Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) addresses the financial condition of Hartford Life, Inc. and its subsidiaries (“Hartford Life” or the “Company”) as of December 31, 2001, compared with December 31, 2000, and its results of operations for the years ended December 31, 2001, 2000 and 1999. This discussion should be read in conjunction with the Consolidated Financial Statements and related Notes beginning on page.
Hartford Life provides investment and retirement products such as variable and fixed annuities, mutual funds and retirement plan services; individual and corporate owned life insurance; and, group benefit products such as group life and group disability insurance.
[1] For the year ended December 31, 2001, represents the cumulative impact of the Company’s adoption of EITF Issue 99-20 and SFAS No. 133.
On April 2, 2001, The Hartford acquired the United States individual life insurance, annuity and mutual fund businesses of Fortis. This transaction was accounted for as a purchase and, as such, the revenues and expenses generated by this business from April 2, 2001 forward are included in the Company’s consolidated results of operations. (For further disclosure, see Note 5).
Benefits, claims and expenses increased $582, or 11%, primarily associated with the growth in revenues discussed above.
Benefits, claims and expenses increased $352, or 7%, primarily related to the growth in the Company’s principal operating segments described above.
Operating income increased $165, or 35%, led by the Investment Products segment, where net income increased $94, or 28%. Additionally, net income related to each of the remaining three operating segments increased 10% or more. As discussed above, Hartford Life also recorded benefits of $32 in 2000 related to favorable tax items. Excluding these tax items, operating income increased $133, or 28%.
A description of each segment as well as an analysis of the operating results summarized above is included on the following pages. Deferred Acquisition Costs (DAC), Reserves and Investments are discussed in separate sections.
Net income increased $39, or 9%. These increases were driven by the growth in revenues in other investment products described above, the favorable impact of Fortis and the lower effective tax rate related to the individual annuity business.
Net income increased $94, or 28%, primarily due to the growth in revenues discussed above. Additionally, the Investment Products segment continued to maintain its profit margins related to its primary businesses, thus contributing to the segment’s earnings growth. In particular, its individual annuity operation’s operating expenses as a percentage of average individual annuity account values remained consistent with the prior year at 21 basis points.
The market for retirement products continues to expand as individuals increasingly save and plan for retirement. Demographic trends suggest that as the “baby boom” generation matures, a significant portion of the United States population will allocate a greater percentage of their disposable income to saving for their retirement years due to uncertainty surrounding the Social Security system and increases in average life expectancy. As this market grows, particularly for variable annuities and mutual funds, new companies are continually entering the market, aggressively seeking distribution channels and pursuing market share. This trend is not expected to subside, particularly in light of the Gramm-Leach-Bliley Act of 1999 (“the Financial Services Modernization Act”), which permits affiliations among banks, insurance companies and securities firms.
Management believes that it has developed and implemented strategies to maintain and enhance its position as a market leader in the financial services industry. For example, Hartford Life is introducing a tax advantaged college savings product (529 Plan) in early 2002 called SMART 529. SMART 529 is a state-sponsored education savings program established by the State of West Virginia
Net income increased $8, or 11%, primarily due to higher fee income as mortality experience (death claims as a percentage of net amount at risk) was consistent with prior year.
Hartford Life is a leading provider of group benefits, and through this segment sells group life and group disability insurance as well as other products, including stop loss and supplementary medical coverage to employers and employer sponsored plans, accidental death and dismemberment, travel accident and other special risk coverages to employers and associations. The Company also offers disability underwriting, administration, claims processing services and reinsurance to other insurers and self-funded employer plans.
2001 Compared to 2000 - Revenues in the Group Benefits segment increased $300, or 14%, driven primarily by growth in earned premiums, which increased $278, or 14%, due to solid persistency and increased premium rates related to the in force block of business, and strong sales to new customers. Fully insured ongoing sales for the year ended December 31, 2001 were $531, $85 or 19% higher than the prior year. Additionally, net investment income increased $22, or 10% due to the overall growth in the in-force business.
Net income increased $16, or 18% driven by overall revenue growth and consistent loss and expense ratios as compared to the prior year. Group Benefits incurred an after-tax loss of $2 related to the September 11 terrorist attack; excluding this loss, net income increased $18, or 20%.
Total benefits, claims and expenses increased $171, or 9%, primarily due to higher benefits, claims and claim adjustment expenses which, excluding buyouts, increased $168, or 12%, directly related to revenue growth in this segment. The segment’s combined ratio (ratio of total benefits, claims and expenses as a percentage of earned premiums and other) was consistent with the prior year.
Net income increased $11, or 14%, primarily driven by the increased revenues described above.
As employers continue to offer benefit plans in order to attract and retain valued employees, management expects that the need for group life and group disability insurance will continue to expand and believes that the Company is well positioned to take advantage of this growth potential.
Hartford Life is a leader in the COLI market, which includes life insurance policies purchased by a company on the lives of its employees, with the company or a trust sponsored by the company named as beneficiary under the policy. Until the Health Insurance Portability and Accountability Act of 1996 (“HIPA Act of 1996”), the Company sold two principal types of COLI business, leveraged and variable products. Leveraged COLI is a fixed premium life insurance policy owned by a company or a trust sponsored by a company. The HIPA Act of 1996 phased out the deductibility of interest on policy loans under leveraged COLI through the end of 1998, virtually eliminating all future sales of this product. Variable COLI continues to be a product used by employers to fund non-qualified benefits or other postemployment benefit liabilities.
Total benefits, claims and expenses decreased $70, or 9%, consistent with the decline in revenues described above.
Net income increased $4, or 13%, principally due to the variable COLI business where related account values increased $3.6 billion, or 29%, as well as earnings associated with a block of leveraged COLI business recaptured in 1998.
The focus of this segment is variable COLI, which continues to be a product generally used by employers to fund non-qualified benefits or other postemployment benefit liabilities. The leveraged COLI product has been an important contributor to the Company profitability in recent years and will continue to contribute to the profitability of the Company in the future, although the level of profit is expected to decline over the long run. COLI is subject to a changing legislative and regulatory environment that could have a material adverse effect on its business.
Management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The most significant estimates include those used in determining deferred policy acquisition costs and the liability
Deferred policy acquisition costs related to investment contracts and universal life type contracts are deferred and amortized using the retrospective deposit method. Under the retrospective deposit method, acquisition costs are amortized in proportion to the present value of expected gross profits from investment, mortality and expense margins and surrender charges. Actual gross profits can vary from management’s estimates, resulting in increases or decreases in the rate of amortization. Management periodically reviews these estimates and evaluates the recoverability of the deferred acquisition cost asset. When appropriate, management revises its assumptions on the estimated gross profits of these contracts and the cumulative amortization for the books of business are re-estimated and adjusted by a cumulative charge or credit to income. The average rate of assumed future investment yield used in estimating expected gross profits related to variable annuity and variable life business was 9.0% at December 31, 2001 and for all other products including fixed annuities and other universal life type contracts, the average assumed investment yield ranged from 5.0-8.5%.
To date, the Company’s experience has generally been consistent or favorable to the assumptions used in determining DAC amortization. However, if the Company were to experience a material adverse deviation in certain critical assumptions, including surrender rates, mortality experience, or investment performance, there could be a negative affect to the Company’s reported earnings and shareholder’s equity.
The persistency of Hartford Life’s annuity and other interest-sensitive life insurance reserves is enhanced by policy restrictions on the withdrawal of funds. Withdrawals in excess of allowable penalty-free amounts are assessed a surrender charge during a penalty period, which is usually at least seven years. Such surrender charge is initially a percentage of either the accumulation value or considerations received, which varies by product, and generally decreases gradually during the penalty period. Surrender charges are set at levels to protect Hartford Life from loss on early terminations and to reduce the likelihood of policyholders terminating their policies during periods of increasing interest rates, thereby lengthening the effective duration of policy liabilities and improving the Company’s ability to maintain profitability on such policies.
Hartford Life’s investments are managed by Hartford Investment Management Company, a wholly-owned subsidiary of The Hartford. Hartford Investment Management Company is responsible for monitoring and managing the asset/liability profile, establishing investment objectives and guidelines, and determining, within specified risk tolerances and investment guidelines, the
appropriate asset allocation, duration, convexity and other characteristics of the portfolios. Security selection and monitoring functions are performed by asset class specialists working within dedicated portfolio management teams.
Invested assets in the Company’s general account totaled $28.4 billion as of December 31, 2001 and were comprised of $23.3 billion of fixed maturities, $3.3 billion of policy loans, equity securities of $428 and other investments of $1.3 billion. As of December 31, 2000, general account invested assets totaled $22.9 billion and were comprised of $18.2 billion of fixed maturities, $3.6 billion of policy loans, equity securities of $171 and other investments of $910. The decrease in policy loans was primarily due to the decline in leveraged COLI business (as discussed in the COLI section). Policy loans are secured by the cash value of the underlying life policy and do not mature in a conventional sense, but expire in conjunction with the related policy liabilities. The increase in other investments primarily reflects an increase in limited partnership investments.
The following table sets forth by type, the fixed maturity securities held in the Company’s general account as of December 31, 2001 and 2000.
As of December 31, 2001 and 2000, approximately 21% and 22%, respectively, of the Company’s fixed maturities were invested in private placement securities (including 12% and 13% of Rule 144A offerings as of December 31, 2001 and December 31, 2000, respectively). Private placement securities are generally less liquid than public securities. However, private placements generally have covenants designed to compensate for liquidity risk. Most of the private placement securities in the Company’s portfolio are rated by nationally recognized rating agencies. For further discussion of the Company’s investment credit policies, see the Capital Markets Risk Management section under “Credit Risk”.
Investment objectives for non-guaranteed separate accounts vary by fund type, as outlined in the applicable fund prospectus or separate account plan of operations. Non-guaranteed separate account products include variable annuities, variable life insurance contracts and variable COLI. Guaranteed separate account products primarily consist of modified guaranteed individual annuities and modified guaranteed life insurance and generally include market value adjustment features and surrender charges to mitigate the risk of disintermediation.
The Company invests primarily in securities which are rated investment grade and has established exposure limits, diversification standards and review procedures for all credit risks including borrower, issuer and counterparty. Creditworthiness of specific obligors is determined by an internal credit evaluation supplemented by consideration of external determinants of creditworthiness, typically ratings assigned by nationally recognized ratings agencies. Obligor, asset sector and industry concentrations are subject to established limits and monitored on a regular interval.
Hartford Life is not exposed to any significant credit concentration risk of a single issuer greater than 10% of the Company’s stockholders’ equity.
As of December 31, 2001 and 2000, over 96% and 97%, respectively, of the fixed maturity portfolio, including guaranteed separate accounts, was invested in investment grade securities. During 2001, the percentage of BBB related fixed maturity investments increased primarily due to the continued active management of the general account portfolios.
The Company uses derivative instruments in its management of market risk consistent with four risk management strategies: hedging anticipated transactions; hedging liability instruments; hedging invested assets and hedging portfolios of assets and/or liabilities. (For additional information on these strategies along with tables reflecting outstanding derivative instruments, see the discussions below.)
Derivative activities are monitored by an internal compliance unit, reviewed frequently by senior management and reported to The Hartford’s Finance Committee of the Board of Directors. 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 for both general and guaranteed separate accounts at December 31, 2001 and 2000 totaled $9.9 billion and $8.5 billion, respectively.
Changes in interest rates can potentially impact Hartford Life’s profitability. Under certain circumstances of interest rate volatility, the Company could be exposed to disintermediation risk and reduction in net interest rate spread or profit margins. The Company analyzes interest rate risk using various models, including multi-scenario cash flow projection models that forecast cash flows of the liabilities and their supporting investments, including derivative instruments. For non-guaranteed separate accounts, the Company’s exposure is not significant, as the policyholder assumes substantially all the investment risk.
The Company’s general account and guaranteed separate account investment portfolios primarily consist of investment grade, fixed maturity securities, including corporate bonds, asset backed securities, commercial mortgage backed securities, tax-exempt municipal securities and collateralized mortgage obligations. The fair value of these and the Company’s other invested assets fluctuates depending on the interest rate environment and other general economic conditions. During periods of declining interest rates, paydowns on mortgage backed securities and collateralized mortgage obligations increase as the underlying mortgages are prepaid. During such periods, the Company generally will not be able to reinvest the proceeds of any such prepayments at comparable yields. Conversely, during periods of rising interest rates, the rate of prepayments generally declines, exposing the Company to the possibility of asset/liability cash flow and yield mismatch. For a discussion of the Company’s risk management techniques to manage this market risk, see “Asset/Liability Management Strategies Used to Manage Market Risk” below.
Represents company obligated mandatorily redeemable preferred securities of subsidiary trust holding solely parent junior subordinated debentures.
The economic objectives and strategies for which the Company utilized derivatives are categorized as follows:
Liability Hedging - Several products obligate the Company to credit a return to the contract holder which is indexed to a market rate. To hedge risks associated with these products, the Company enters into various derivative contracts. Interest rate swaps are used to convert the contract rate into a rate that trades in a more liquid and efficient market. This hedging strategy enables the Company to customize contract terms and conditions to customer objectives and satisfies the operation’s asset/liability matching policy. In addition, interest rate swaps are used to convert certain variable contract rates to different variable rates, thereby allowing them to be appropriately matched against variable rate assets. Finally, interest rate caps and option contracts are used to hedge against the risk of contract holder disintermediation in a rising interest rate environment. The notional amounts of derivatives used for liability hedging as of December 31, 2001 and 2000 were $1.7 billion and $2.0 billion, respectively.
Portfolio Hedging -The Company periodically compares the duration and convexity of its portfolios of assets to its corresponding liabilities and enters into portfolio hedges to reduce any difference to desired levels. Portfolio hedges reduce the duration and convexity mismatch between assets and liabilities and offset the potential impact to cash flows caused by changes in interest rates. The notional amounts of portfolio hedges as of December 31, 2001 and 2000, were $1.1 and $1.0 billion, respectively.
Fixed Rate - Products in this category require the Company to pay a fixed rate for a certain period of time. The cash flows are not interest sensitive because the products are written with a market value adjustment feature and the liabilities have protection against the early withdrawal of funds through surrender charges. Product examples include fixed rate annuities with a market value adjustment and fixed rate guaranteed investment contracts. Contract duration is dependent on the policyholder’s choice of guarantee period.
Management of the duration of investments with respective policyholder obligations is an explicit objective of the Company’s management strategy. The estimated cash flows of insurance policy liabilities based upon internal actuarial assumptions as of December 31, 2001 are reflected in the table below by expected maturity year. Comparative totals are included for December 31, 2000.
As of December 31, 2001 and 2000, the fair value of the Company’s investment contracts, including guaranteed separate accounts, were $26.0 billion and $21.4 billion, respectively.
For liabilities whose cash flows are not substantially affected by changes in interest rates (fixed liabilities) and where investment experience is substantially absorbed by the Company, the sensitivity of the net economic value (discounted present value of asset cash flows less the discounted present value of liability cash flows) of those portfolios to 100 basis point shifts in interest rates is shown in the table below. These fixed liabilities represented approximately 61% and 60% of the Company’s general and guaranteed separate account liabilities at December 31, 2001 and 2000, respectively. The remaining liabilities generally allow the Company significant flexibility to adjust credited rates to reflect actual investment experience and thereby pass through a substantial portion of actual investment experience to the policyholder. The fixed liability portfolios are managed and monitored relative to defined objectives and are analyzed regularly by management for internal risk management purposes using scenario simulation techniques, and are evaluated annually in compliance with regulatory requirements.
Capital resources and liquidity represent the overall financial strength of Hartford Life and its ability to generate strong cash flows from each of the business segments and borrow funds at competitive rates to meet operating and growth needs. The Company maintained cash and short-term investments totaling $1.4 billion and $1.1 billion as of December 31, 2001 and 2000, respectively.
For a discussion of Debt, see Note 10 of Notes to Consolidated Financial Statements.
Hartford Life declared $66 in dividends for 2001 to Hartford Fire Insurance Company. Future dividend decisions will be based on, and affected by, a number of factors, including the operating results and financial requirements of Hartford Life on a stand-alone basis and the impact of regulatory restrictions discussed in Liquidity Requirements below.
As a holding company, Hartford Life, Inc. has no significant business operations of its own and, therefore, relies mainly on the dividends from its insurance company subsidiaries, which are primarily domiciled in Connecticut, as the principal source of cash to meet its obligations (predominantly debt obligations) and pay stockholder dividends. The Company’s direct regulated life insurance subsidiary, Hartford Life and Accident Insurance Company, declared and paid to the Company dividends of $128 in 2001. Statutory net loss in 2001 was $364 as compared to net income of $399 in 2000. The loss in the current year was primarily the result of the ceding commission paid on the Fortis Financial Group acquisition. Statutory capital and surplus as of December 31, 2001 was $3.0 billion, a 25% increase over December 31, 2000.
As a result of The Hartford Acquisition, during the second quarter of 2000, the Company canceled the remaining 80,152 treasury shares with a cost basis of $4.
A.M. Best ratings were adjusted to reflect the integration of A.M. Best’s debt and preferred stock scales.
As a result of the September 11 terrorist attack and subsequent reviews by major independent rating agencies, all insurance financial strength and debt ratings of the Company were reaffirmed. However, negative outlooks were placed upon the debt ratings of the Company by Moody’s. All other ratings were reaffirmed with stable outlooks.
The insurance holding company laws of the other jurisdictions in which Hartford Life’s insurance subsidiaries are incorporated or deemed commercially domiciled generally contain similar limitations on the payment of dividends.
The primary uses of funds are to pay claims, policy benefits, operating expenses and commissions and to purchase new investments. Hartford Life carries a significant short-term investment position and accordingly does not anticipate selling intermediate- and long-term fixed maturity investments to meet any liquidity needs. For a discussion of the Company’s investment objectives and strategies, see the Investments and Capital Markets Risk Management sections.
The National Association of Insurance Commissioners (“NAIC”) has regulations establishing minimum capitalization requirements based on risk-based capital (“RBC”) formulas for both life and property and casualty companies. The requirements consist of formulas, which identify companies that are undercapitalized and require specific regulatory actions. The RBC formula for life companies establishes capital requirements relating to insurance, business, asset and interest rate risks. As of December 31, 2001, Hartford Life had more than sufficient capital to meet the NAIC’s RBC requirements.
2001 Compared to 2000 - The decrease in cash provided by operating activities was primarily the result of the timing of the settlement of receivables, payables and other related liabilities. The increase in cash (used for) provided by investing activities and the decrease in cash used for financing activities primarily relates to the purchase of Fortis Financial Group. Operating cash flows in the periods presented have been more than adequate to meet liquidity requirements.
2000 Compared to 1999 - The increase in cash provided by operating activities was primarily the result of the timing of the settlement of receivables, payables and other related liabilities, as well as increased future policy benefits and net income associated with growth in the business. The decrease in cash (used for) provided by investing activities and the decrease in cash used for financing activities primarily relates to the significant downsizing of the leveraged COLI block of business during 1999 as compared to 2000. Operating cash flow in the periods presented have been more than adequate to meet liquidity requirements.
The enactment of the Financial Services Modernization Act has focused renewed attention on state regulation of insurance. Life insurers are working with state insurance regulators to improve and centralize the process for agent licensing and form filing. Both of these areas of regulation are critical to the development of new business. In addition, Congress may consider legislation providing for optional federal regulation of insurance in the future. These measures, state and federal, may lead to improved regulation and reduced transaction costs.
The NAIC adopted the Codification of Statutory Accounting Principles (“Codification”) in March 1998. The effective date for the statutory accounting guidance was January 1, 2001. Each of Hartford Life’s domiciliary states has adopted Codification, and the Company has made the necessary changes in its statutory accounting and reporting required for implementation. The overall impact of applying the new guidance resulted in a one-time statutory cumulative transition benefit of $74 in statutory surplus for the Company.
The rate of inflation as measured by the change in the average consumer price index has not had a material effect on the revenues or operating results of Hartford Life during the fiscal years presented.