings per common share data for the past three years:
The retail mutual fund business has seen a substantial increase in net sales and assets over the past year as a result of focused wholesaling efforts as well as strong investment performance. Net sales can vary significantly depending on market conditions. As this business continues to evolve, success will be driven by diversifying net sales across the mutual fund platform, delivering superior investment performance and creating new investment solutions for current and future mutual fund shareholders.
The future profitability of the Retirement Plans segment will depend on Life’s ability to increase assets under management across all businesses, achieve scale in areas with a high degree of fixed costs and maintain its investment spread earnings on the general account products sold largely in the 403(b)/457 business. During December 2007, the Company announced three acquisitions. Disciplined expense management will continue to be a focus; however, as Life looks to expand its reach in these markets, additional investments in service and technology will occur.
Individual Life continues to expand its core distribution model of sales through financial advisors and banks, while also pursuing growth opportunities through other distribution sources such as life brokerage. In its core channels, the Company is looking to broaden its sales system and internal wholesaling, take advantage of cross selling opportunities and extend its penetration in the private wealth management services areas. Variable universal life mix remained strong during the year ended December 31, 2007. Future sales will be driven by the Company’s management of current distribution relationships and development of new sources of distribution while offering competitive and innovative new products and product features.
Management is committed to selling competitively priced Group Benefits products that meet the Company’s internal rate of return guidelines and as a result, sales may fluctuate based on the competitive pricing environment in the marketplace. In 2007, the Company generated premium growth due to the increased scale of the group life and disability operations. However, fully insured on-going sales, excluding buyouts declined primarily due to fewer large national account sales, and the small case competitive environment remained intense. In addition, there was an anticipated reduction in association life sales from an unusually high prior year period. The Company also completed a renewal rights transaction associated with its medical stop loss business during the second quarter of 2007. The Company anticipates relatively stable loss ratios and expense ratios based on underlying trends in the in-force business and disciplined new business and renewal underwriting.
Competition has continued to increase in the Japanese market as the most significant competition the result of the strengthening of domestic competitors. This competition has resulted in changes in key distribution relationships that have negatively impacted current year deposits and could potentially impact future deposits. Deposits in 2007 were also negatively impacted by new financial regulations and laws that affect distribution. The Company continues to focus its efforts on strengthening our distribution relationships and improving our wholesaling and servicing efforts. In addition, the Company continues to evaluate product designs that meet customers’ needs while maintaining prudent risk management. In February 2007, Life introduced a new variable annuity product called “3 Win” to complement its existing variable annuity product offerings in Japan. The new product has been favorably received by the market with the new product accounting for 42% of Japan’s sales for the year ended December 31, 2007. The success of the Company’s enhanced product offerings, including those to be launched in 2008, will ultimately be based on customer acceptance in an increasingly competitive environment.
In 2008, management expects written premium growth to be flat to 3% higher, primarily driven by an increase in Personal Lines and Small Commercial, partially offset by an expected decline in Middle Market.
The Personal Lines segment is expected to deliver written premium growth of 2% to 5% in 2008, including growth from both AARP and Agency. The Company expects personal auto written premium to increase 3% to 6% and homeowners’ written premium to be flat to 3% higher. Management expects that growth from Agency business will be largely driven by appointing more agents and increasing the flow of new business from recently appointed agents and growth in AARP business will be largely driven by continued direct marketing to AARP members and an expansion of underwriting appetite through the continued roll-out of the “Next Gen Auto” product.
Within Small Commercial, management expects written premium in 2008 to be flat to 3% higher, primarily driven by increasing the flow of new business from agents, selectively expanding its underwriting appetite, refining pricing models and upgrading product features. Management expects that 2008 written premium for Middle Market will be 1% to 4% lower as the Company takes a disciplined approach to evaluating and pricing risks in the face of declines in written pricing. Contributing to the expected decline in Middle Market written premium is the effect of state-mandated rate reductions in workers’ compensation and increased competition in specific geographic markets and lines. Within Specialty Commercial, management expects written premium to be flat to 3% higher, primarily driven by an increase in professional liability, fidelity and surety written premium, partially offset by a decrease in property written premium.
Market conditions in the commercial lines industry continue to be soft with written pricing likely to decline further in 2008, more so on the larger accounts. While carriers in the personal lines industry will continue to compete on price, management expects that pricing will firm a bit in 2008 as combined ratios have risen in the past couple of years and eroded profitability. For the Company, written pricing in 2007 was flat in auto and increased in homeowners. Written pricing increases in homeowners were due largely to higher insured property values and higher insurance-to-value. Written pricing declined in the Company’s Small Commercial and Middle Market segments during 2007 with the largest written pricing decreases on commercial auto, marine and Middle Market workers’ compensation insurance.
Excluding catastrophes and prior accident year development, underwriting margins will likely continue to decline in 2008 due to an increase in non-catastrophe property loss costs in some lines of business, a decrease in earned pricing and an increase in insurance operating costs and expenses, partially offset by a slightly lower expected loss and loss adjustment expense ratio on workers’ compensation business and a decrease in policyholder dividends. Management expects that an increase in non-catastrophe property claim severity will be partially offset by favorable frequency. Reflecting favorable trends in workers’ compensation loss costs in recent accident years, management expects a slightly lower loss and loss adjustment expense ratio for workers’ compensation claims in the 2008 accident year, although the improvement, if any, depends on continued favorable frequency. Due to the earned pricing and loss cost trends, management expects that, in 2008, the loss and loss adjustment expense ratio before catastrophes and prior accident year development will increase in Personal Lines and Specialty Commercial, remain relatively flat in Middle Market and may decrease slightly in Small Commercial.
Current accident year catastrophe losses in 2007, at 1.7 percent of Ongoing Operations’ earned premium, were lower than the long-term historical average. While catastrophe losses vary significantly from year to year and are unpredictable, management has assumed that catastrophe losses in 2008 will be closer to 3% to 3.5% of earned premium. Despite a mild hurricane season and a relatively low level of catastrophe losses in 2007, the Company will continue to manage its exposure to catastrophe losses through the ongoing assessment of its risk, disciplined underwriting and the use of reinsurance and other risk transfer alternatives, as appropriate. As of January 1, 2008, the Company’s retention under its principal property catastrophe reinsurance program remained at $250 per catastrophe event. With the January 1, 2008 renewal, the cost of the company’s principal property catastrophe reinsurance program decreased modestly.
The expense ratio is expected to increase in 2008, in part, due to a lower expected earned premium in Middle Market, an increase in the cost of sales and service operations and investments in technology to support future growth. The policyholder dividend ratio was unusually high in 2007 due to the accrual of $25 in dividends due to certain workers’ compensation policyholders as a result of underwriting profits. (See the Property and Casualty MD&A section for further discussion.)
Life provides retail and institutional investment products such as variable and fixed annuities, mutual funds, PPLI, and retirement plan services, individual life insurance and group benefit products, such as group life and group disability insurance. In 2007, Life changed its reporting for realized gains and losses, as well as credit risk charges previously allocated between Life Other and each of Life’s reporting segments. All segment data for prior reporting periods have been adjusted to reflect the current segment reporting.
Life’s profitability in its variable annuity, mutual fund and, to a lesser extent, variable universal life businesses, depends largely on the amount of the contract holder account value or assets under management on which it earns fees and the level of fees charged. Changes in account value or assets under management are driven by two main factors: net flows, which measure the success of the Company’s asset gathering and retention efforts, and the market return of the funds, which is heavily influenced by the return realized in the equity markets. Net flows are comprised of new sales and other deposits less surrenders, death benefits, policy charges and annuitizations of investment type contracts, such as variable annuity contracts. In the mutual fund business, net flows are known as net sales. Net sales are comprised of new sales less redemptions by mutual fund customers. Life uses the average daily value of the S&P 500 Index as an indicator for evaluating market returns of the underlying account portfolios in the United States. Relative profitability of variable products is highly correlated to the growth in account values or assets under management since these products generally earn fee income on a daily basis. An immediate significant downturn in the financial markets could result in a charge against deferred acquisition costs. See the Critical Accounting Estimates section of the MD&A for further information on DAC unlocks.
Life’s profitability in its individual life insurance and group benefits businesses depends largely on the size of its in-force block, the adequacy of product pricing and underwriting discipline, actual mortality and morbidity experience, and the efficiency of its claims and expense management.
Fee income is largely driven from amounts collected as a result of contractually defined percentages of assets under management on investment type contracts. These fees are generally collected on a daily basis. For individual life insurance products, fees are contractually defined as percentages based on levels of insurance, age, premiums and deposits collected and contract holder value. Life insurance fees are generally collected on a monthly basis. Therefore, the growth in assets under management either through positive net flows or net sales, or favorable equity market performance will have a favorable impact on fee income. Conversely, either negative net flows or net sales, or unfavorable equity market performance will reduce fee income generated from investment type contracts.
In addition to strong positive net flows, market appreciation and diversified sales growth during the year contributed to Retail mutual funds assets under management growth.
International - Japan annuity account values continue to grow as a result of positive net flows and a strengthening of the yen versus the dollar offset by a decline in market performance throughout the year.
Net flows for the Retail U.S. individual variable annuity business were negative and have worsened from prior year levels resulting from higher surrenders outpacing increased deposits due primarily to increased competition in the living benefit market.
Individual Life variable universal life account value increased due primarily to premiums, deposits and market appreciation. Life insurance in-force increased from December 31, 2005 due to business growth.
As discussed above, traditional insurance type products, such as those sold by Group Benefits, collect premiums from policyholders in exchange for financial protection for the policy holder from a specified insurable loss, such as death or disability. These premiums together with net investment income earned from the overall investment strategy are used to pay the contractual obligations under these insurance contracts. Two major factors, new sales and persistency, impact premium growth. Sales can increase or decrease in a given year based on a number of factors, including but not limited to, customer demand for the Company’s product offerings, pricing competition, distribution channels and the Company’s reputation and ratings. A majority of sales correspond with the open enrollment periods of employers’ benefits, typically January 1 or July 1. Persistency is the percentage of insurance policies remaining in-force from year to year as measured by premiums.
Earned premiums and other considerations include $27, $12 and $27 in buyout premiums for the years ended December 31, 2007, 2006 and 2005, respectively. The increase in premiums and other considerations for Group Benefits in 2007 compared to 2006 was driven by growth in the block of business. The increase in premiums and other considerations for Group Benefits in 2006 compared to 2005 was driven by a sales growth of 11%.
Fully insured ongoing sales, excluding buyouts, declined in 2007 from 2006 primarily due to fewer large national account sales, and the small case competitive environment remained intense. The Company also completed a renewal rights arrangement
See Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A
Retail individual annuity general insurance expense ratio increased in 2007 primarily due to higher service and technology costs.
Group Benefits expense ratio, excluding buyouts, increased in 2007 primarily due to higher DAC amortization.
International - Japan general insurance expense ratio declined in 2007 as Japan further leveraged the existing infrastructure as it attains economies of scale.
See “Realized Capital Gains and Losses by Segment” table within the Life Section of the MD&A.
Individual Life’s after-tax margin, excluding realized gains (losses) and DAC unlock, increased primarily due to favorable mortality experience in 2006 compared to 2005 as well as favorable revisions to DAC estimates reflected in the first half of 2006.
The improvement in the Group Benefits after-tax margin, excluding realized gains (losses) and DAC unlock, for 2006 was primarily due to an improvement in the loss ratio, including the release of certain life reserves, partially offset by higher income tax expense.
Net income increased primarily due to growth in assets under management resulting from market growth and sales, along with higher earned premiums in Group Benefits. The increase in net investment income was primarily due to income earned on higher average invested assets base, an increase in interest rates and a change in asset mix (e.g. greater investment in mortgage loans and limited partnerships). The increase in average invested assets base, as compared to the prior year, was primarily due to positive operating cash flows, investment contract sales such as retail and institutional notes, and universal life-type product sales.
Life recorded an after-tax charge of $102 in 2005 to establish reserves for regulatory matters for investigations related to market timing by the SEC and New York Attorney General’s Office, directed brokerage by the SEC, and single premium group annuities by the New York Attorney General’s Office and the Connecticut Attorney General’s Office.
Life includes net realized capital gains and losses in each reporting segment. Following is a summary of the types of realized gains and losses by segment:
Net realized gains (losses) for the year ended December 31, 2005
Net realized capital losses increased in 2007 as compared to 2006 were primarily due to higher losses on impairments, GMWB derivatives, and other net losses, partially offset by higher net gains on sale of investments. A more expanded discussion of these components is as follows:
Across all lines of business, other-than-temporary impairments were primarily recorded on corporate fixed maturities. For further discussion, see the Other-Than-Temporary Impairments section within the Investments section of the MD&A.
Mutual fund fee income increased 23% for the year ended December 31, 2007 due to increased assets under management driven by net sales of $5.5 billion and market appreciation of $4.4 billion during 2007.
Net investment income has declined for the year ended December 31, 2007 due to a decrease in variable annuity fixed option account values of 11% or $635. The decrease in these account values can be attributed to a combination of transfers into separate accounts and surrender activity. Offsetting this decrease in net investment income was an increase in the returns on partnership income of $14 for the year ended December 31, 2007.
Net income in the Retail segment for the year ended December 31, 2006 decreased primarily due to higher amortization of DAC resulting from the unlock expense during the fourth quarter of 2006. In addition, realized capital losses increased $49 for the year ended December 31, 2006 as compared to the prior year period. For further discussion, see Realized Capital Gains and Losses by Segment table under Life’s Operating Section of the MD&A. Offsetting these losses was improved fee income driven by higher assets under management resulting primarily from market growth. The following other factors contributed to the change in income:
The increase in fee income in the variable annuity business for the year ended December 31, 2006 was mainly a result of growth in average account values. The year-over-year increase in average variable annuity account values can be attributed to market appreciation of $12.2 billion during 2006. Variable annuities had net outflows of $3.2 billion for the year ended December 31, 2006 compared to net outflows of $881 for the year ended December 31, 2005. Net outflows from additional surrender activity were due to increased deposits competition, particularly from competitors offering variable annuity products with guaranteed living benefits.
The effective tax rate declined due to separate account DRD and foreign tax credit true-up benefits recorded in 2006.
In 2006, 403(b)/457 mutual fund assets declined to zero due to remaining business being transferred to the Institutional segment. In 2007, Life began selling mutual fund based products in the 403(b) market.
The Retirement Plans segment primarily offers customized wealth creation and financial protection for corporate and government employers through its two business units, 403(b)/457 and 401(k).
Net investment income increased for the year ended December 31, 2007 for 403(b)/457 business due to growth in general account assets along with an increase in return on partnership investments.
In December 2007, the Company announced three acquisitions. The acquisition of part of the defined contribution recordkeeping business of Princeton Retirement Group will give Life a foothold in the business of providing recordkeeping services to large financial firms which offer defined contribution plans to their clients. The acquisition of Sun Life Retirement Services, Inc. will add $17 billion in Retirement Plan assets across 6,000 plans and will provide new service locations in Boston, Massachusetts and Phoenix, Arizona. The acquisition of TopNoggin LLC., which closed in January 2008, provides web-based technology to address data management, administration and benefit calculations. These acquisitions, including the two which have not closed but are expected to close in the first quarter of 2008, will increase scale in the Retirement Plans segment and grow its offering to serve additional markets, customers and types of retirement plans across the defined contribution and defined benefit spectrum.
Mutual fund assets under management include transfers from the Retirement Plans segment of $178 during 2006.
Net income in Institutional decreased for the year ended December 31, 2007 primarily due to increased realized capital losses of $151 as compared to the prior year period. For further discussion, see Realized Capital Gains and Losses by Segment table under Life’s Operating Section of the MD&A. Offsetting the impact of realized capital losses, Institutional’s net income increased driven by higher assets under management in both IIP and PPLI, combined with increased returns on general account assets, primarily due to strong partnership income. The following other factors contributed to the changes in income:
Net income in Institutional decreased for the year ended December 31, 2006 compared to the prior year driven by realized capital loss increases of $73 for the year ended December 31, 2006 as compared to the prior year period. For further discussion, see Realized Capital Gains and Losses by Segment table under Life’s Operating Section of the MD&A. The following other factors contributed to the changes in income:
Net investment income increased in Institutional driven by positive net flows of $2.2 billion during the year, which resulted in higher assets under management. Net flows for IIP were strong primarily as a result of the Company’s funding agreement backed
Investor Notes program. Investor Note deposits for the years ended December 31, 2006 and 2005 were $2.3 billion and $2.0 billion, respectively.
Net income increased for the year ended December 31, 2007, driven primarily by the unlock benefit in the third quarter of 2007 as compared to an unlock expense in the fourth quarter of 2006 partially offset by unfavorable mortality in 2007. The year ended December 31, 2006 also included favorable revisions to prior period DAC estimates of $7, after-tax. A more expanded discussion of income growth is presented below:
Benefits, losses and loss adjustment expenses increased for 2006 consistent with the growth in account values and life insurance in-force, and also reflect favorable mortality experience in 2006 compared to 2005.
Effective November 1, 2007, Individual Life reinsured the policy liability related to statutory reserves in universal life with secondary guarantees to a captive reinsurance subsidiary. These reserves are calculated under prevailing statutory reserving requirements as promulgated under Actuarial Guideline 38, “The Application of the Valuation of Life Insurance Policies Model Regulation”. An unaffiliated standby third party letter of credit supports a portion of the statutory reserves that have been ceded to this subsidiary. The transaction released approximately $300 of statutory capital previously supporting our universal life products with secondary guarantees. The release of this capital from Individual Life will result in a decline in net investment income and increased expenses in future periods for Individual Life. The released capital is available to the Company for general corporate purposes. As its business grows, from time to time, Individual Life will evaluate the need for an additional capital structure.
Group Benefits has a block of financial institution business that is experience rated. This business comprised approximately 9-10% of the segment’s 2007, 2006 and 2005 premiums and other considerations (excluding buyouts) respectively, and, on average, 4% to 5% of the segment’s 2007, 2006 and 2005 net income.
Net income increased in Group Benefits for the year ended December 31, 2007, primarily due to higher earned premiums, higher net investment income, a gain on a renewal rights transaction associated with the Company’s medical stop loss business and a change in assumptions underlying the valuation of long term disability claims incurred in 2007. Partially offsetting the higher net income was increased DAC amortization due to the adoption of SOP 05-1. In addition, realized capital losses increased $17 for the year ended December 31, 2007 as compared to the prior year period. For further discussion, see Realized Capital Gains and Losses by Segment table under Life’s Operating Section of the MD&A. A more expanded discussion of income growth is presented below:
Premiums and other considerations increased largely due to business growth driven by new sales and persistency over the last twelve months.
The segment’s expense ratio, excluding buyouts, for the year ended December 31, 2007, increased primarily due to higher DAC amortization resulting from a shorter amortization period following the adoption of SOP 05-1.
International, with operations in Japan, Brazil, Ireland and the United Kingdom, focuses on the savings and retirement needs of the growing number of individuals outside the United States who are preparing for retirement, or have already retired, through the sale of variable annuities, fixed annuities and other insurance and savings products. The Company’s Japan operation is the largest component of the International segment.
Fee income increased $218 or 45%, for the year ended December 31, 2006. As of December 31, 2006, Japan’s variable annuity assets under management were $29.7 billion, a 20% increase from the prior year period. The increase in average assets under management was driven by positive net flows of $4.2 billion and market appreciation of $1.2 billion during the year. The amount of variable annuity deposits has declined for the year ended December 31, 2006 by 46%, compared to the prior year periods primarily due to increased competition and changes in key distribution relationships.
Contributing to the increase in net income for the year ended December 31, 2006 was a cumulative tax benefit of $9, that resulted from a change in the effective tax rate on Japan earnings resulting from a change in management’s intent under Accounting Principles Board Opinion No. 23 “Accounting for Income Taxes”.
Partially offsetting the positive earnings drivers discussed above were the following items:
Insurance operating costs and other expenses increased for the year ended December 31, 2006 by 11%. These increases are due to higher maintenance costs and non-deferred asset-based commissions resulting from the growth in the Japan operation.
Variable annuity deposits of ¥550 billion to ¥770 billion ($5.0 billion to $7.0 billion)
Variable annuity net flows of ¥275 billion to ¥500 billion ($2.5 billion to $4.5 billion)
Life includes in Other its leveraged PPLI product line of business; corporate items not directly allocated to any of its reporting segments; inter-segment eliminations and the mark-to-mark adjustment for the International variable annuity assets that are classified as equity securities held for trading reported in net investment income and the related change in interest credited reported as a component of benefits, losses and loss adjustment expenses since these items are not considered by the Company’s chief operating decision maker in evaluating the International results of operations.
Net investment income includes the mark-to-market adjustment for equity securities held for trading which decreased primarily due to decreased fund performance of Japan variable annuities. This decrease in net investment income is offset by a decrease in benefit, losses and loss adjustment expenses which reflects the interest credited on the Japan account balance liability.
Earned premium growth is an objective for Personal Lines, Small Commercial and Middle Market. Earned premium growth is not a specific objective for Specialty Commercial since Specialty Commercial is comprised of transactional businesses where premium writings may fluctuate based on the segment’s view of perceived market opportunity. Written premiums are earned over the policy term, which is six months for certain Personal Lines auto business and 12 months for substantially all of the remainder of the Company’s business. Written pricing, new business growth and premium renewal retention are factors that contribute to growth in written and earned premium.
Total Property & Casualty earned premiums increased by $63 due to an increase in Personal Lines and Small Commercial, partially offset by a decrease in Middle Market and Specialty Commercial.
Total Property & Casualty earned premiums grew $277, or 3%, due primarily to growth in Personal Lines, Small Commercial and Middle Market, partially offset by a decrease in Specialty Commercial. Contributing to the growth in earned premium was a $73 reduction of earned premium in 2005 due to catastrophe treaty reinstatement premium payable to reinsurers as a result of losses from hurricanes Katrina, Rita and Wilma, including $31 in Personal Lines, $7 in Small Commercial, $8 in Middle Market and $27 in Specialty Commercial. Before catastrophe treaty reinstatement premium, Ongoing Operations’ earned premium grew $203, or 2%, for 2006.
Specialty Commercial earned premiums decreased by $204, or 12%, primarily driven by a decrease in casualty, property and other earned premiums, partially offset by an increase in professional liability, fidelity and surety. Casualty earned premiums decreased by $217, primarily because of the non-renewal of a single captive insurance program. The decrease in property earned premium was primarily due to a decline in new business, an increase in catastrophe treaty reinsurance costs and a strategic decision not to renew certain accounts with properties in catastrophe-prone areas.
Net income decreased by $12, or 1%, for the year ended December 31, 2007, driven by the following changes:
Primarily driving the $201 increase in net investment income was a higher average invested asset base and income earned from a higher portfolio yield. The increase in the average invested asset base contributing to the increase in investment income was primarily due to positive operating cash flows, partially offset by the return of capital to Corporate. Contributing to the increase in net investment income was an increase in income from limited partnerships and other alternative investments, driven by a higher yield on these investments and shifting a greater allocation of investments to these asset classes.
The $81 increase in net favorable prior accident year development in Ongoing Operations was primarily due to $151 release of workers’ compensation loss and loss adjustment expenses reserves in 2007, partially offset by an $83 net release of prior accident year hurricane reserves in 2006. Refer to the “Reserves” section of the MD&A for further discussion.
The $26 increase in other expenses was primarily due to $49 of interest charged by Corporate on the amount of capital held by the Property & Casualty operation in excess of the amount needed to support the capital requirements of the Property & Casualty operation, partially offset by a reduction in the estimated cost of legal settlements in 2007.
Net income increased $283 for the year ended December 31, 2006, primarily due to:
The $148 increase in net unfavorable prior accident year development in Other Operations was primarily due to a $243 reduction of reinsurance recoverables in 2006 resulting from an agreement with Equitas and the Company’s evaluation of the reinsurance recoverables and allowance for uncollectible reinsurance associated with older, long-term casualty liabilities.
The change to $64 of net favorable prior accident year development in 2006 for Ongoing Operations was primarily due to an $83 release of prior accident year hurricane reserves and a $58 release of allocated loss adjustment expense reserves for workers’ compensation and package business, partially offset by reserve strengthenings in Specialty Commercial. See the “Reserves” section for a discussion of prior accident year reserve development.
Net realized capital gains decreased by $35 in total, primarily due to a $24, pre-tax, realized capital loss from the sale of Omni, an increase in other-than-temporary-impairments and losses on the sale of fixed maturity investments, partially offset by an increase in income from other sources.
The Company considers several measures and ratios to be the key performance indicators for the property and casualty underwriting businesses. The following table and the segment discussions for the years ended December 31, 2007, 2006 and 2005 include various ratios and measures of profitability. Management believes that these ratios and measures are useful in understanding the underlying trends in The Hartford’s property and casualty insurance underwriting business. However, these key performance indicators should only be used in conjunction with, and not in lieu of, underwriting income for the underwriting segments of Personal Lines, Small Commercial, Middle Market and Specialty Commercial and net income for the Property & Casualty business as a whole, Ongoing Operations and Other Operations. These ratios and measures may not be comparable to other performance measures used by the Company’s competitors.
The rate of decline in Specialty Commercial earned premium slowed in 2007, primarily due to a lower earned premium decrease in casualty and property, partially offset by a lower earned premium increase in professional liability, fidelity and surety. Casualty earned premium experienced a larger decrease in 2006, primarily because of a decrease in 2006 earned premium from a single captive insured program that expired in 2005. Earned premium decreases in property were larger in 2006 than in 2007 as a result of a strategic decision in 2006 not to renew certain accounts with properties in catastrophe-prone areas. The growth rate in professional liability, fidelity and surety earned premium slowed in 2007 due to a decrease in earned pricing and a decline in new business growth and premium renewal retention.
Net non-catastrophe prior accident year reserve development was slightly unfavorable in 2006, but favorable in 2007. Favorable reserve development in 2007 was largely attributable to the release of reserves for workers’ compensation claims, primarily related to accident years 2002 to 2006. See the “Reserves” section for a discussion of prior accident year reserve development for Ongoing Operations in 2007.
The lower growth rate in Small Commercial was primarily attributable to a decrease in new business written premium, lower earned pricing increases and higher property catastrophe treaty reinsurance costs.
The lower growth rate in Middle Market was primarily attributable to a decrease in new business written premium in the first six months of 2006, larger earned pricing decreases and higher property catastrophe treaty reinsurance costs.
The decline in Specialty Commercial earned premium in 2006 primarily resulted from the non-renewal of a single captive insurance program within specialty casualty that accounted for $241 of earned premium in 2005 and a decrease in specialty property earned premium, partially offset by the effect of $26 of catastrophe treaty reinstatement premium recorded as a reduction of earned premium in 2005 and a higher growth rate in professional liability, fidelity and surety business.
For 2006, the combined ratio before catastrophes and prior accident year development decreased by 1.4 points, to 88.0, driven largely by the effect of $73 of catastrophe treaty reinstatement premium recorded as a reduction of earned premium in 2005 and an
improvement in the expense ratio. Before the effect of reinstatement premium in 2005, the combined ratio before catastrophes and prior accident year development decreased by 0.7 points, primarily due to a 0.8 point decrease in the expense ratio and a lower current accident year loss and loss adjustment expense ratio for workers’ compensation business in Small Commercial, partially offset by an increase in non-catastrophe property loss costs in Middle Market and Personal Lines homeowners. The decrease in the expense ratio was primarily driven by a reduction of $41 for Citizens’ assessments in 2006 and a charge of $64 for Citizens assessments in 2005.
Net income is a measure of profit or loss used in evaluating the performance of Total Property & Casualty and the Ongoing Operations and Other Operations segments. Within Ongoing Operations, the underwriting segments of Personal Lines, Small Commercial, Middle Market and Specialty Commercial are evaluated by The Hartford’s management primarily based upon underwriting results. Underwriting results within Ongoing Operations are influenced significantly by earned premium growth and the adequacy of the Company’s pricing. 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, its management of claims, its use of reinsurance and its ability to manage its expense ratio which it accomplishes through economies of scale and its management of acquisition costs and other underwriting expenses.
In setting its pricing, Property & Casualty assumes an expected level of losses from natural or man-made catastrophes that will cover the Company’s exposure to catastrophes over the long-term. In most years, however, Property & Casualty’s actual losses from catastrophes will be more or less than that assumed in its pricing due to the significant volatility of catastrophe losses. ISO defines a catastrophe loss as an event that causes $25 or more in industry insured property losses and affects a significant number of property and casualty policyholders and insurers.
Given the lag in the period from when claims are incurred to when they are reported and paid, final claim settlements may vary from current estimates of incurred losses and loss expenses, particularly when those payments may not occur until well into the future. Reserves for lines of business with a longer lag (or “tail”) in reporting are more difficult to estimate. Reserve estimates for longer tail lines are initially set based on loss and loss expense ratio assumptions estimated when the business was priced and are adjusted as the paid and reported claims develop, indicating that the ultimate loss and loss expense ratio will differ from the initial assumptions. Adjustments to previously established loss and loss expense reserves, if any, are reflected in underwriting results in the period in which the adjustment is determined to be necessary.
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. Due to the emphasis on preservation of capital and the need to maintain sufficient liquidity to satisfy claim obligations, the vast majority of Property & Casualty’s invested assets have been held in fixed maturities, including, among other asset classes, corporate bonds, municipal bonds, government debt, short-term debt, mortgage-backed securities and asset-backed securities.
Underwriting results is a before-tax measure that represents earned premiums less incurred losses, loss adjustment expenses and underwriting expenses. The Hartford believes that underwriting results provides investors with a valuable measure of before-tax profitability derived from underwriting activities, which are managed separately from the Company’s investing activities. Underwriting results is also presented for Ongoing Operations and Other Operations. A reconciliation of underwriting results to net income for Ongoing Operations and Other Operations is set forth in their respective discussions herein.
Property & Casualty’s insurance business has been written by a number of writing companies that, under a pooling arrangement, participate in the Hartford Fire Insurance Pool, the lead company of which is the Hartford Fire Insurance Company (“Hartford Fire”).
The Hartford attributes capital to each line of business or segment using an internally-developed, risk-based capital attribution methodology that incorporates management’s assessment of the relative risks within each line of business or segment, as well as the capital requirements of external parties, such as regulators and rating agencies. Net investment income earned on the Hartford Fire invested asset portfolio is allocated between Ongoing Operations and Other Operations based on the allocation of invested assets to each segment and the expected investment yields earned by each segment. Net investment income earned on the separate portfolios within Other Operations is recorded entirely within Other Operations. Based on the Company’s method of allocating net investment income for the Hartford Fire Insurance Pool and the net investment income earned by Other Operations on its separate investment portfolios, in 2007, the after-tax investment yield for Ongoing Operations was 4.6% and the after-tax investment yield for Other Operations was 3.3%.
As part of its quarterly reserve review process, the Company is closely monitoring reported loss development in certain lines where the recent emergence of paid losses and case reserves could indicate a trend that may eventually lead the Company to change its estimate of ultimate losses in those lines. If, and when, the emergence of reported losses is determined to be a trend that changes the Company’s estimate of ultimate losses, prior accident year reserves would be adjusted in the period the change in estimate is made.
For example, the Company has experienced favorable emergence of reported workers’ compensation claims for recent accident years and, during 2007, released workers’ compensation reserves in Small Commercial for the 2002 to 2006 accident years by $151. If reported losses on workers’ compensation claims for recent accident years continue to emerge favorably, reserves could be reduced further.
The Company expects to perform its regular reviews of asbestos liabilities in the second quarter of 2008, Other Operations’ reinsurance recoverables and the allowance for uncollectible reinsurance in the second quarter of 2008 and environmental liabilities in the third quarter of 2008. If there are significant developments that affect particular exposures, reinsurance arrangements or the financial conditions of particular reinsurers, the Company will make adjustments to its reserves, or the portion of liabilities it expects to cede to reinsurers.
During the second quarter of 2007, an arbitration panel found that a Hartford subsidiary, established as a captive reinsurance company in the 1970s by The Hartford’s former parent, ITT Corporation (“ITT”), had additional obligations to ITT’s primary insurance carrier under ITT’s captive insurance program, which ended in 1993. When ITT spun off The Hartford in 1995, the former captive became a Hartford subsidiary. The arbitration concerned whether certain claims could be presented to the former captive in a different manner than ITT’s primary insurance carrier historically had presented them. The Company recorded a charge of $99 principally as a result of this adverse arbitration decision.
The Company completed its environmental reserve evaluation and increased its environmental reserves by $25. As part of this evaluation, the Company reviewed all of its open direct domestic insurance accounts exposed to environmental liability as well as assumed reinsurance accounts and its London Market exposures for both direct and assumed reinsurance. The Company found estimates for individual cases changed based upon the particular circumstances of each account. These changes were case specific and not as a result of any underlying change in the current environment.
A rollforward of liabilities for unpaid losses and loss adjustment expenses by segment for Property & Casualty for the year ended December 31, 2006 follows:
Includes reserve discount accretion of $32, including $6 in Small Commercial, $8 in Middle Market, $11 in Specialty Commercial and $7 in Other Operations.
During the year ended December 31, 2006, the Company’s re-estimates of prior accident year reserves included the following significant reserve changes.
Released net reserves related to prior year hurricanes by a total of $83, including $57 for hurricanes Katrina and Rita in 2005 and $26 for hurricanes Charley, Frances and Jeanne in 2004. Initial reserve estimates for the 2005 and 2004 hurricanes were higher because of the difficulty claim adjusters had in accessing the most significantly impacted areas and initially higher estimates of the cost of building materials and contractors due to “demand surge”. As the reported claims have matured, the estimated settlement value of the claims has decreased from the initial estimates. The ultimate estimate for hurricane Katrina was increased in the first quarter of 2006 because of higher than expected claim reporting, particularly in Personal Lines. Net loss reserves within Specialty Commercial decreased, primarily because hurricane Katrina losses on specialty property business were reimbursable under a specialty property reinsurance treaty as well as under the Company’s principal property catastrophe reinsurance program. After the first quarter of 2006, Katrina new claim intake abated and settlement percentages increased, resulting in a reduction of reserves in the last nine months of 2006. In addition, the rate of newly reported compensable claims for Rita and the 2004 hurricanes was less than expected, resulting in a reduction of reserves for these hurricanes.
Company determined that the facts and circumstances necessitated an increase in the reserve estimate. The $30 of reserve strengthening represented 2% of the Company’s net reserves for Personal Lines auto liability claims as of December 31, 2005.
Strengthened construction defect claim reserves by $45 for accident years 1997 and prior as a result of an increase in claim severity trends. In 2004, two large construction defects claims were reported, but these were not viewed as an indication of an increase in the severity trend for all claims. In 2005, two additional large cases were reported. Management performed an expanded review of construction defects claims in the second quarter of 2006. Based on the expanded review and additional reported claim experience, management concluded that reported losses would likely continue at a higher level in the future and this resulted in strengthening the recorded reserves. The $35 of reserve strengthening in Specialty Commercial represented 4% of the Company’s net reserves for Specialty Commercial general liability claims as of December 31, 2005. The $10 of strengthening in Middle Market represented 1% of net reserves for Middle Market general liability claims as of December 31, 2005.
Reduced the reinsurance recoverable asset associated with older, longer-term casualty liabilities by $243. The Company reviewed the reinsurance recoverables and allowance for uncollectible reinsurance associated with older, long-term casualty liabilities in the second quarter 2006. As a result of this study, and the outcome of an agreement that resolved, with minor exception, all of the Company’s ceded and assumed domestic reinsurance exposures with Equitas, Other Operations recorded prior accident year development of $243.
A rollforward of liabilities for unpaid losses and loss adjustment expenses by segment for Property & Casualty for the year ended December 31, 2005 follows:
During the year ended December 31, 2005, the Company’s re-estimates of prior accident year reserves included the following significant reserve changes.
Strengthened general liability reserves within Middle Market by $40 for accident years 2000-2003 due to higher than anticipated loss payments beyond four years of development. The $40 reserve strengthening represented 2% of the Company’s net reserves for general liability claims as of December 31, 2004.
Strengthened environmental reserves by $37 as a result of an environmental reserve evaluation completed during the third quarter of 2005. While the review found no underlying cause or change in the claim environment, loss estimates for individual cases changed based upon the particular circumstances of each account. The $37 of reserve strengthening represented 1% of the Company’s net reserves for asbestos and environmental claims as of December 31, 2004.
The table below shows the range of annual reserve re-estimates experienced by The Hartford over the past three 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 three 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.
Range of prior accident year development for the three years ended December 31, 2007 [1] [2]
Over the past ten years, reserve re-estimates for total Property & Casualty ranged from (1.3)% to 21.5%. Before the reserve strengthening for asbestos and environmental reserves, over the past ten years reserve re-estimates for total Property & Casualty ranged from (3.0)% to 1.6%.
The Company has several catastrophe reinsurance programs, including reinsurance treaties that cover property and workers’ compensation losses aggregating from single catastrophe events. The following table summarizes the primary catastrophe treaty reinsurance coverages that the Company has in place as of January 1, 2008:
The following table summarizes the terms of the reinsurance treaties with Foundation Re and Foundation Re II that were in place as of January 1, 2008:
The Company’s modeled loss estimates are derived by averaging 21 modeled loss events representing a 250-year return period loss. For the peril of earthquake, the 21 events averaged to determine the modeled loss estimate include events occurring in the Northwestern, Northeastern, Southeastern and Midwestern regions of the United States with associated magnitudes ranging from 6.5 to 8.5 on the Richter scale. For the peril of hurricane, the 21 events averaged to determine the modeled loss estimate include category 3, 4 and 5 events in Florida as well as other Southeastern, Northeastern and Gulf region landfalls.
The Company does not provide residential flood insurance under its insurance policies. However, the Company acts as an administrator for the Write Your Own flood program on behalf of the National Flood Insurance Program under FEMA, for which it earns a fee for collecting premiums and processing claims. Under the program, the Company services both personal lines and commercial lines flood insurance policies and does not assume any underwriting risk.
Reinsurance recoverables represent loss and loss adjustment expenses recoverable from a number of entities, including reinsurers and pools. As shown in the following table, a portion of the total gross reinsurance recoverable relates to the Company’s mandatory participation in various involuntary assigned risk pools and the value of annuity contracts held under structured settlement agreements. Reinsurance recoverables due from mandatory pools are backed by the financial strength of the property and casualty insurance industry. Annuities purchased from third party life insurers under structured settlements are recognized as reinsurance recoverables in cases where the Company has not obtained a release from the claimant. Of the remaining gross reinsurance recoverable as of December 31, 2007 and 2006, the following table shows the portion of recoverables due from companies rated by A.M. Best.
Based on A.M. Best ratings as of December 31, 2007 and 2006, respectively.
Net prior year incurred losses in 2006 includes the effect of reducing net reinsurance recoverables by $243 as a result of an agreement with Equitas and strengthening of the allowance for uncollectible reinsurance.
Includes net realized capital gains (losses), after tax, of $(112), $46 and $29 for the years ended December 31, 2007, 2006 and 2005, respectively.
Underwriting results decreased by $142, from $1,111 to $969, with a corresponding 1.5 point increase in the combined ratio, from 89.3 to 90.8, due to:
Excluding the effect of Omni, the 3.3 point increase in the current accident year loss and loss adjustment expense ratio before catastrophes in Personal Lines was primarily due to increased severity on auto liability claims, increased frequency on auto property damage claims and, to a lesser extent, increased severity on homeowners claims, partially offset by the effect of earned pricing increases in homeowners.
The 1.4 point increase in the current accident year loss and loss adjustment expense ratio before catastrophes in Small Commercial was primarily due to a higher loss ratio and loss adjustment expense ratio for package business and commercial auto claims, partially offset by a lower loss and loss adjustment expense ratio for workers’ compensation claims.
Increase in net favorable prior accident year reserve development by $81
Net income increased by $389, or 33%, due primarily to an increase in underwriting results and an increase in net investment income.
Underwriting results increased by $420, from $691 to $1,111, with a corresponding 3.9 point decrease in the combined ratio, from 93.2 to 89.3, due to:
Ongoing Operations’ earned premium increased by $276, or 3%, to $10,428, in part due to $73 of catastrophe treaty reinstatement premium recorded as a reduction of earned premium in 2005. Apart from the effect of catastrophe treaty reinstatement premium in 2005, earned premium grew by $203, or 2%, driven by earned premium increases in Small Commercial, Personal Lines and Middle Market, partially offset by an earned premium decrease in Specialty Commercial. Refer to the earned premium discussion in the Executive Overview section of the Property & Casualty MD&A for further discussion of the increase in earned premium.
Excluding the effect of catastrophe treaty reinstatement premium, the 0.9 point increase in the current accident year loss and loss adjustment expense ratio before catastrophes in Personal Lines was primarily due to an increase in non-catastrophe property loss costs for homeowners, primarily driven by an increase in claim severity, and an increase in the loss and loss adjustment expense ratio for auto liability claims, partially due to a shift to more Dimensions product business within Agency.
Excluding the effect of catastrophe treaty reinstatement premium, the 1.8 point decrease in the current accident year loss and loss adjustment expense ratio before catastrophes in Small Commercial was primarily due to a lower loss and loss adjustment expense ratio on workers’ compensation business and a decrease in non-catastrophe property loss costs, partially offset by a shift to more workers’ compensation premium which has a higher loss and loss adjustment expense ratio than other business in the segment. Non-catastrophe property loss costs were favorable primarily due to favorable claim frequency.
Excluding the effect of catastrophe treaty reinstatement premium, the 2.1 point increase in the current accident year loss and loss adjustment expense ratio before catastrophes in Middle Market was primarily due to an increase in non-catastrophe property loss costs, the effect of earned pricing decreases and the effect of a shift to more workers’ compensation premium which has a higher loss and loss adjustment expense ratio than other business in the segment. The increase in non-catastrophe property loss costs was primarily due to increasing claim severity.
Change to net favorable prior accident year reserve development by $100
Prior accident year reserve development changed from net unfavorable development of $36, or 0.4 points, in 2005 to net favorable development of $64, or 0.6 points, in 2006. The $64 of net favorable prior accident year development in 2006 for Ongoing Operations was primarily due to an $83 release of prior accident year hurricane reserves and a $58 release of allocated loss adjustment expense reserves for workers’ compensation and package business, partially offset by reserve strengthenings in Specialty Commercial. Net unfavorable reserve development of $36 in 2005 included a $120 increase in workers’ compensation reserves related to reserves for claim payments expected to emerge after 20 years of development, a $40 strengthening of general liability reserves within Middle Market for accident years 2000 to 2003 due to higher than anticipated loss payments beyond four years of development and $33 of reserve strengthening related to the third quarter 2004 hurricanes. Partially offsetting the reserve increases in 2005 was a $95 reduction in prior accident year reserves for allocated loss adjustment expenses in Personal Lines, predominantly related to auto liability claims, and a $75 reduction in workers’ compensation reserves recorded related to accident years 2003 and 2004. See the “Reserves” section of the MD&A for further discussion of reserve development.
The $17 in net realized capital losses during 2006 included a $24 pre-tax realized capital loss from the sale of Omni, an increase in other-than-temporary-impairments and losses on the sale of fixed maturity investments, partially offset by an increase in income from other sources. (See the Other-Than-Temporary Impairments discussion within Investment Results for more information on the increase in impairments).
Other expenses increased by $20, primarily due to lower bad debt expense in 2005.
Premium renewal retention for auto increased from 87% to 88% for the year ended December 31, 2007, primarily due to the sale of the Omni non-standard auto business during 2006, which had a lower premium renewal retention than the Company’s standard auto business. Excluding Omni business, premium renewal retention decreased slightly, from 89% to 88%, as renewal retention remained flat in AARP and decreased in Agency. Premium renewal retention for homeowners increased from 94% to 96% for the year ended December 31, 2007, primarily due to an increase in retention of Agency business.
The trend in earned pricing during 2007 was primarily a reflection of the written pricing changes in the last six months of 2006 and the first six months of 2007. Written pricing remained flat in auto primarily due to an extended period of favorable results factoring into the rate setting process. Homeowners’ written pricing continued to increase due largely to increases in insurance to value and an increase in the value of insured properties. Insurance to value is the ratio of the amount of insurance purchased to the value of the insured property.
Earned premiums for the Personal Lines segment increased $150, or 4%, due primarily to earned premium growth in both AARP and Agency business, partially offset by higher property catastrophe treaty reinsurance costs and a reduction in other earned premium. Also contributing to the increase in earned premiums was $31 of catastrophe treaty reinstatement premium payable to reinsurers recorded as a reduction of earned premium in 2005. Other earned premium consists of premium earned on non-standard auto business written by Omni and on business written through affinity partners other than AARP.
Auto earned premium grew $64, or 2%, primarily from new business outpacing non-renewals in both AARP and Agency over the last six months of 2005 and the year ended December 31, 2006, partially offset by a decline in other auto business. Before considering the decline in other auto business, auto earned premium grew $154, or 6%. Homeowners’ earned premium grew $86, or 10%, primarily due to new business outpacing non-renewals in both AARP and Agency business over the last six months of 2005 and the year ended December 31, 2006 and due to earned pricing increases. Consistent with the growth in earned premium, the number of policies in-force
has increased in auto and homeowners. The growth in policies in-force does not correspond directly with the growth in earned premiums due to the effect of earned pricing changes and because policy in-force counts are as of a point in time rather than over a period of time.
Net favorable prior accident year reserve development of $38 in 2006 included a $53 reduction in prior accident year reserves for auto liability claims related to accident years 2003 to 2005 and a $23 reduction in hurricane catastrophe reserves related to the 2004 and 2005 hurricanes, partially offset by a $30 increase in reserves for personal auto liability claims due to an increase in estimated severity on claims where the Company is exposed to losses in excess of policy limits.
Omni accounted for $30 of amortization of deferred policy acquisition costs in 2006. Excluding Omni, amortization of deferred policy acquisition costs increased by $25, or 4%, driven primarily by the increase in earned premium.
Underwriting results decreased by $31, from $460 to $429, with a corresponding 1.3 point increase in the combined ratio, from 87.3 to 88.6, due to:
Current accident year loss and loss adjustment expenses before catastrophes increased by $105
Personal Lines current accident year loss and loss adjustment expenses before catastrophes increased by $105 in 2006, to $2,396, due to an increase in earned premium and an increase in the current accident year loss and loss adjustment expense ratio before catastrophes. Excluding the effect of catastrophe treaty reinstatement premium, the current accident year loss and loss adjustment expense ratio before catastrophes increased by 0.9 points, to 63.8, due to an increase in non-catastrophe property loss costs for homeowners, primarily driven by an increase in claim severity, and an increase in the loss and loss adjustment expense ratio for auto liability claims, partially due to a shift to more Dimensions product business within Agency.
Current accident year catastrophe losses increased by $22, from $98, or 2.7 points, in 2005 to $120, or 3.2 points, in 2006. Catastrophe losses increased principally due to losses in 2006 from tornados and hail storms in the Midwest and windstorms in Texas and on the East coast. Catastrophe losses in 2005 included $51 of losses from hurricanes Katrina, Rita and Wilma.
Decrease in net favorable prior accident year reserve development by $57
Net favorable prior accident year reserve development decreased from $95, or 2.6 points, in 2005 to $38, or 1.0 point, in 2006. Net favorable prior accident year reserve development of $38 in 2006 included a $53 reduction in auto liability reserves and a $23 reduction in hurricane catastrophe reserves, including $10 related to hurricane Katrina in 2005 and $7 related to hurricane Charley in 2004, partially offset by a $30 increase in reserves for personal auto liability claims due to an increase in estimated severity on claims where the company is exposed to losses in excess of policy limits. The $53 reduction in auto liability reserves in 2006 included a $31 reduction in reserves for auto liability claims related to accident year 2005 as a result of better than expected frequency trends and a $22 reduction of reserves for AARP and other affinity auto liability claims related to accident years 2003 to 2005 as a result of better than expected severity trends. Net favorable prior accident year reserve development of $95 in 2005 included a $95 reduction in reserves for allocated loss adjustment expenses.
The expense ratio decreased by 1.0 point, to 22.7, in 2006, due primarily to a decrease in insurance operating costs and expenses. Insurance operating costs decreased by $44, largely because of a $19 decrease in estimated Citizens’ assessments in 2006 compared to a $30 increase in Citizens assessments in 2005. Amortization of deferred policy acquisition costs increased by $41, due largely to the increase in earned premium.
Management expects the Personal Lines segment to deliver 2% to 5% written premium growth in 2008. Despite a decline in new business in the second half of 2007, in 2008, written premium growth of 3% to 6% in auto and flat to 3.0% in homeowners is expected to come from growth in both AARP and Agency. For AARP business, management expects to achieve its targeted written premium growth primarily through continued direct marketing to AARP members and an expansion of underwriting appetite through the continued roll-out of the “Next Gen Auto” product. Through improvements in technology, the Company seeks to increase AARP new business flow from the internet and increase the percentage of AARP new business submissions that can be quoted real-time. In addition to marketing directly to AARP members, the Company will increase its media spend to enhance brand awareness.
For the Agency business in 2008, management expects to increase written premium by appointing more agents, increasing the flow of new business from recently appointed agents and improving its price competitiveness across a broader spectrum of risks. The Company will seek to increase the number of opportunities to quote on new business as more agencies use comparative raters to obtain quotes from multiple carriers.
Written premium growth of 2% to 5%, with auto written premium 3% to 6% higher and homeowners written premium flat to 3.0% higher
Small Commercial provides standard commercial insurance coverage to small commercial businesses, primarily throughout the United States, with up to $5 in annual payroll, $15 in annual revenues or $15 in total property values. This segment offers workers’ compensation, property, automobile, liability and umbrella coverages.
Earned premiums for the Small Commercial segment increased $84, or 3%, primarily due to new business premiums outpacing non-renewals for workers’ compensation business over the last six months of 2006 and the first six months of 2007. Premium renewal retention for Small Commercial decreased due, in part, to lower retention of larger accounts and a reduction in average premium per account. New business written premium for Small Commercial decreased by $52, or 10%, as increased competition led to a reduction in new business for workers’ compensation, package business and commercial auto. While the Company has focused on increasing new business from its agents and expanding writings in certain territories, actions taken by some of the Company’s competitors to increase market share and increase business appetite in certain classes of risks may be contributing to the Company’s lower new business growth. Also contributing to the decrease in new business premium is lower average premium per account partly due to writing more liability-only policies.
Small Commercial current accident year loss and loss adjustment expenses before catastrophes increased by $85 in 2007, to $1,594, due to an increase in earned premium and a 1.4 point increase in the current accident year loss and loss adjustment expense ratio before catastrophes, to 58.3. The 1.4 point increase in the current accident year loss and loss adjustment expense ratio before catastrophes was primarily due to a higher loss ratio and loss adjustment expense ratio for package business and commercial auto claims, partially offset by a lower loss and loss adjustment expense ratio for workers’ compensation claims. The higher loss and loss adjustment expense ratio on package business was primarily driven by an increase in the number of individual large losses and the higher loss and loss adjustment expense ratio for auto claims was driven, in part, by earned pricing decreases. Expected loss and loss adjustment expenses on workers’ compensation claims for the 2007 accident year were lower as the assumed level of medical claim severity was not as high as it had been for the 2006 accident year.
Current accident year catastrophe losses in 2007 of $28, or 1.0 point, were moderately lower than current accident year catastrophes of $34, or 1.3 points, in 2006. The largest catastrophe losses in 2007 were from spring windstorms in the Southeast and Northeast, tornadoes and thunderstorms in the Midwest and wildfires in California. Catastrophes in 2006 included tornadoes and hail storms in the Midwest.
The 0.7 point increase in the expense ratio and the 0.4 point increase in the policyholder dividend ratio was primarily due to an increase in insurance operating costs and expenses. Insurance operating costs increased by $52 due to an increase in IT and other operating costs, a $10 decrease in estimated Citizens’ assessments in 2006 and a $10 increase in policyholder dividends in 2007. The increase in policyholder dividends in 2007 was largely attributable to a $10 increase in the estimated amount of dividends payable to certain workers’ compensation policyholders due to underwriting profits. Despite a 3% increase in earned premium, amortization of deferred policy acquisition costs was relatively flat from 2006 to 2007 due largely to an increase in non-deferrable salaries and benefits and other internal operating costs.
Underwriting results increased by $190, from $232 to $422, with a corresponding 6.3 point decrease in the combined ratio, from 90.4 to 84.1, due to:
Small Commercial current accident year loss and loss adjustment expenses before catastrophes increased by $83 in 2006, to $1,509, due to an increase in earned premium, partially offset by a decrease in the current accident year loss and loss adjustment expense ratio before catastrophes. Excluding the effect of catastrophe treaty reinstatement premium, the current accident year loss and loss adjustment expense ratio before catastrophes decreased by 1.8 points, to 56.9, due to a lower loss and loss adjustment expense ratio on workers’ compensation business and a decrease in non-catastrophe property loss costs, partially offset by a shift to more workers’ compensation premium which has a higher loss and loss adjustment expense ratio than other business in the segment. Non-catastrophe property loss costs were favorable primarily due to favorable claim frequency.
Current accident year catastrophe losses decreased by $16, from $50, or 2.1 points, in 2005 to $34, or 1.3 points, in 2006. Catastrophe losses in 2005 included catastrophe losses from hurricanes Katrina, Rita and Wilma. While hurricane losses were significantly lower in 2006, non-hurricane catastrophe losses increased significantly due, in large part, to tornadoes and hail storms in the Midwest.
Net favorable prior accident year reserve development increased from $24, or 1.0 point, in 2005 to $75, or 2.8 points, in 2006. Net favorable reserve development of $75 in 2006 included a $33 reduction in allocated loss adjustment expense reserves, primarily for workers’ compensation and package business related to accident years 2003 to 2005, and a $22 reduction in prior accident year catastrophe reserves in 2006 related to hurricanes Katrina, Rita and Wilma in 2005 and hurricanes Charley, Frances and Jeanne in 2004. Net favorable reserve development of $24 in 2005 included a $23 reduction of reserves for allocated loss adjustment expenses and a $37 reduction in workers’ compensation reserves related to accident years 2003 and 2004, partially offset by a $15 increase in workers’ compensation reserves related to reserves for claim payments expected to emerge after 20 years of development and a $20 strengthening of reserves for the 2004 hurricanes.
The expense ratio decreased by 1.7 points, to 28.5, primarily due to a decrease in insurance operating costs and expenses. Insurance operating costs decreased by $13, largely because of a $10 decrease in estimated Citizens’ assessments in 2006 compared to a $16 increase in Citizens assessments in 2005. Partially offsetting the improvement due to changes in the Citizens’ assessments was an increase in IT and other insurance operating costs. Amortization of deferred policy acquisition costs increased by $38, due largely to the increase in earned premium.
Management expects written premium in 2008 to be flat to 3% higher than in 2007 as it seeks to increase the flow of new business from its agents. Small Commercial expects to increase written premium by selectively expanding its underwriting appetite, refining its pricing models and upgrading product features. In 2008, the Company expects to add a pricing tier for workers’ compensation business to provide more pricing flexibility and introduce an enhanced renewal pricing model for the Company’s Spectrum business owners’ package product. Despite a decline in new business in 2007, management expects new business will increase in 2008, driven by an increased flow of new business submissions from the larger producers. Including supplemental commissions, the Company has increased commissions paid to agents and expects that this will help it achieve its growth objectives in 2008.
Through technology and process improvements, in 2008, the Company plans to improve efficiency and service levels in its underwriting centers and enhance the agent’s on-line experience. Average premium per policy is expected to continue to decline due to the sale of more liability-only policies, workers’ compensation rate reductions and a lower average premium on Next Generation Auto business. Written pricing has remained relatively flat for Small Commercial business as carriers have competed for new business through new product features and expanded coverage. In 2008, the Company will continue to focus on renewal retention, particularly in the mid-Western states, where competition has been particularly strong.
To summarize, management’s outlook in Small Commercial for the 2008 full year is:
Earned premiums for the Middle Market segment decreased by $103, or 4%. The decrease was primarily due to earned pricing decreases and a decrease in new business written premium and premium renewal retention over the last six months of 2006 and the first six months of 2007. The decrease in both new business written premium and premium renewal retention was primarily due to continued price competition and the effect of state-mandated rate reductions in workers’ compensation. Earned pricing and premium renewal retention decreased in all lines of business, including property, commercial auto, general liability, workers’ compensation and marine. New business written premium declined in all lines except workers’ compensation.
Despite the decrease in earned premium, the number of policies in-force has increased. The growth in policies in-force does not correspond directly with the change in earned premiums due to a reduction in the average premium per policy and because policy in-force counts are as of a point in time rather than over a period of time.
Earned premiums for the Middle Market segment increased $99, or 4%. The increase was primarily due to new business growth outpacing non-renewals, predominately in workers’ compensation and marine insurance, over the last six months of 2005 and the full year 2006, partially offset by the effect of earned pricing decreases and higher property catastrophe treaty reinsurance costs.
As written premium is earned over the 12 month term of the policies, the decrease in earned pricing during 2006 was primarily a reflection of the written pricing decreases over the last six months of 2005 and the first six months of 2006.
Middle Market current accident year loss and loss adjustment expenses before catastrophes decreased by $10 in 2007, to $1,523, due to a decrease in earned premium, largely offset by the effect of an increase in the current accident year loss and loss adjustment expense ratio before catastrophes. Before catastrophes, the current accident year loss and loss adjustment expense ratio increased by 2.2 points, to 64.8, primarily due to a higher loss and loss adjustment expense ratio for workers’ compensation, general liability and commercial auto claims driven, in part, by earned pricing decreases. For commercial auto, loss costs increased for both liability and property damage claims.
Net unfavorable reserve development of $15 in 2006 consisted primarily of a $20 increase in general liability loss and loss adjustment expense reserves related to accident years 1998 to 2005 and a $10 increase in construction defect reserves, partially offset by a $25 reduction in allocated loss adjustment expense reserves for workers’ compensation business related to accident years 2003 to 2005.
The 1.7 point increase in the expense ratio and the 0.4 point increase in the policyholder dividend ratio was primarily due to an increase in insurance operating costs and expenses and the decrease in earned premiums. Insurance operating costs and expenses increased by $35, partially due to the effect of a $12 reduction of estimated Citizens’ assessments related to the 2005 Florida hurricanes recorded in 2006. Also contributing to the increase in insurance operating costs and expenses was an increase in IT costs, an increase in non-deferrable salaries and benefits, and an $8 increase in policyholder dividends. The increase in policyholder dividends was largely due to an $8 increase in the estimated amount of dividends payable to certain workers’ compensation policyholders due to underwriting profits.
Underwriting results increased by $44, from $163 to $207, with a corresponding 1.6 point decrease in the combined ratio.
Middle Market earned premium increased by $99, or 4%, to $2,454. Refer to the earned premium discussion for a description of the increase in earned premium.
Current accident year loss and loss adjustment expenses before catastrophes increased by $102
Current accident year catastrophe losses decreased by $2, from $38, or 1.6 points, in 2005 to $36, or 1.5 points, in 2006. Catastrophe losses in 2005 included catastrophe losses from hurricanes Katrina, Rita and Wilma. While hurricane losses were significantly lower in 2006, non-hurricane catastrophe losses increased significantly due, in large part, to tornadoes and hail storms in the Midwest and windstorms in Texas and on the East coast.
Management expects written premium to be 1% to 4% lower in 2008 as the Company takes a disciplined approach to evaluating and pricing risks in the face of declines in written pricing. Contributing to the expected decline in Middle Market written premium is the effect of state-mandated rate reductions in workers’ compensation and increased competition in specific geographic markets and lines. For both workers’ compensation and commercial auto products, the Company will improve the sophistication of its pricing models, resulting in an expanded underwriting appetite in selected industries and regions of the country. Targeting those agents and brokers with the greatest opportunity for writing new profitable business, management plans to offer key agents added value through agency service and sales support. Including supplemental commissions, the Company has increased commissions paid to agents and expects that this will help it achieve its growth objectives in 2008.
Written pricing has been affected by increased competition for new business as evidenced by 5% written pricing decreases in 2007. Market conditions in the commercial lines industry continue to be soft with written pricing likely to decline further in 2008, more so on the larger accounts. The Hartford’s new business has been declining due to the increased competition and written pricing decreases; in 2008, the Company will continue to focus on protecting its renewals.
To summarize, management’s outlook in Middle Market for the 2008 full year is:
Earned premiums for the Specialty Commercial segment decreased by $47, or 3%, for the year ended December 31, 2007, primarily due to a decrease in casualty, property and other earned premiums, partially offset by an increase in professional liability, fidelity and surety earned premiums.
Property earned premiums decreased by $11, or 5%, primarily due to lower premium renewal retention and the effect of an arrangement with Berkshire Hathaway to share premiums written under subscription policies. Under the arrangement with Berkshire Hathaway that commenced in the second quarter of 2007, a share of excess and surplus lines business that was previously written entirely by the Company is now being written in conjunction with Berkshire Hathaway under subscription policies, whereby both companies share, or participate, in the business written. The arrangement with Berkshire Hathaway enables the Company to offer its insureds larger policy limits and thereby enhance its competitive position in the marketplace. The decrease in earned premium was partially offset by the effect of earned pricing increases, new business growth, lower reinsurance costs and a decrease in reinstatement premium payable to reinsurers. Renewal retention has decreased in 2007, primarily due to increased competition on national account business as well as in the standard excess and surplus lines market. After experiencing significant rate increases throughout 2006 and smaller rate increases for the first six months of 2007, written pricing decreased in the last six months of the year. While new business decreased in the fourth quarter of 2007, new business increased for the full year, largely because the Company had significantly curtailed new business in 2006 in order to reduce catastrophe loss exposures in certain geographic areas.
Property earned premium decreased by $32, or 13%, primarily due to a decrease in new business and renewals in the latter half of 2005 and the full year of 2006 as well as the effect of an increase in reinsurance costs for 2006 treaties and additional catastrophe reinsurance purchased in the fourth quarter of 2005. Partially offsetting the decrease in earned premiums was the non-recurrence of $34 of catastrophe treaty reinstatement premiums payable to reinsurers recorded as a reduction of earned premium in 2005 and double digit earned pricing increases during 2006. The reduction in new business and renewals reflects a decision to reduce catastrophe loss exposures in certain geographic areas and a determination that, despite rate increases, rates on some business opportunities were not adequate. Property business has experienced significant rate increases throughout 2006, reflecting a hardening of the market after the 2005 hurricanes.
Within the “other” category, earned premium decreased by $50, or 29%. The “other” category of earned premiums includes premiums assumed and ceded under inter-segment arrangements and co-participations. Under an inter-segment arrangement, beginning in the first quarter of 2006, the Company allocated more of the premiums ceded under the principal property catastrophe reinsurance program to Specialty Commercial and less to Personal Lines, Small Commercial and Middle Market. In addition, beginning in the third quarter of 2006, the Company reduced the premiums assumed by Specialty Commercial under inter-segment arrangements covering certain liability claims.
Net unfavorable prior accident year reserve development increased from $34, or 2.3 points, in 2006 to $82, or 5.4 points, in 2007. Net unfavorable prior accident year reserve development of $82 in 2007 consisted primarily of a $47 strengthening of workers’ compensation loss and loss adjustment expense reserves for accident years 1987 to 2001, a $34 strengthening of general liability reserves, primarily related to accident years 1987 to 1997 and a $25 strengthening of general liability reserves for accident years more than 20 years old. Partially offsetting the unfavorable reserve development in 2007 was a $22 release of reserves for surety business for accident years 2003 to 2006.
Specialty Commercial earned premium decreased by $204, or 12%, to $1,562. Refer to the earned premium discussion for a description of the decrease in earned premium.
Current accident year loss and loss adjustment expenses before catastrophes decreased by $147
Current accident year catastrophe losses decreased by $156, from $165, or 9.3 points, in 2005 to $9, or 0.6 points, in 2006. Catastrophe losses in 2005 included losses for hurricanes Katrina, Rita and Wilma.
Net unfavorable prior accident year reserve development decreased from $103, or 5.8 points, in 2005 to $34, or 2.3 points, in 2006. Net unfavorable prior accident year reserve development of $34 in 2006 included a $35 strengthening of reserves for construction defects claims on casualty business for accident years 1997 and prior and a $20 strengthening of allocated loss adjustment expense reserves on workers’ compensation policies, partially offset by a $35 reduction in catastrophe reserves related to the 2005 hurricanes. The reduction in catastrophe reserves included a $28 reduction in net losses related to hurricane Katrina, despite a $24 increase in the gross loss estimate for hurricane Katrina. The decrease in net catastrophe loss reserves was primarily because hurricane Katrina losses on specialty property business were reimbursable under a specialty property reinsurance treaty covering national account business as well as under the Company’s principal property catastrophe reinsurance program. Under the provisions of an inter-segment reinsurance arrangement, a portion of the recoveries from the Company’s principal property catastrophe reinsurance program related to the reserve strengthening were allocated to Specialty Commercial.
Management expects a modest increase in casualty written premium in 2007 due largely to an increase in new business while retaining its profitable renewals. Within the specialty casualty business, the Company will improve interaction with agents by reducing the number of internal touch points through the underwriting process and will realign the field office organization to better serve specialty construction accounts. Within professional liability, fidelity and surety, management expects an increase in written premium for 2008, primarily driven by increases in directors’ and officers’ insurance (“D&O”), errors and omissions insurance (“E&O”) and contract surety business. The Company will focus on D&O and E&O new business opportunities with both large and middle market private companies and seeks to grow its business in Europe through its new underwriting office in the United Kingdom. In addition, the Company will continue to cross-sell professional liability coverage to small businesses that purchase business owners package policies and capitalize on the increased demand for separate Side-A D&O insurance limits of liability that provide protection to individual directors and officers. In the face of written pricing decreases, the Company will maintain underwriting discipline when writing professional liability coverage for larger public companies. The increase in contract surety business will be driven, in part, by continued organic premium growth from the existing portfolio of accounts and by target marketing for new business opportunities. We will also seek to diversify our portfolio of commercial surety business, including a focus on growing our small bond book of business. Written premium growth could be lower than planned in any one or all of the Specialty Commercial businesses if written pricing is less favorable than anticipated and management determines that new and renewal business is not adequately priced.
Written pricing has been decreasing in professional liability and property lines of business. Since 2006, competition has intensified for professional liability business, particularly for directors’ and officers’ insurance coverage. A lower frequency of class action cases in the past couple of years has put downward pressure on rates. Written pricing for property business began to decline in the second half of 2007, primarily due to price competition which has resulted in lower pricing in the standard core excess and surplus lines markets. The industry has increased its capacity and appetite to write business in catastrophe-prone markets and this has increased competition in those markets.
A combined ratio before catastrophes and prior accident year development of 96.0 to 99.0
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 Company that have discontinued writing new business. The second is the management of claims (and the associated reserves) related to asbestos, environmental and other exposures. The Other Operations book of business contains policies written from approximately the 1940s to 2003. The Company’s experience has been that this book of run-off business has, over time, produced significantly higher claims and losses than were contemplated at inception.
A $40 decrease in income tax benefit, primarily as a result of a change from a pre-tax loss in 2006 to pre-tax income in 2007.
A $22 decrease in net investment income, primarily as a result of a decrease in invested assets resulting from net loss and loss adjustment expenses paid.
Gross of reinsurance, asbestos and environmental reserves, including liabilities in Ongoing Operations, were $2,707 and $290, respectively, as of December 31, 2007, $3,242 and $362, respectively, as of December 31, 2006, and $3,845 and $432, respectively, as of December 31, 2005.
During the third quarters of 2007, 2006 and 2005, the Company completed its annual ground up environmental reserve evaluations. In each of these evaluations, the Company reviewed all of its open direct domestic insurance accounts exposed to environmental liability as well as assumed reinsurance accounts and its London Market exposures for both direct insurance and assumed reinsurance. In all three
years, the Company found estimates for individual cases changed based upon the particular circumstances of each account. These changes were case specific and not as a result of any underlying change in the current environment. The net effect of these changes resulted in $25, $43 and $37 increases in net environmental liabilities in 2007, 2006 and 2005, respectively. The Company currently expects to continue to perform an evaluation of its environmental liabilities annually.
The following table displays gross environmental reserves and other statistics by category as of December 31, 2007.
The one year gross paid amount for total environmental claims is $121, resulting in a one year gross survival ratio of 2.4.
The three year average gross paid amount for total environmental claims is $108, resulting in a three year gross survival ratio of 2.7.
During the second quarter of 2007, an arbitration panel found that a Hartford subsidiary, established as a captive reinsurance company in the 1970s by The Hartford’s former parent, ITT, had additional obligations to ITT’s primary insurance carrier under ITT’s captive insurance program, which ended in 1993. When ITT spun-off The Hartford in 1995, the former captive became a Hartford subsidiary. The arbitration concerned whether certain claims could be presented to the former captive in a different manner than ITT’s primary insurance carrier historically had presented them. Principally as a result of this adverse arbitration decision, the Company recorded a charge of $99.
In conducting these evaluations of reinsurance recoverables, the Company used its most recent detailed evaluations of ceded liabilities reported in the segment. The Company analyzed the overall credit quality of the Company’s reinsurers, recent trends in arbitration and litigation outcomes in disputes between cedants and reinsurers, and recent developments in commutation activity between reinsurers and cedants. In 2006 and 2007, the Company also considered the effect of the Equitas settlement on the collectibility of amounts due from other upper-layer reinsurers under the BCT. The allowance for uncollectible reinsurance reflects management’s current estimate of reinsurance cessions that may be uncollectible in the future due to reinsurers’ unwillingness or inability to pay. As of December 31, 2007, the allowance for uncollectible reinsurance for Other Operations totals $267. The Company currently expects to perform its regular comprehensive review of Other Operations reinsurance recoverables annually. Uncertainties regarding the factors that affect the allowance for uncollectible reinsurance could cause the Company to change its estimates, and the effect of these changes could be material to the Company’s consolidated results of operations or cash flows.
The Company divides its gross asbestos exposures into Direct, Assumed Reinsurance and London Market. The Company further divides its direct asbestos exposures into the following categories: Major Asbestos Defendants (the “Top 70” accounts in Tillinghast’s published Tiers 1 and 2 and Wellington accounts), which are subdivided further as: Structured Settlements, Wellington, Other Major Asbestos Defendants; Accounts with Future Expected Exposures greater than $2.5, Accounts with Future Expected Exposures less than $2.5 and Unallocated.
The Wellington subcategory includes insureds that entered into the “Wellington Agreement” dated June 19, 1985. The Wellington Agreement provided terms and conditions for how the signatory asbestos producers would access their coverage from the signatory insurers.
An account may move between categories from one evaluation to the next. Reclassifications were made as a result of the reserve evaluation completed in the second quarter of 2007.
Survival ratio is a commonly used industry ratio for comparing reserve levels between companies. While the method is commonly used, it is not a predictive technique. Survival ratios may vary over time for numerous reasons such as large payments due to the final resolution of certain asbestos liabilities, or reserve re-estimates. The survival ratio presented in the above table is computed by dividing the recorded reserves by the average of the past three years of payments. The ratio is the calculated number of years the recorded reserves would survive if future annual payments were equal to the average annual payments for the past three years. The 3-year gross survival ratio of 5.4 as December 31, 2007 is computed based on total paid losses of $1.506 billion for the period from January 1, 2005 to December 31, 2007. As of December 31, 2007, the one year gross paid amount for total asbestos claims is $397 resulting in a one year gross survival ratio of 6.8.
Includes 26 open accounts at June 30, 2007. Included 28 open accounts at June 30, 2006.
Excludes asbestos and environmental paid and incurred loss and LAE reported in Ongoing Operations. Total gross losses and LAE incurred in Ongoing Operations for the twelve months ended December 31, 2007, 2006, and 2005 includes $9, $10 and $17, respectively, related to asbestos and environmental claims. Total gross losses and LAE paid in Ongoing Operations for the twelve months ended December 31, 2007, 2006, and 2005 includes $10, $12 and $23, respectively, related to asbestos and environmental claims.
The Company expects to perform its regular reviews of asbestos liabilities in the second quarter of 2008, Other Operations reinsurance recoverables and the allowance for uncollectible reinsurance in the second quarter 2008, and environmental liabilities in the third quarter of 2008. If there are significant developments that affect particular exposures, reinsurance arrangements or the financial condition of particular reinsurers, the Company will make adjustments to its reserves, or the portion of liabilities it expects to cede to reinsurers.
HIMCO’s security selection process is a multi-dimensional approach that combines independent internal credit research along with a macro-economic outlook of technical trends (e.g., interest rates, slope of the yield curve and credit spreads) and market pricing to identify valuation inefficiencies and relative value buying and selling opportunities. Security selection and monitoring are performed by asset class specialists working within dedicated portfolio management teams.
Fluctuations in interest rates affect the Company’s return on, and the fair value of, fixed maturity investments, which comprised approximately 61% and 66% of the fair value of its invested assets as of December 31, 2007 and 2006, respectively. Other events beyond the Company’s control, including changes in credit spreads, could also adversely impact the fair value of these investments. Additionally, 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 partnerships and other alternative investments in order to further diversify its investment portfolio. These investment types comprised approximately 23% and 21% of the fair value of its invested assets as of December 31, 2007 and 2006, 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.
The primary investment objective of Life’s general account is to maximize economic value consistent with acceptable risk parameters, including the management of the interest rate sensitivity of invested assets, while generating sufficient after-tax income to support policyholder and corporate obligations, as discussed in the Capital Markets Risk Management section of the MD&A under “Market Risk - Life”.
The following table identifies the invested assets by type held in the general account as of December 31, 2007 and 2006.
The following table summarizes Life’s limited partnerships and other alternative investments as of December 31, 2007 and 2006.
Yields calculated using investment income before investment expenses (excluding income related to equity securities held for trading) divided by the monthly weighted average invested assets at cost, amortized cost, or adjusted carrying value, as applicable excluding equity securities held for trading, collateral received associated with the securities lending program and consolidated variable interest entity minority interests. Included in the fixed maturity yield is Other income (loss) as it primarily relates to fixed maturities, see footnote [3] below. Included in the total net investment income yield is investment expense.
Other, net losses in both 2007 and 2006 primarily resulted from the change in value of non-qualifying derivatives due to fluctuations in credit spreads, interest rates, and equity markets. The increase in net losses in 2007 compared to the prior year was primarily due to changes in value associated with credit derivatives due to credit spreads widening. Credit spreads widened primarily due to the deterioration in the U.S. housing market, tightened lending conditions, the market’s flight to quality securities as well as increased likelihood of a U.S. recession. For further discussion, see the “Capital Market Risk Management” section of the MD&A.
For 2006, the yield on average invested assets increased slightly over the prior year. An increase in the yield on fixed maturities was offset by a decrease in the yield on limited partnerships.
Total net realized capital losses were higher in 2006 compared to 2005 primarily as a result of a higher interest rate environment. The components that drove the increase in net losses during the year ended December 31, 2006 included net losses on sales of fixed maturity securities, other-than-temporary impairments, and losses in Other, net, partially offset by a decrease in losses associated with GMWB derivatives. The circumstances giving rise to these components are as follows:
The net losses on fixed maturity sales for the year ended December 31, 2006 were primarily the result of rising interest rates from the date of security purchase and, to a lesser extent, credit spread widening on certain issuers that were sold. For further discussion of gross gains and losses, see the following discussion below.
Gross losses on sales for the year ended December 31, 2006, were primarily within fixed maturities and were concentrated in the corporate and commercial mortgage-backed securities (“CMBS”) sectors with no single security sold at a loss in excess of $6, and an
Separate account products are those for which a separate investment and liability account is maintained on behalf of the policyholder. The Company’s separate accounts reflect accounts wherein the policyholder assumes substantially all the risk and reward. Investment objectives for separate accounts, which consist of the participants’ account balances, vary by fund account type, as outlined in the applicable fund prospectus or separate account plan of operations. Separate account products include variable annuities (except those sold in Japan), variable universal life insurance contracts, 401(K) and variable corporate owned life insurance. The assets and liabilities associated with variable annuity products sold in Japan do not meet the criteria to be recognized as a separate account because the assets are not legally insulated from the Company. Therefore, these assets are included with the Company’s general account assets. As of December 31, 2007 and 2006, the Company’s separate accounts totaled $199.9 billion and $180.5 billion, respectively.
Limited partnerships and other alternative investments increased by $458 during 2007. HIMCO believes investing in limited partnerships provides an opportunity to diversify its portfolio and earn above average returns over the long-term. However, significant price volatility can exist quarter to quarter. Prior to investing, HIMCO performs an extensive due diligence process which attempts to identify funds that have above average return potential and managers with proven track records for results, many of which utilize sophisticated risk management techniques. Due to capital requirements, HIMCO closely monitors the impact of these investments in relationship to the investment portfolio and the overall consolidated balance sheets. HIMCO does not expect investments in limited partnerships to exceed 3% of the fair value of each statutory legal entity’s investment portfolio.
Yields calculated using investment income before investment expenses divided by the monthly weighted average invested assets at cost, amortized cost, or adjusted carrying value, as applicable, and collateral received associated with the securities lending program. Included in the fixed maturity yield is Other income (loss) as it primarily relates to fixed maturities, see footnote [3] below. Included in the total net investment income yield is investment expense.
Before-tax net investment income increased $201, or 14%, and after-tax net investment income increased $139, or 13%, compared to the prior year period. The increase in net investment income was primarily due to a higher average invested asset base and a higher portfolio yield. The increase in the average invested asset base as compared to the prior year period, was primarily due to positive operating cash flows. Limited partnerships and other alternative investments contributed to the increase in income compared to the prior year period due to a higher portfolio yield and greater allocation of investments to this asset class. Based upon market expectation of future interest rates and a lower expected yield from limited partnership and other alternative investments, Property and Casualty expects the average portfolio yield in 2008 to modestly decline compared to 2007 levels. The Company expects a lower yield from limited partnerships and other alternative investments primarily due to reduced liquidity and the wider credit spread environment.
For 2006, the yield on average invested assets was consistent with the prior year. An increase in the yield on fixed maturities was offset by a decrease in the yield on limited partnerships.
The carrying value of CLOs and other funds and Other investments is equal to fair value. Limited partnerships are accounted for under the equity method.
The maximum exposure to loss does not include changes in fair value or the Company’s proportionate shares of earnings associated with limited partnerships accounted for under the equity method. The Company’s maximum exposure to loss as of December 31, 2007 and 2006 based on the carrying value was $649 and $295, respectively. The Company’s maximum exposure to loss as of December 31, 2007 and 2006 based on the Company’s initial co-investment or amortized cost basis was $644 and $274, respectively.
As of December 31, 2007 and 2006, the Company had relationships with seven and four VIEs, respectively, where the Company was the primary beneficiary.
HIMCO is the collateral manager for four market value CLOs (included in the VIE discussion above) that invest in senior secured bank loans through total return swaps. For two of the CLOs, the Company has determined it is the primary beneficiary and accordingly consolidates the transactions. The maximum exposure to loss for these two consolidated CLOs, which is included in the “Collateral loan obligations and other funds” line in the table above, is $107 of which the Company has recognized a realized capital loss of $26. The Company is not the primary beneficiary for the remaining two CLOs, but maintains a significant involvement in the transactions. The maximum exposure to loss for these remaining two CLOs, included in the $150 in the preceding paragraph, is $37. The CLOs have triggers that allow the total return swap counterparty to terminate the transactions if the fair value of the aggregate referenced bank loan portfolio declines below a stated level. Due to the bank loan valuation declines in the first quarter of 2008, the CLO termination triggers were breached. The Company expects these transactions will be terminated in the first quarter of 2008 with a realized capital loss, which the Company estimates could be between $75-$115, before-tax.
For the year ended December 31, 2007, the other-than-temporary impairments reported as Credit related primarily consisted of ABS securities backed by sub-prime residential mortgage loans rated A and below in the 2006 and 2007 vintage years. Other credit related impairments were primarily in the financial services and home builders sectors. For the majority of the credit related impairments recognized during the year, the Company expects to recover principal and interest substantially greater than what the market price indicates. These impairments were included in credit related because of the extensive credit spread widening and were recognized due to the Company’s uncertainty of its intent to retain the investments for a period of time sufficient to allow recovery to amortized cost.
The following table presents the notional, fair value, derivative credit risk, and underlying referenced asset average credit ratings for credit derivatives in which the Company is assuming credit risk as of December 31, 2007.
Includes $2.0 billion, as of December 31, 2007, of a standard market index of diversified portfolios of corporate issuers referenced through credit default swaps. These swaps are subsequently valued based upon the observable standard market index.
The Company’s total return swaps assume the credit risk of a referenced portfolio of bank loans. Total return swaps involve the periodic exchange of payments with other parties, at specified intervals, calculated using the agreed upon index and notional principal amounts. The party assuming the credit risk receives periodic coupon payments plus changes in value of a referenced asset, portfolio or index while paying the other counterparty a fixed or floating cash flow unrelated to the referenced credit(s) or index. Typically, the net payments exchanged associated with total return swaps have similar economic characteristics to fixed maturities.
Includes securities with an amortized cost and fair value of $270 as of December 31, 2007, and $72 as of December 31, 2006, which were backed by pools of loans issued to Alt-A borrowers.
ABS CDOs was primarily related to the investment of the cash collateral received from securities lending programs into AAA rated CLOs that have underlying bank loan collateral. The increases in the financial services and municipal securities were due to the sectors attractive risk/return profiles. The majority of the increase in the financial services sector occurred during the first nine months of the year.
Securities backed by Alt-A residential mortgages, including CMOs, have an amortized cost and fair value of $366 and $357, respectively, as of December 31, 2007, and $99 as of December 31, 2006. These amounts are not included in the table.
The Company’s exposure to second lien residential mortgages is composed primarily of loans to prime and Alt-A borrowers, of which approximately half were wrapped by monoline insurers. These securities are included in the table above and have an amortized cost and fair value of $260 and $217, respectively, as of December 31, 2007 and $160 and $161, respectively, as of December 31, 2006.
As of December 31, 2007, the weighted average life of the sub-prime residential mortgage portfolio was 3.3 years.
Represents the current weighted average percentage, excluding wrapped securities, of the capital structure subordinated to the Company’s investment holding that is available to absorb losses before the security incurs the first dollar loss of principal.
Commercial real estate market cash flow fundamentals have been solid with mortgage delinquencies near all time lows. Recently, however, commercial real estate rents and property values have begun to soften. The following tables represent the Company’s exposure to CMBS bonds and commercial real estate CDOs by credit quality and vintage year.
In addition to commercial mortgage-backed securities, the company has whole loan commercial real estate investments. The carrying value of these investments was $5.4 billion and $3.3 billion as of December 31, 2007 and 2006, respectively. The Company’s mortgage loans are collateralized by a variety of commercial and agricultural properties. The mortgage loans are geographically dispersed throughout the United States and by property type. At December 31, 2007 and 2006, the Company held no impaired, restructured, delinquent or in-process-of-foreclosure mortgage loans and accordingly had no valuation allowance for mortgage loans at December 31, 2007 and 2006.
There are a growing number of concerns with consumer loans, including rising delinquency and default rates spurred on by the softening economy and higher unemployment rates. The Company expects delinquencies and losses on consumer loans to modestly rise in 2008, primarily associated with sub-prime borrowers. However, the Company does not expect its ABS consumer loan holdings to face credit concerns, as the quality and credit enhancement of the securities is sufficient to absorb a significantly higher level of defaults than are currently anticipated. The following table presents the Company’s exposure to ABS consumer loans by credit quality.
Monoline insurers guarantee the timely payment of principal and interest of certain securities. Municipalities will often purchase monoline insurance to “wrap” a security issuance in order to benefit from better market execution. As of December 31, 2007, the fair value of the Company’s total monoline insured securities was $8.7 billion, with the fair value of the insured municipal securities totaling $7.8 billion. At December 31, 2007, the overall credit quality of the municipal bond portfolio, including the benefits of monoline insurance, was AA+ and excluding monoline insurance, the overall credit quality dropped to AA-. In addition to the insured municipal securities, as of December 31, 2007 the Company has other insured securities with an amortized cost and fair value of $790 and $721, respectively. These securities include the below prime mortgage-backed securities and other consumer loan receivables discussed above and corporate securities. The Company also has direct investments in monoline insurers with a fair value of approximately $140 as of December 31, 2007.
Mortgage lenders are typically corporate securities within the financial services sector. Mortgage lenders and other financial service companies were forced to recapitalize to solidify balance sheets and financial position resulting from the significant sub-prime mortgage write-downs. The Company has favored broad based diversified financial institutions and has limited its holdings in entities that primarily write residential mortgage loans. As of December 31, 2007, the Company has approximately $374 and $348 of amortized cost and fair value, respectively, of securities for which the issuers primary business was residential mortgage lending.
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, 2007 and 2006, by length of time the security was in an unrealized loss position.
Financial services - As of December 31, 2007, the Company held approximately 230 different securities in the financial services sector that were in an unrealized loss position for greater than six months. Substantially all of these securities are rated investment grade securities, most of which are priced at, or greater than, 90% of amortized cost as of December 31, 2007. The increase in unrealized losses was primarily due to the recent credit spread widening stemming from concerns over risks in the sub-prime mortgage and leveraged finance markets and the associated impact of issuer credit losses, earnings volatility, and access to liquidity for companies involved in those markets as well as the financial sector as a whole. Future changes in fair value of these securities are primarily dependent on the extent of future issuer credit losses, return of liquidity, and changes in general market conditions, including interest rates and credit spread movements.
RMBS - As of December 31, 2007, the Company held approximately 100 different securities that had been in an unrealized loss position for greater than six months, of which 80% were rated AA and above. The remaining securities primarily consist of securities from vintage years 2005 and prior. Fundamentals impacting the RMBS market, as discussed in the “Sub-prime Residential Mortgage Loans” section above have caused a pull-back in market liquidity and repricing of risk. Future changes in fair value of these securities are primarily dependent upon sector fundamentals and credit spread movements.
As part of the Company’s ongoing security monitoring process by a committee of investment and accounting professionals, the Company has reviewed its investment portfolio and concluded that there were no additional other-than-temporary impairments as of December 31, 2007 and 2006. Due to the issuers’ continued satisfaction of the securities’ obligations in accordance with their contractual terms and the expectation that they will continue to do so, management’s intent and ability to hold these securities to recovery, as well as the evaluation of the fundamentals of the issuers’ financial condition and other objective evidence, the Company believes that the prices of the securities in the sectors identified above were temporarily depressed.
As interest rates decline, certain securities such as MBS and CMO as well as other mortgage loans backed securities are more susceptible to paydowns and prepayments. During such periods, the Company generally will not be able to reinvest the proceeds at comparable yields, however in 2007, in general, increases in credit spreads off-set lower interest rates. Lower interest rates will also likely result in lower net investment income increased hedging cost associated with variable annuities and, if declines are sustained for a long period of time, it may subject the Company to reinvestment risks, higher pension costs expense and possibly reduced profit margins associated with guaranteed crediting rates on certain Life products. Conversely, the fair value of the investment portfolio will increase when interest rates decline and the Company’s interest expense will be lower on its variable rate debt obligations.
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 variable annuity 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 fair value of the investment portfolio, increase interest expense on the Company’s variable rate debt obligations and, if
The Company is also exposed to credit spread risk related to security market price and cash flows associated with changes in credit spreads. Credit spreads widening will reduce the fair value of the investment portfolio and will increase net investment income on new purchases. This will also result in losses associated with credit based non-qualifying derivatives where the Company assumes credit exposure. If issuer credit spreads increase significantly or for an extended period of time, it would likely result in higher other-than-temporary impairments. Credit spreads tightening will reduce net investment income associated with new purchases of fixed maturities and increase the fair value of the investment portfolio.
Interest rate cap and floor contracts entitle the purchaser to receive from the issuer at specified dates, the amount, if any, by which a specified market rate exceeds the cap strike interest rate or falls below the floor strike interest rate, applied to a notional principal amount. A premium payment is made by the purchaser of the contract at its inception and no principal payments are exchanged.
Derivative activities are monitored by an internal compliance unit and reviewed frequently by senior management. The notional amounts of derivative contracts represent the basis upon which pay or receive amounts are calculated and are not reflective of credit risk. Notional amounts pertaining to derivative instruments used in the management of market risk, excluding the credit derivatives as discussed in the “Investment Credit Risk” section, at December 31, 2007 and 2006, were $101.0 billion and $78.2 billion, respectively. The increase in the derivative notional amount during 2007 was primarily due to the derivatives associated with the GMWB product feature. For further information, see Note 4 of Notes to Consolidated Financial Statements. For further discussion on credit derivatives, see the “Investment Credit Risk” section.
Life’s exposure to interest rate risk relates to the market price and/or cash flow variability associated with changes in market interest rates. As stated above, changes in interest rates can potentially impact Life’s profitability. In certain scenarios where interest rates are volatile, Life could be exposed to disintermediation risk and a reduction in net interest rate spread or profit margins. The investments and liabilities primarily associated with interest rate risk are included in the following discussion. Certain product liabilities, including those containing GMWB, GMAB, or GMDB, expose the Company to interest rate risk but also have significant equity risk. These liabilities are discussed as part of the Equity Risk section below.
The Company’s operations are significantly influenced by changes in the equity markets, primarily in the U.S., but increasingly in Japan and other global markets. The Company’s profitability in its investment products businesses depends largely on the amount of assets under management, which is primarily driven by the level of deposits, 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 effect 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 effect on the Company’s financial results, primarily due to lower fee income related to the Retail, Retirement Plans, Institutional and International and, to a lesser extent, the Individual Life segment, 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 U.S. 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.
In addition, immediate and significant declines in one or more equity markets may also decrease the Company’s expectations of future gross profits in one or more product lines, which are utilized to determine the amount of DAC to be amortized in reporting product profitability in a given financial statement period. A significant decrease in the Company’s future estimated gross profits would require the Company to accelerate the amount of DAC amortization in a given period, which, particularly in the case of U.S. variable annuities, could potentially cause a material adverse deviation in that period’s net income. Although an acceleration of DAC amortization would have a negative effect on the Company’s earnings, it would not affect the Company’s cash flow or liquidity position.
significant equity market movements, either up, to a level that the specified appreciation target is reached, or down by more than 20% of the actual deposit, can result in significant DAC charges as the life of the product will have expired upon reaching either target. There is also a return of premium death benefit attached to this product. In addition, the Company expects to make further changes in its living benefit offerings from time to time. Depending on the degree of consumer receptivity and competitor reaction to continuing changes in the Company’s product offerings, the Company’s future level of sales will continue to be subject to a high level of uncertainty. As of December 31, 2007, account values associated with 3 Win were $2.7 billion. In addition, as of December 31, 2007, guaranteed balances associated with 3 Win were $2.8 billion.
The accounting for various benefit guarantees offered with variable annuity contracts can be significantly different. Those accounted for under SFAS 133 (such as GMWBs or GMABs) are subject to significant fluctuation in value, which is reflected in net income, due to changes in interest rates, changes in the risk-free rate used for discounting equity markets and equity market volatility as use of those capital market rates are required in determining the liability’s fair value at each reporting date. Benefit guarantee liabilities accounted for under SOP 03-1 (such as GMIBs and GMDBs) may also change in value; however, the change in value is not immediately reflected in net income. Under SOP 03-1, the income statement reflects the current period increase in the liability due to the deferral of a percentage of current period revenues. The percentage is determined by dividing the present value of claims by the present value of revenues using best estimate assumptions over a range of market scenarios and discounted at a rate consistent with that used in the Company’s DAC models. Current period revenues are impacted by actual increases or decreases in account value. Claims recorded against the liability have no immediate impact on the income statement unless those claims exceed the liability. As a result of these significant accounting differences the liability for guarantees recorded under SOP 03-1 may be significantly different than if it was recorded under SFAS 133 and vice versa. In addition, the conditions in the capital markets in Japan vs. those in the U.S. are sufficiently different than if the Company’s GMWB product currently offered in the U.S. were offered in Japan, the capital market conditions in Japan would have a significant impact on the valuation of the GMWB, irrespective of the accounting model. The same would hold true if the Company’s GMIB product currently offered in Japan were to be offered in the U.S. Capital market conditions in the U.S. would have a significant impact on the valuation of the GMIB. Many benefit guarantees meet the definition of an embedded derivative, under SFAS 133 (GMWB and GMAB), and as such are recorded at fair value with changes in fair value recorded in net income. However, certain contract features that define how the contract holder can access the value and the substance of the guaranteed benefit change the accounting from SFAS 133 to SOP 03-1. For contracts where the contract holder can only obtain the value of the guaranteed benefit upon the occurrence of an insurable event such as death (GMDB) or when the benefit received is in substance a long-term financing (GMIB), the accounting for the benefit is prescribed by SOP 03-1.
In the U.S., the Company sells variable annuity contracts that offer various guaranteed death benefits. The Company maintains a liability, under SOP 03-1, for the death benefit costs of $529, as of December 31, 2007. 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 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.
The majority of the Company’s recent U.S. variable annuities are sold with a GMWB living benefit rider, which, as described above, is accounted for under SFAS 133. Declines in the equity market may increase the Company’s exposure to benefits under the GMWB contracts. For all contracts in effect through July 6, 2003, the Company entered into a reinsurance arrangement to offset its exposure to the GMWB for the remaining lives of those contracts. Substantially all U.S. GMWB riders sold since July 6, 2003 are not covered by reinsurance. These unreinsured contracts generate volatility in net income each quarter as the underlying embedded derivative liabilities are recorded at fair value each reporting period, resulting in the recognition of net realized capital gains or losses in response to changes in certain critical factors including capital market conditions and policyholder behavior. In order to minimize the volatility associated with the unreinsured GMWB liabilities, the Company established an alternative risk management strategy.
The net effect of the change in value of the U.S. and UK embedded derivatives, net of the results of the hedging program, for the years ended December 31, 2007 and 2006, was a loss of $285 (primarily reflecting modeling refinements, assumption changes and reflecting newly reliable market inputs for volatility made by the Company during 2007) and $(26) before deferred policy acquisition costs and tax effects, respectively. As of December 31, 2007, the notional and fair value related to the embedded derivatives, the hedging strategy and reinsurance was $73.8 billion and $55, respectively. As of December 31, 2006, the notional and fair value related to the embedded derivatives, the hedging strategy, and reinsurance was $53.3 billion and $377, respectively.
The Company continually seeks to improve its equity risk management strategies. The Company has made considerable investment in analyzing current and potential future market risk exposures arising from a number of factors, including but not limited to, product guarantees (GMDB, GMWB, GMAB, and GMIB), equity market and interest rate risks (in both the U.S. and Japan) and foreign currency exchange rates. The Company evaluates these risks individually and, increasingly, in the aggregate to determine the risk profiles of all of its products and to judge their potential impacts on U.S. GAAP net income, statutory capital volatility and other metrics. Utilizing this and future analysis, the Company expects to evolve its risk management strategies over time, modifying its reinsurance, hedging and product design strategies to optimally mitigate its aggregate exposures to market-driven changes in U.S. GAAP equity, statutory capital and other economic metrics. Because these strategies could target an optimal reduction of a combination of exposures rather than targeting a single one, it is possible that volatility of U.S. GAAP net income would increase, particularly if the Company places an increased relative weight on protection of statutory surplus in future strategies.
Each year, Life writes new variable annuity business with existing or new living benefit guarantees, while older business, often without living benefit guarantees, is naturally lapsing. As a result the exposure in the tail scenario is likely to increase over time.
Management regularly evaluates the model used to produce projections of distributable earnings and incorporates changes deemed necessary to improve the relevance and reliability of this estimate.
Life issues non-U.S. dollar denominated funding agreement liability contracts. The Company hedges the foreign currency risk associated with these liability contracts with currency rate swaps. At December 31, 2007 and 2006, the derivatives used to hedge foreign currency exchange risk related to foreign denominated liability contracts had a total notional value of $790 and $585, respectively, and a total fair value of $32 and $(11), respectively.
Based on the fair values of Life’s non-U.S. dollar denominated investments and derivative instruments (including its yen based individual fixed annuity product) as of December 31, 2007 and 2006, management estimates that a 10% unfavorable change in exchange rates would decrease the fair values by an after-tax total of $1 and $3, respectively. The estimated impact was based upon a 10% change in December 31 spot rates. The selection of the 10% unfavorable change was made only for illustration of the potential hypothetical impact of such an event and should not be construed as a prediction of future market events. Actual results could differ materially from those illustrated above due to the nature of the estimates and assumptions used in the above analysis.
The primary exposure to interest rate risk in Property & Casualty relates to its fixed maturity securities, including corporate bonds, ABS, municipal bonds, CMBS and CMOs. The fair value of these investments was $27.2 billion and $26.7 billion at December 31, 2007 and 2006, respectively. The fair value of these and Property & Casualty’s other invested assets fluctuates depending on the interest rate environment and other general economic conditions. A variety of derivative instruments, primarily swaps, are used to manage interest rate risk and had a total notional amount as of December 31, 2007 and 2006 of $1.8 billion and $2.1 billion, respectively, and fair value of $(15) and $(4), respectively.
Based on the fair values of Property & Casualty’s non-U.S. dollar denominated securities and derivative instruments as of December 31, 2007 and 2006, management estimates that a 10% unfavorable change in exchange rates would decrease the fair values by an after-tax total of approximately $37 and $34, respectively. The estimated impact was based upon a 10% change in December 31 spot rates. The selection of the 10% unfavorable change was made only for illustration of the potential hypothetical impact of such an event and should not be construed as a prediction of future market events. Actual results could differ materially from those illustrated above due to the nature of the estimates and assumptions used in the above analysis.
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 or other capital 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 were 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 Arrangements and Aggregate Contractual Obligations section below.
On February 12, 2007, The Hartford entered into a put option agreement (the “Put Option Agreement”) with Glen Meadow ABC Trust, a Delaware statutory trust (the “ABC Trust”), and LaSalle Bank National Association, as put option calculation agent. The Put Option Agreement provides The Hartford with the right to require the ABC Trust, at any time and from time to time, to purchase The Hartford’s junior subordinated notes (the “Notes”) in a maximum aggregate principal amount not to exceed $500. Under the Put Option Agreement, The Hartford will pay the ABC Trust premiums on a periodic basis, calculated with respect to the aggregate principal amount of Notes that The Hartford had the right to put to the ABC Trust for such period. The Hartford has agreed to reimburse the ABC Trust for certain fees and ordinary expenses. The Company holds a variable interest in the ABC Trust where the Company is not the primary beneficiary. As a result, the Company did not consolidate the Trust, as they did not meet the consolidation requirements under FIN 46(R).
In August 2007, The Hartford amended and restated its existing credit facility. The revolving credit facility provides for up to $2.0 billion of unsecured credit. Of the total availability under the revolving credit facility, up to $100 is available to support letters of credit issued on behalf of The Hartford or other subsidiaries of The Hartford. Under the revolving credit facility, the Company must maintain a minimum level of consolidated net worth. In addition, the Company must not exceed a maximum ratio of debt to capitalization. Quarterly, the Company certifies compliance with the financial covenants for the syndicate of participating financial institutions. As of December 31, 2007, the Company was in compliance with all such covenants.
In estimating the timing of future payments by year, the Company has assumed that its historical payment patterns will continue. However, the actual timing of future payments could vary materially from these estimates due to, among other things, changes in claim reporting and payment patterns and large unanticipated settlements. In particular, there is significant uncertainty over the claim payment patterns of asbestos and environmental claims. Also, estimated payments in 2008 do not include payments that will be made on claims incurred in 2008 on policies that were in-force as of December 31, 2007. In addition, the table does not include future cash flows related to the receipt of premiums that may be used, in part, to fund loss payments.
Under U.S. GAAP, the Company is only permitted to discount reserves for losses and loss adjustment expenses in cases where the payment pattern and ultimate loss costs are fixed and determinable on an individual claim basis. For the Company, these include claim settlements with permanently disabled claimants and certain structured settlement contracts that fund loss runoffs for unrelated parties. As of December 31, 2007, the total property and casualty reserves in the above table are gross of a reserve discount of $568.
Includes cash collateral of $4.7 billion which the Company has accepted in connection with the Company’s securities lending program and derivative instruments. Since the timing of the return of the collateral is uncertain, the return of the collateral has been included in the payments due in less than 1 year.
Pension expense reflected in the Company’s net income was $131, $152 and $137 in 2007, 2006 and 2005, respectively. The Company estimates its 2008 pension expense will be approximately $113, based on current assumptions.
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 difference between actual asset returns for the plans of $331 and $356 for the years ended December 31, 2007 and 2006, respectively, as compared to expected returns of $283 and $244 for the years ended December 31, 2007 and 2006, respectively, will be fully reflected in the market-related value of plan assets over the next five years using the methodology described above. The level of actuarial net losses continues to exceed the allowable amortization corridor as defined under SFAS No. 87. Based on the 6.25% discount rate selected as of December 31, 2007 and taking into account estimated future minimum funding, the difference between actual and expected performance in 2007 will decrease annual pension expense in future years. The decrease in pension expense will be approximately $2 in 2008 and will increase ratably to a decrease of approximately $12 in 2013.
The Hartford’s total capitalization as of December 31, 2007 increased $732 as compared with December 31, 2006. This increase was due to a $404 and $328 increase in total debt and total stockholders’ equity, respectively. Total debt increased from issuance of $500 of 5.375% senior notes, a $202 net increase in commercial paper and capital lease obligations, offset by $300 repayment on long-term debt. Total stockholders’ equity increased primarily due to net income of $2.9 billion partially offset by treasury stock acquired of $1.2 billion, other comprehensive loss of $1.0 billion, primarily due to unrealized losses on securities, and stockholder dividends of $643.
The following discussion describes the Company’s debt financing activities for 2007. For additional information regarding debt, see Note 14 of Notes to Consolidated Financial Statements.
Institutional Solutions Group began issuing Consumer Notes through its Retail Investor Notes Program in September 2006. A Consumer Note is an investment product distributed through broker-dealers directly to retail investors as medium-term, publicly traded fixed or floating rate, or a combination of fixed and floating rate, notes. In addition, discount notes, amortizing notes and indexed notes may also be offered and issued. Consumer Notes are part of the Company’s spread-based business and proceeds are used to purchase investment products, primarily fixed rate bonds. Proceeds are not used for general operating purposes. Consumer Notes are offered weekly with maturities up to 30 years and varying interest rates and may include a call provision. Certain Consumer Notes may be redeemed by the holder in the event of death. Redemptions are subject to certain limitations, including calendar year aggregate and individual limits equal to the greater of $1 or 1% of the aggregate principal amount of the notes and $250 thousand per individual, respectively. Derivative instruments will be utilized to hedge the Company’s exposure to interest rate risk in accordance with Company policy.
As of December 31, 2007 and 2006, $809 and $258 of consumer notes had been issued. These notes have interest rates ranging from 4.75% to 6.25% for fixed notes and for variable notes, either consumer price index plus 157 basis points to 267 basis points, or indexed to the S&P 500, Dow Jones Industrials or the Nikkei 225. The aggregate maturities of consumer notes are as follows: $222 in 2008, $494 in 2009, $34 in 2010, $19 in 2011 and $40 thereafter. For 2007 and 2006, interest credited to holders of consumer notes was $11 and $2, respectively.
Treasury stock acquired - For the year ended December 31, 2007, The Hartford repurchased $1.2 billion of its common stock (12.9 million shares) under its share repurchase program. For additional information regarding the share repurchase program, see the Liquidity Requirements section above.
AOCI - AOCI, net of tax, decreased by $1.0 billion as of December 31, 2007 compared with December 31, 2006. The decrease in AOCI, net of tax, includes unrealized losses on securities of $1.4 billion, primarily due to widening credit spreads associated with fixed maturities, partially offset by changes in gains on cash-flow hedging instruments of $94, change in foreign currency translation adjustments of $146, and pension and other postretirement plan adjustments of $141. Because The Hartford’s investment portfolio has a duration of approximately 5 years, a 100 basis point parallel movement in rates would result in approximately a 5% change in fair value. Movements in short-term interest rates without corresponding changes in long-term rates will impact the fair value of our fixed maturities to a lesser extent than parallel interest rate movements.
The increase in cash from operating activities compared to prior year period was primarily the result of premium cash flows in excess of claim payments, partially offset by increases in taxes paid. Net purchases of available-for-sale securities continue to account for the majority of cash used for investing activities. Cash from financing activities decreased primarily due to treasury stock acquired and increases in dividends paid; partially offset by higher net receipts from policyholder’s accounts related to investment and universal life contracts, proceeds from consumer notes, and issuance of long-term debt, net of repayments.
For a discussion of terrorism reinsurance legislation and how it affects The Hartford, see the “Risk Management Strategy-Terrorism” under the Property & Casualty section of the MD&A.