Certain of the statements contained herein are forward-looking statements. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include estimates and assumptions related to economic, competitive and legislative developments. These forward-looking statements are subject to change and uncertainty which are, in many instances, beyond the Company’s control and have been made based upon management’s expectations and beliefs concerning future developments and their potential effect upon the Company. There can be no assurance that future developments will be in accordance with management’s expectations or that the effect of future developments on the Company will be those anticipated by management. Actual results could differ materially from those expected by the Company, depending on the outcome of various factors, including, but not limited to, those set forth in Part II, Item 1A, Risk Factors. These important risks and uncertainties include, without limitation, uncertainties related to the depth and duration of the current recession and related financial crisis, and the impact of these volatile market conditions on, among other things, our investment portfolio, liabilities from variable annuity products and capital position; the success of our efforts to preserve capital and reduce risk, and the costs and charges associated therewith; our ability to participate in programs under the Emergency Economic Stabilization Act of 2008 and similar initiatives and the terms of such participation; changes in financial and capital markets, including changes in interest rates, credit spreads, equity prices and foreign exchange rates; the inability to effectively mitigate the impact of equity market volatility on the Company’s financial position and results of operations arising from obligations under annuity product guarantees; the amount of statutory capital that the Company has, changes to the statutory reserves and/or risk based capital requirements, and the Company’s ability to hold sufficient statutory capital to maintain financial strength and credit ratings; a downgrade in the Company’s financial strength or credit ratings; the incidence and severity of catastrophes, both natural and man-made; losses due to nonperformance or defaults by others; the potential for differing interpretations of the methodologies, estimations and assumptions that underlie the valuation of the Company’s financial instruments that could result in changes to investment valuations; the subjective determinations that underlie the Company’s evaluation of other-than-temporary impairments on available-for-sale securities; the potential for acceleration of DAC amortization; the potential for an impairment of our goodwill; the possible occurrence of terrorist attacks; the response of reinsurance companies under reinsurance contracts and the availability, pricing and adequacy of reinsurance to protect the Company against losses; stronger than anticipated competitive activity; unfavorable judicial or legislative developments; the potential effect of domestic and foreign regulatory developments, including those which could increase the Company’s business costs and required capital levels; the Company’s ability to distribute its products through distribution channels, both current and future; the ability to recover the Company’s systems and information in the event of a disaster or other unanticipated event; potential for difficulties arising from outsourcing relationships; potential changes in federal or state tax laws, including changes impacting the availability of the separate account dividend received deduction; the Company’s ability to protect its intellectual property and defend against claims of infringement; and other factors described in such forward-looking statements.
The Company is organized into three groups which are comprised of four reporting segments: The Retail Products Group (“Retail”) and Individual Life segments make up the Individual Markets Group. The Retirement Plans segment represents the Employer Market Group and the Institutional Solutions Group (“Institutional”) makes up its own group. The Company provides retail and institutional investment products such as variable and fixed annuities, private placement life insurance (“PPLI”) and retirement plan services, individual life insurance products including variable universal life, universal life, interest sensitive whole life and term life.
The Company includes in an Other category its leveraged PPLI product line of business; corporate items not directly allocated to any of its reportable operating segments; intersegment eliminations, guaranteed minimum income benefit (“GMIB’), guaranteed minimum death benefit (“GMDB”) guaranteed minimum withdrawal benefit (“GMWB”) and guaranteed minimum accumulation benefit (“GMAB”) reinsurance assumed from Hartford Life Insurance KK (“HLIKK”), a related party and subsidiary of Hartford Life, as well as certain group benefit products, including group life and group disability insurance that is directly written by the Company and for which nearly half is ceded to its parent, HLA.
impacts to individual variable annuity EGPs and earnings for DAC amortization caused by changes in separate account returns, mortality and future lapse rate assumptions:
Decrease: Expected fee income would decrease and expected claims would increase.
Increase: Expected fee income would increase because the time period in which fees would be collected would increase and claims would decrease.
Decrease: Expected fee income would decrease because the time period in which fees would be collected would be reduced and claims would decrease.
Estimating future gross profits is a complex process requiring considerable judgment and the forecasting of events well into the future. Given the current volatility in the capital markets and the evaluation of other factors, the Company will continually evaluate its separate account return estimation process and may change that process from time to time.
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 the use of internally developed models, which run a large number of stochastically determined scenarios of separate account fund performance. Incorporated in each scenario are assumptions with respect to lapse rates, mortality and expenses, based on the Company’s most recent assumption study. These scenarios are run for the Company’s individual variable annuity businesses, the Company’s Retirement Plans businesses, and for the Company’s individual variable universal life business and are used to calculate statistically significant ranges of reasonable EGPs. The statistical ranges produced from the stochastic scenarios are
As a result of the Unlock, death benefit reserves, in Retail, increased $389, pre-tax, offset by an increase of $273, pre-tax, in reinsurance recoverables.
The Company reduced its 20 year projected separate account return assumption from 7.8% to 7.2% in the U.S.
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:
The following were the most significant contributors to the Unlock amounts recorded during the third quarter of 2007:
As part of its continual enhancement to its assumption setting processes and in connection with its assumption study, the Company included dynamic lapse behavior assumptions. Dynamic lapses reflect that lapse behavior will be different depending upon market movements. The impact of this assumption change along with other base lapse rate changes was an approximate benefit of $40, after-tax, for U.S. variable annuities.
Sensitivity around lapses assumes lapses increase or decrease consistently across all cohort years and products.
The overall actual return generated by the variable annuity separate accounts is dependent on several factors, including the relative mix of the underlying sub-accounts among bond funds and equity funds as well as equity sector weightings and as a result of the large proportion of separate account assets invested in equity markets, the Company’s overall separate account fund performance has been reasonably correlated to the overall performance of the S&P 500, although no assurance can be provided that this correlation will continue in the future. Since September 30, 2008, the date of the last unlock, the actual return on U.S. variable annuity assets has been 21% below our estimated aggregate return. The Company estimates the actual return would need to drop by an additional 6% before EGPs in the Company’s models fall outside of the statistical ranges of reasonable EGPs.
An “Unlock” only revises EGPs to reflect current best estimate assumptions. With or without an Unlock, and even after an Unlock occurs, the Company must also test the aggregate recoverability of the DAC and sales inducement assets by comparing the existing DAC balance to the present value of future EGPs. In addition, the Company routinely stress tests its DAC and sales inducement assets for recoverability against severe declines in its separate account assets, which could occur if the equity markets experienced a significant sell-off, as the majority of policyholders’ funds in the separate accounts is invested in the equity market. As of December 31, 2008, the Company believed individual variable annuity EGPs could fall, through a combination of negative market returns, lapses and mortality, by at least 6% before portions of its DAC and sales inducement assets would be unrecoverable. The extent of the charge against earnings upon the DAC and sales inducement assets becoming unrecoverable is dependent upon how much further beyond the thresholds listed above variable annuity EGPs decline. The Company estimates that for every 1% decline in variable annuity EGPs beyond the thresholds listed above, the DAC and sales inducements write-off would be $65, after-tax, for U.S. variable annuity. If, at the end of any quarter, the EGPs in the Company’s models fall outside of the statistical ranges of reasonable EGPs and the Company has exceeded the threshold for recoverability, the Company will first “Unlock” the future EGPs to reflect the Company’s revised best estimates and second will re-test for recoverability.
risk-free rates as represented by the current LIBOR forward curve rates;
As many guaranteed benefit obligations are relatively new in the marketplace, actual policyholder behavior experience is limited. As a result, estimates of future policyholder behavior are subjective and based on analogous internal and external data. As markets change, mature and evolve and actual policyholder behavior emerges, management continually evaluates the appropriateness of its assumptions for this component of the fair value model.
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 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. Recent capital markets conditions, in particular high equity index volatility and low interest rates have increased the Attributed Fees for recent cohorts to a level above our rider fees.
increasing the value of the embedded derivative liability and the value of the reinsurance liability as of December 31, 2008 resulting in a realized loss in net income. Furthermore, changes in policyholder behavior can also significantly change the value of the GMWB embedded derivative liability, as well as the GMIB reinsurance liability. 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, as applicable, and decreases in lapses will all have the effect of increasing the value of the GMWB embedded derivative liability, and decreasing the value of the GMIB reinsurance liability, as applicable, as of December 31, 2008 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 embedded derivative liability and the reinsurance liability as of December 31, 2008 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.
The fair value for fixed maturity, short-term and equity securities, available-for-sale, is determined by management after considering one of three primary sources of information: third party pricing services, independent broker quotations or pricing matrices. Security pricing is applied using a “waterfall” approach whereby publicly available prices are first sought from third party pricing services, the remaining unpriced securities are submitted to independent brokers for prices, or lastly, securities are priced using a pricing matrix. Typical inputs used by these three pricing methods include, but are not limited to, reported trades, benchmark yields, issuer spreads, bids, offers, and/or estimated cash flows and prepayments speeds. Based on the typical trading volumes and the lack of quoted market prices for fixed maturities, third party pricing services will normally derive the security prices through recent reported trades for identical or similar securities making adjustments through the reporting date based upon available market observable information as outlined above. If there are no recent reported trades, the third party pricing services and brokers may use matrix or model processes to develop a security price where future cash flow expectations are developed based upon collateral performance and discounted at an estimated market rate. Included in the pricing of asset-backed securities (“ABS”), collateralized mortgage obligations (“CMOs”), and mortgage-backed securities (“MBS”) are estimates of the rate of future prepayments of principal over the remaining life of the securities. Such estimates are derived based on the characteristics of the underlying structure and prepayment speeds previously experienced at the interest rate levels projected for the underlying collateral. Actual prepayment experience may vary from these estimates.
In accordance with SFAS 157, the Company has analyzed the third party pricing services valuation methodologies and related inputs, and has also evaluated the various types of securities in its investment portfolio to determine an appropriate SFAS 157 fair value hierarchy level based upon trading activity and the observability of market inputs. The SFAS 157 fair value hierarchy prioritizes the inputs in the valuation techniques used to measure fair value into three broad levels (Level 1 - quoted prices in active markets for identical assets, Level 2 - significant observable inputs, or Level 3 - significant unobservable inputs). For further discussion of SFAS 157, see Note 4 in the Notes to the Consolidated Financial Statements. Based on this, each price was classified into Level 1, 2, or 3. Most prices provided by third party pricing services are classified into Level 2 because the inputs used in pricing the securities are market observable.
Due to a general lack of transparency in the process that brokers use to develop prices, most valuations that are based on brokers’ prices are classified as Level 3. Some valuations may be classified as Level 2 if the price can be corroborated. Internal matrix priced securities, primarily consisting of certain private placement debt, are also classified as Level 3. The matrix pricing of certain private placement debt includes significant non-observable inputs, the internally determined credit rating of the security and an externally provided credit spread.
The following table presents the fair value of fixed maturity, short-term and equity securities, available-for-sale, by pricing source and SFAS 157 hierarchy level as of December 31, 2008.
The evaluation of securities for 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 future prospects, the effects of changes in interest rates or credit spreads and the expected 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, during 2008, the Company concluded $1.9 billion of unrealized losses were other-than-temporarily impaired and as of December 31, 2008, the Company’s unrealized losses on available-for-sale securities of $9.8 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
SFAS No. 142, “Goodwill and Other Intangible Assets,” requires that goodwill balances be reviewed for impairment at least annually or more frequently if events occur or circumstances change that would indicate that
The goodwill impairment test follows a two step process as defined in SFAS 142. In the first step, the fair value of a reporting unit is compared to its carrying value. If the carrying value of a reporting unit exceeds its fair value, the second step of the impairment test is performed for purposes of measuring the impairment. In the second step, the fair value of the reporting unit is allocated to all of the assets and liabilities of the reporting unit to determine an implied goodwill value. This allocation is similar to a purchase price allocation performed in purchase accounting. If the carrying amount of the reporting unit goodwill exceeds the implied goodwill value, an impairment loss shall be recognized in an amount equal to that excess.
Management’s determination of the fair value of each reporting unit incorporates multiple inputs including discounted cash flow calculations, peer company price to earnings multiples, the level of The Hartford’s share price and assumptions that market participants would make in valuing the reporting unit. Other assumptions include levels of economic capital, future business growth, earnings projections, assets under management and the weighted average cost of capital used for purposes of discounting. Decreases in the amount of economic capital allocated to a reporting unit, decreases in business growth, decreases in earnings projections and increases in the weighted average cost of capital will all cause the reporting unit’s fair value to decrease.
However, as noted above, goodwill is reassessed at an interim date if certain circumstances occur which would cause the entity to conclude that it was more likely than not that the carrying value of one or more of its reporting units would be in excess of the respective reporting unit’s fair value. As a result of the sharp decline in the equity markets during the fourth quarter of 2008 and a comparable sharp decline in The Hartford’s share price below book value per share, the Company concluded, in connection with the preparation of its year end financial statements, that the conditions had been met to warrant an interim goodwill impairment test.
The Company believes one of the significant drivers in the decline of The Hartford’s traded per share price is the risks associated with the death and living benefit guarantees offered with the products sold by the Individual Annuity reporting unit and the related GAAP and statutory requirements.
The decrease in Life’s net income was due to the following:
Realized losses increased as compared to the comparable prior year period primarily due to net losses from impairments on investment securities as well as increased credit related losses and increased losses on GMWB/GMIB/GMAB reinsurance and the adoption of SFAS 157. For further discussion, please refer to the Realized Capital Gains and Losses by Segment table under the Operating Section of the MD&A.
Declines in assets under management in Retail, primarily driven by market depreciation of $37.8 billion for Individual Annuity during 2008, drove declines in fee income compared to 2007.
Net investment income on securities, available-for-sale, and other declined primarily due to declines in limited partnership and other alternative investment income and a decrease in investment yield for fixed maturities.
Increased income on asset growth in the variable annuity, retirement and institutional businesses.
During the first quarter of 2006, the Company achieved favorable settlements in several cases brought against the Company by policyholders regarding their purchase of broad-based leveraged corporate owned life insurance (“leveraged COLI”) policies in the early to mid-1990s and therefore, released a reserve for these matters of $34, after-tax.
During periods of volatile equity markets, policyholders may allocate more of their variable account assets to the fixed account options and fixed annuities may see increased sales. In the fourth quarter of 2008, the Company has seen an increase in fixed annuity deposits compared to prior quarters. Management expects this trend to continue throughout 2009 until the equity markets begin to stabilize and improve.
The decline in assets under management as a result of continued declines in the equity markets throughout 2008 have decreased the extent of the scale of efficiencies that Retail has benefited from in recent years. The significant reduction in assets under management has resulted in revenues declining faster than expenses causing lower earnings during the fourth quarter of 2008 and management expects this strain to continue in 2009. Management will continue to actively evaluate its expense structure to ensure the business is controlling costs while maintaining its level of service to our customers.
Sales and account values for variable universal life products have been under pressure due to continued equity market volatility and declines. For the year ended December 31, 2008, variable universal life sales and account values decreased 30% and 34%, respectively, compared to prior year. Continued volatility and declines in the equity markets may reduce the attractiveness of variable universal life products and put additional strain on future earnings as variable life fees earned by the Company are driven by the level of assets under management. The variable universal life mix was 41% of total life insurance in-force for the year ended December 31, 2008.
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. As of December 31, 2008, the transaction provided approximately $429 of statutory capital relief associated with the Company’s universal life products with secondary guarantees. The Company expects this transaction to accommodate future statutory capital needs for in-force business and new business written through approximately December 31, 2009. The use of the letter of credit will result in a decline in net investment income and increased expenses in future periods for Individual Life. As its business evolves in this product line, Individual Life will evaluate the need for, and availability of, an additional capital transaction which may impact the capacity to write these policies in the future.
For risk management purposes, Individual Life accepts and retains up to $10 in risk on any one life. Individual Life uses reinsurance where appropriate to mitigate earnings volatility; however, death claim experience may lead to periodic short-term earnings volatility. Individual Life is currently evaluating and preparing to implement changes to its reinsurance structure in 2009 in an effort to balance the overall profitability of its business while minimizing earnings volatility associated with higher retention limits.
Given the recent market declines and increased volatility during the fourth quarter of 2008, the Company has seen and expects that growth in Retirement deposits will be negatively affected if businesses reduce their workforces and offer more modest salary increases and as workers potentially allocate less to retirement accounts in the near term. The severe decline in equity markets in the second half of 2008 has significantly reduced Retirement Plans account values, which has strained its net income. This earnings strain is expected to continue throughout 2009 or until the equity markets improve.
Institutional’s markets are highly competitive from a pricing perspective, and a small number of cases often account for a significant portion of deposits. Most Institutional product issuances depend on pricing levels as well as the Company’s credit ratings and perceived financial stability and may be negatively impacted by credit rating agency downgrades of the Company that have occurred during February 2009 or could occur in the future.
During 2008, the Company ceased issuance of retail and institutional funding agreement backed notes, largely due to the change in customer preference to FDIC-insured products. Prospectively, the Company will issue only Guaranteed Investment Contracts (GIC) and on a limited basis, funding agreements. The Company will be disciplined and opportunistic in capturing new GIC and funding agreement opportunities, and accordingly, deposits in 2009 are expected to be substantially lower than 2008 amounts. The Company expects stable value products will experience negative net flows in 2009 as contractual maturities and the payments associated with certain contracts which allow an investor to accelerate principal repayments (after a defined notice period of typically thirteen months). Approximately $3.9 billion of account value will be paid out on stable value contracts during 2009. As of December 31, 2008, Institutional has no remaining contracts that contain an investor option feature that allows for contract surrender at book value. The Company has the option to accelerate the repayment of principal for certain other stable value products and will evaluate calling these contracts on a contract by contract basis based upon the financial benefits to the Company.
Account values, across all businesses, have had substantial reductions in values from prior year, primarily due to declines in equity markets during 2008. In addition:
Retail individual variable annuity recorded increased negative net flows as a result of increased competition and equity market volatility.
Retirement Plans group annuities has seen positive net flows driven by strong sales.
Individual Life variable universal life account values decreased primarily due to equity market declines, partially offset by positive net flows. Life insurance in-force growth has occurred across multiple product lines, including term, universal life and variable universal life.
Retail - Individual Annuity business accounts for the majority of the amortization of deferred policy acquisition costs and present value of future profits for the Company.
The Retail DAC amortization ratio (individual annuity), excluding the effects of the DAC Unlock and realized losses, decreased due to the write-off of goodwill and changes in assumptions made as part of the 2007 Unlock.
Individual Life death benefits increased, primarily due to growth of life insurance in-force and unfavorable mortality.
Institutional general insurance expense ratio decreased in 2007 primarily due to higher assets under management.
Management evaluates the rates of return various businesses can provide as an input in determining where additional capital should be invested to increase net income and shareholder returns. The Company uses the return on assets for the individual annuity business for evaluating profitability. In Individual Life, after-tax margin is a key indicator of overall profitability.
See “Realized Capital Gains and Losses by Segment” table within the this Section of the MD&A
The decrease in Individual Life’s after-tax margin, excluding realized gains (losses) and the effect of the DAC Unlock, was primarily due to lower net investment income from limited partnership and other alternative investments, unfavorable mortality, reduced net investment income associated with a more efficient capital approach for our secondary guarantee universal life business which released assets supporting capital and the related net investment income earned on those assets (described further in the “Outlook” section) and lower fees from equity market declines, partially offset by life insurance in-force growth, lower credited rates and higher surrender charges.
The increase in Retail Individual annuity’s ROA, excluding realized gain (losses) and DAC Unlock, was primarily due to increased net investment income on allocated capital and an increase in limited partnership and other alternative investment income. This was partially offset by an increase in the effective tax rate as a result of revisions in the estimates of the separate account DRD and FTC.
The decrease in Retirement Plans ROA, excluding realized gains (losses) and DAC Unlock, was primarily due to higher service and technology costs.
Gross gains on sales for the year ended December 31, 2006 were primarily within fixed maturities and were concentrated in corporate, U.S. government, and foreign government securities. Gross losses on sale for the year ended December 31, 2006 were primarily within fixed maturities and were concentrated in the corporate and CMBS sectors.
For the year ended December 31, 2008, the transition impact related to the SFAS 157 adoption was a reduction in revenues of $616. For further discussion of the SFAS 157 transition impact, refer to Note 3 in the Notes to the Consolidated Financial Statements.
Retail focuses on the savings and retirement needs of the growing number of individuals who are preparing for retirement, or have already retired, through the sale of individual variable and fixed annuities and other investment products. The Company is both a leading writer and seller of individual variable annuities and a top seller of individual variable annuities through banks in the United States.
further discussion of the SFAS 157 transition impact, see Note 3 in the Notes to the Consolidated Financial Statements. For further discussion of realized capital losses, see the Realized Capital Gains and Losses by Segment table under the Consolidated Results of Operations Section of the MD&A. For further discussion of the 2008 and 2007 Unlock; and the impairment of goodwill, see the Critical Accounting Estimates section of the MD&A. The following other factors also contributed to the changes in net income:
Amortization of DAC increased, primarily due to the impact of the 2008 Unlock charge as compared to the 2007 Unlock benefit, offset by DAC amortization benefits associated with increased realized capital losses. This was partially offset by a DAC benefit associated with the adoption of SFAS 157 at the beginning of the first quarter of 2008.
Insurance operating costs and other expenses increased for the year ended December 31, 2007. These increases were principally driven by non-deferrable variable annuity asset based commissions, which increased $67 for the year ended December 31, 2007 due to a 4% growth in assets under management, as well as an increase in the number of contracts reaching anniversaries when trail commission payments begin.
Insurance operating costs and other increased less than the growth of in-force business as a result of active expense management efforts.
Fee income and other decreased primarily due to the impacts of the 2007 and 2006 Unlocks. Offsetting the impacts of the Unlocks, fee income increased primarily due to higher cost of insurance charges, the largest component of fee income, of $35 primarily driven by growth in variable universal and universal life insurance in-force. Variable fee income increased consistent with the growth in variable universal life insurance account value.
Insurance operating costs and other expenses increased in 2007 consistent with life insurance in-force growth.
Net income in Retirement Plans decreased due to higher net realized capital losses, the higher DAC Unlock expense in 2008 as compared to 2007 and increased operating expenses. For further discussion of net realized capital losses, see Realized Capital Gains and Losses by Segment table under the Consolidated Results of Operations section of the MD&A. For further discussion of the DAC Unlock, see Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A. The following other factors contributed to the changes in net income:
Fee income declined as average account values were impacted by market depreciation of $7.3 billion, partially offset by positive net flows of $2.4 billion over the past four quarters.
Net investment income declined due to a decrease in limited partnership and other alternative investment income of $34, partially offset by growth in general account assets.
Insurance operating costs and other expenses increased for the year ended December 31, 2008, attributable to higher trail commissions from assets under management aging beyond their first year; and higher service and technology costs.
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 limited partnership and other alternative investments.
Benefits, losses and loss adjustment expenses and earned premiums decreased for the year ended December 31, 2008 primarily due to a large case annuitization in the 401(k) business of $12 which occurred in the first quarter of 2006. This decrease was partially offset by an increase in interest credited resulting from the growth in general account assets.
Institutional investment product account values include transfers from Retirement Plans of $413 and $350 from the Retail segment during 2006.
Earned premiums decreased as compared to the prior year due to greater amounts of life contingent business sold in 2007. The decrease in earned premiums was offset by a corresponding decrease in benefits, losses, and loss adjustment expenses.
PPLI collects front-end loads recorded in fee income, offset by corresponding premium taxes reported in insurance operating costs and other expenses. During the year ended December 31, 2007, PPLI had deposits of $5.2 billion, which resulted in an increase in fee income due to front-end loads of $107.
Net investment income increased due to higher assets under management resulting from positive net flows of $1.5 billion during the year, and higher returns on limited partnerships and other alternative investments. Net flows were favorable primarily as a result of the Company’s funding agreement backed Investor Notes program.
The change in income taxes was due to lower income before income taxes primarily driven by the increase in realized capital losses.
The transition impact related to the SFAS 157 adoption was a reduction in revenues of $172 for Other for the year ended December 31,2008. For further discussion of the SFAS 157 transition impact, please refer to Note 3 in the Notes to the Condensed Consolidated Financial Statements.
The Company includes in an Other category its leveraged PPLI product line of business; corporate items not directly allocated to any of its reporting segments; intersegment eliminations, guaranteed minimum income benefit, guaranteed minimum death benefit (“GMDB”), guaranteed minimum accumulation benefit and guaranteed minimum withdrawal benefit (“GMWB”) and reinsurance assumed from Hartford Life Insurance KK (“HLIKK”), a related party and subsidiary of Hartford Life, as well as certain group benefit products, including group life and group disability insurance that is directly written by the Company and for which nearly half is ceded to its parent, HLA.
See Realized Capital Gains and Losses by Segment table under the Consolidated Operating summary section of the MD&A.
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 30% of the fair value of its invested assets as of December 31, 2008 and 2007. 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 over the life of the investment to compensate for the liquidity risk.
Total investments decreased $125 since December 31, 2007 primarily as a result of increased unrealized losses on available-for-sale securities due to credit spread widening, offset by positive operating cash flows. In addition, the Company increased its investment in short-term securities in preparation for funding liability outflows and to maintain higher than average liquidity while waiting for market and asset valuations to stabilize. Mortgage loans increased due to diversification opportunities.
Mortgage and real estate funds consist of investments in funds whose assets consist of mortgage loans, participations in mortgage loans, mezzanine loans or other notes which may be below investment grade credit quality as well as equity real estate. Also included is the investment in a real estate joint venture.
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 excluding 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.
Year ended December 31, 2008 compared to the year ended December 31, 2007
Year ended December 31, 2007 compared to the year ended December 31, 2006
The following table summarizes the Company’s net realized capital gains and losses results.
The circumstances giving rise to the changes in these components are as follows:
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, variable universal life insurance contracts, 401(K) and variable corporate owned life insurance. As of December 31, 2008 and 2007, the Company’s separate accounts totaled $129.8 billion and $199.3 billion, respectively.
VIEs may or may not be consolidated on the Company’s consolidated financial statements. When the Company is the primary beneficiary of the VIE, all of the assets and liabilities of the VIE are consolidated into the Company’s financial statements. The Company also reports a liability for the portion of the VIE that represents the minority interest of other investors in the VIE. When the Company concludes that it is not the primary beneficiary of the VIE, only the fair value of the Company’s interest in the VIE is recorded in the Company’s financial statements.
Creditors have no recourse against the Company in the event of default by the VIE.
The Company’s maximum exposure to loss represents the maximum loss amount that the Company could recognize as a reduction in net investment income or as a realized capital loss and is the consolidated assets net of liabilities at cost. The Company has no implied or unfunded commitments to these VIEs.
CLOs represent one fund at December 31, 2008, which is a cash flow CLO financed by issuing debt in tranches of varying seniority and is a VIE due to the lack of voting equity in the capital structure. HIMCO provides collateral management services to the CLO and earns a fee for those services and the Company has investments in debt issued by the CLO. Taking those interests into consideration, the Company has performed a quantitative analysis and determined that it will absorb a majority of the expected losses or residual returns in the fund and as a result is the primary beneficiary. Consolidated assets are classified in cash and fixed maturities and consolidated liabilities are classified in other liabilities. At December 31, 2007, CLOs represent two market value CLOs, one of which converted to the cash flow CLO described above and the second which terminated during the fourth quarter of 2008.
As of December 31, 2008 and 2007, the Company also held significant variable interests in three and four VIEs, respectively, where the Company is not the primary beneficiary. That determination has been made based on a quantitative analysis of whether the Company will absorb a majority of the expected losses or residual returns of the VIE, considering its variable interests, as well as, those of other variable interest holders. These investments have been held by the Company for two years.
The following table sets forth the carrying value of assets and liabilities that relate to the Company’s variable interests in unconsolidated VIEs and the Company’s maximum exposure to loss resulting from involvement with those VIEs.
At December 31, 2008, CLOs include one fund that is financed by issuing debt securities in tranches of varying seniority. That fund is a cash flow CLO and a VIE due to the lack of voting equity in its capital structure. The Company holds variable interests through fees earned by HIMCO as the collateral manager and investments in debt issued by the fund with a carrying amount at December 31, 2008 of $280. At December 31, 2007, CLOs represent two market value CLOs, one of which converted to the cash flow CLO described above and the second for which the Company is no longer involved with following its conversion from a market value to a cash flow CLO.
The Company has a comprehensive security monitoring process overseen by a committee of investment and accounting professionals that, on a quarterly basis, identifies securities that could potentially be other-than-temporarily impaired. When a security is deemed to be other-than-temporarily impaired, its cost or amortized cost is written down to current fair value and a realized loss is recorded in the Company’s consolidated statements of operations. For fixed maturities, the Company accretes the new cost basis to par or to the estimated future value over the expected remaining life of the security by adjusting the security’s yield. For further discussion regarding the Company’s other-than-temporary impairment policy, see “Evaluation of Other-Than-Temporary Impairments on Available-for-Sale Securities” included in the Critical Accounting Estimates section of the MD&A and Note 1 of Notes to Consolidated Financial Statements.
Of the $931 of impairments on financial services companies for 2008, the Company does not anticipate substantial recovery of $224 due to bankruptcy, financial restructurings or concerns about the issuer’s ability to continue to make contractual payments. The remaining balance primarily relates to securities that experienced extensive credit spread widening and the Company could not reasonably assert that the security would recover in value in a reasonable period of time or the Company did not wish to assert its intent to hold the security until recovery. To the extent the Company does not sell these securities, the Company expects to recover principal and interest in accordance with the security’s contractual terms over a period up to and including the security’s contractual maturity.
Impairments on securitized securities totaled $589 for the year ended December 31, 2008. For these securities, the Company determines impairments by modeling cash flows in a severe negative economic outlook scenario. If the results of this cash flow modeling result in an economic loss, an impairment was taken. The Company continues to receive contractual principal and interest payments on the majority of CMBS and sub-prime ABS securities impaired, however the Company is uncertain of its ability to recover principal and interest in accordance with the security’s original contractual terms.
security would recover in value in a reasonable period of time. For the majority of these securities, the Company expects to recover principal and interest substantially greater than what the market price indicates.
For the year ended December 31, 2006, impairments were primarily recorded on corporate fixed maturities and ABS. In fixed maturities, impairments were across over 25 issuers with individually significant impairments (i.e., $10 or greater) recorded on any single security or issuer. The impairments on ABS primarily related to investments backed by aircraft lease receivables. Impairments resulted from higher than expected maintenance expenses.
Other than U.S. government and certain U.S. government agencies backed by the full faith and credit of the U.S. government, the Company’s exposures to credit concentration risk of single issuers greater than 10% of the Company’s stockholders’ equity, are as follows:
The Company minimizes the credit risk of derivative instruments by entering into transactions with high quality counterparties rated A2/A or better, which are monitored and evaluated by the Company’s risk management team and reviewed by senior management. In addition, the internal compliance unit monitors counterparty credit exposure on a monthly basis to ensure compliance with Company policies and statutory limitations. The Company
The Company has developed credit exposure thresholds which are based upon counterparty ratings. Credit exposures are measured using the market value of the derivatives, resulting in amounts owed to the Company by its counterparties or potential payment obligations from the Company to its counterparties. Credit exposures are generally quantified daily based on the prior business day’s market value and collateral is pledged to and held by, or on behalf of, the Company to the extent the current value of derivatives exceeds the contractual thresholds. In accordance with industry standards and the contractual agreements, collateral is typically settled on the next business day. The Company has exposure to credit risk for amounts below the exposure thresholds which are uncollateralized, as well as, for market fluctuations that may occur between contractual settlement periods of collateral movements.
For the year ended December 31, 2008, the Company has incurred losses of $39 on derivative instruments due to counterparty default related to the bankruptcy of Lehman Brothers Holdings Inc. These losses were a result of the contractual collateral threshold amounts and open collateral calls in excess of such amounts immediately prior to the bankruptcy filing, as well as, interest rate and credit spread movements from the date of the last collateral call to the date of the bankruptcy filing.
In addition to counterparty credit risk, the Company enters into credit derivative instruments to manage credit exposure. Credit derivatives used by the Company include credit default swaps, credit index swaps, and total return swaps.
The following table identifies fixed maturities by credit quality. The ratings referenced below are based on the ratings of a nationally recognized rating organization or, if not rated, assigned based on the Company’s internal analysis of such securities.
The Company’s investment ratings as a percentage of total fixed maturities experienced a downward shift from AAA since December 31, 2007 primarily due to rating agency downgrades of monoline insurers, as well as, downgrades of sub-prime, CMBS, and financial services sector securities. The movement in both government rated and BB & below securities is attributable to efforts to reallocate the portfolio to higher quality, risk adverse assets
Includes securities with an amortized cost and fair value of $170 and $108, respectively, as of December 31, 2008, and $212 as of December 31, 2007 which were backed by pools of loans issued to Alt-A borrowers.
The Company’s investment sector allocations as a percentage of total fixed maturities have significantly changed since December 31, 2007 primarily due to efforts to reallocate the portfolio to higher quality, risk adverse assets, such as U.S. government/government agencies, and recession resistance sectors, such as consumer non-cyclical, while reducing its exposure to CMBS, financial services and consumer cyclical sectors.
The available-for-sale net unrealized loss position increased $8.4 billion since December 31, 2007 primarily as a result of credit spread widening, partially offset by declining interest rates and impairments. Credit spreads widened primarily due to continued deterioration in the U.S. housing market, tightened lending conditions and the market’s flight to quality securities, as well as, a U.S. recession and a declining global economy. Despite steps taken by the government to stabilize the financial system, liquidity and confidence in the markets have not yet been restored. The sectors most significantly impacted include financial services, residential and commercial mortgage backed investments, and consumer loan backed investments. The following sections illustrate the Company’s holdings and provide commentary on these sectors.
Financial companies remain under significant stress driven initially by the housing market collapse which led to massive asset write-downs, an inability to source capital, funding pressure and a loss of confidence in the financial system. Numerous government initiatives were put forth over the course of 2008 to address the seizure in the financial and capital markets, including the injection of capital into financial institutions through the Treasury’s Capital Purchase Program, and the establishment of the FDIC Temporary Liquidity Guarantee Program (“TLGP”) whereby the FDIC guarantees newly issued unsecured debt for participating institutions. While the government’s efforts have provided some stability, financial institutions remain vulnerable to ongoing asset write-downs, increasing credit losses associated with a deteriorating economy, weak earnings prospects, and potentially the need for additional capital if losses further weaken current capital positions.
The following table represents Hartford Life Insurance Company’s, exclusive of its wholly-owned subsidiaries, exposure to the financial services sector. Of the Company’s $2.8 billion on a fair value basis, $1.3 billion is senior debt, $0.8 billion is subordinate and Tier 2 holdings and $0.7 billion is Tier 1 and preferred exposure. Our exposure to European financial institutions comprises $247 of senior debt, $394 of subordinate and Tier 2 holdings and $274 of Tier 1 and preferred holdings.
Approximately 93% of the portfolio is backed by adjustable rate mortgages.
The credit qualities above include downgrades which have shifted the portfolio from higher rated assets to lower rated assets since December 31, 2007.
The following table presents the holdings of Hartford Life Insurance Company’s, exclusive of its wholly-owned subsidiaries, exposure to CMBS.
As of December 31, 2008, approximately 30% of the underlying CMBS CRE CDO collateral are seasoned, below investment grade securities.
The following table presents the holdings of Hartford Life Insurance Company’s, exclusive of its wholly-owned subsidiaries, exposure to CMBS CRE CDOs.
As of December 31, 2008, approximately 28% of the underlying CMBS CRE CDO collateral are seasoned, below investment grade securities.
For certain CDO’s, the collateral manager has the ability to reinvest proceeds that become available, primarily from collateral maturities. The increase in the 2008 vintage year represents reinvestment under these CDO’s.
The following table presents the holdings of Hartford Life Insurance Company’s and its wholly-owned subsidiaries’ exposure to CMBS IOs.
In addition to commercial mortgage backed securities, the Company has whole loan commercial real estate investments. The carrying value of mortgage loans on real estate was $4.9 billion and $4.2 billion as of December 31, 2008 and 2007, respectively. The Company’s mortgage loans are collateralized by a variety of commercial and agricultural properties. The mortgage loans are diversified both geographically throughout the United States and by property type.
At December 31, 2008, the Company held delinquent mortgage loans on two properties with a carrying value of $32 which were deemed impaired and accordingly, a valuation allowance of $13 was established. At December 31, 2007, the Company held no impaired, restructured, delinquent or in-process-of-foreclosure mortgage loans and therefore had no valuation allowance.
than are currently anticipated. The following table presents the Company’s exposure to ABS consumer loans by credit quality.
As of December 31, 2008, approximately 8% of the securities were issued by lenders that lend primarily to sub-prime borrowers.
Includes monoline insured securities with an amortized cost and fair value of $33 and $26, respectively, at December 31, 2008, and amortized cost and fair value of $42 at December 31, 2007. Additionally, approximately 15% of the auto consumer loan-backed securities were issued by lenders whose primary business is to sub-prime borrowers.
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. Rating agency downgrades of bond insurers have not had a significant impact on the fair value of the Company’s insured portfolio; however, these downgrades have caused a downshift in rating quality from AAA rated since December 31, 2007. As of December 31, 2008, the fair value of the Company’s total monoline insured securities was $868, with the fair value of the insured municipal securities totaling $580. At December 31, 2008 and 2007, the overall credit quality of the municipal bond portfolio, including the benefits of monoline insurance, was A+ and AA+, respectively, and excluding the benefits of monoline insurance, the overall credit quality was A+ and AA-, respectively. In addition to the insured municipal securities, as of December 31, 2008, the Company has other insured securities with a fair value of $288. These securities include below prime mortgage-backed securities and other consumer loan receivables discussed above, as well as, corporate securities. The Company also has direct investments in monoline insurers with a fair value of approximately $28 as of December 31, 2008.
The following table presents the Company’s unrealized loss aging for available-for-sale securities by length of time the security was in a continuous unrealized loss position.
Future changes in the fair value of the investment portfolio 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.
The evaluation for other-than-temporary impairments is a quantitative and qualitative process, which is subject to risks and uncertainties in the determination of whether declines in the fair value of investments are other-than-temporary. The risks and uncertainties include changes in general economic conditions, the issuer’s financial condition and/or future prospects, the effects of changes in interest rates or credit spreads and the expected recovery period. In addition, for securitized assets with contractual cash flows (e.g., ABS and CMBS), projections of expected future cash flows may change based upon new information regarding the performance of the underlying collateral. As of December 31, 2008 and 2007, management’s expectation of the discounted future cash flows on these securities was in excess of the associated securities’ amortized cost. For a further discussion, see “Evaluation of Other-Than-Temporary Impairments on Available-for-Sale Securities” included in the “Critical Accounting Estimates” section of the MD&A and “Other-Than-Temporary Impairments on Available-for-Sale Securities” section in Note 1 of Notes to Consolidated Financial Statements.
The Company has a disciplined approach to managing risks associated with its capital markets and asset/liability management activities. Investment portfolio management is organized to focus investment management expertise on the specific classes of investments, while asset/liability management is the responsibility of a dedicated risk management unit supporting the Company. Derivative instruments are utilized in compliance with established Company policy and regulatory requirements and are monitored internally and reviewed by senior management. During 2008, the continued deterioration in the U.S. housing market, tightened lending conditions, the market’s flight to quality securities, the U.S. recession, and the declining global economy contributed to substantial spread widening in the Company’s fixed maturity portfolio.
The Company’s exposure to interest rate risk relates to the market price and/or cash flow variability associated with the changes in market interest rates. The Company manages its exposure to interest rate risk through asset allocation
limits, asset/liability duration matching and through the use of derivatives. The Company analyzes interest rate risk using various models including parametric models and cash flow simulation of the liabilities and the supporting investments, including derivative instruments under various market scenarios. Measures the Company uses to quantify its exposure to interest rate risk inherent in its invested assets and interest rate sensitive liabilities include duration and key rate duration. Duration is the weighted average term-to-maturity of a security’s cash flows, and is used to approximate the percentage change in the price of a security for a 100 basis point change in market interest rates. For example, a duration of 5 means the price of the security will change by approximately 5% for a 1% change in interest rates. The key rate duration analysis considers the expected future cash flows of assets and liabilities assuming non-parallel interest rate movements.
The Company is also exposed to interest rate risk based upon the discount rate assumption associated with the Parent’s pension and other postretirement benefit obligations. The discount rate assumption is based upon an interest rate yield curve comprised of bonds rated Aa or higher with maturities primarily between zero and thirty years. For further discussion of interest rate risk associated with the benefit obligations, see the Critical Accounting Estimates section of the MD&A under “Pension and Other Postretirement Benefit Obligations” and Note 14 of Notes to Consolidated Financial Statements.
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 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 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 long-term interest rates rise dramatically within a six to twelve month time period, certain businesses may be exposed to disintermediation risk. Disintermediation risk refers to the risk that policyholders will surrender their contracts in a rising interest rate environment requiring the Company to liquidate assets in an unrealized loss position. In conjunction with the interest rate risk measurement and management techniques, certain of the Company’s fixed income product offerings have market value adjustment provisions at contract surrender.
Derivative counterparty credit risk is measured as the amount owed to the Company based upon current market conditions and potential payment obligations between the Company and its counterparties. Credit exposures are generally quantified daily based on the prior business day’s market value and collateral is pledged to and held by, or on behalf of, the Company to the extent the current value of derivative instruments exceeds the contractual thresholds. In accordance with industry standards and the contractual agreements, collateral is typically settled on the next business day. The Company has exposure to credit risk for amounts below the exposure thresholds which are uncollateralized, as well as, for market fluctuations that may occur between contractual settlement periods of collateral movements.
The Company is also exposed to credit spread risk related to security market price and cash flows associated with changes in credit spreads. Credit spread 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 may 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. During 2008, credit spread widening resulted in a significant increase in the Company’s unrealized losses and other-than-temporary impairments. For further discussion of sectors most significantly impacted, see the “Investment Credit Risk” section. Also, see “Capital Resources and Liquidity” for a discussion of the widening of credit spread impacts on the Company’s statutory financial results as it relates to the accounting and reporting for market value fixed annuities.
The Company does not have significant equity risk exposure from invested assets. The Company’s primary exposure to equity risk relates to the potential for lower earnings associated with certain of the Company’s businesses such as variable annuities where fee income is earned based upon the fair value of the assets under management. In addition, the Company offers certain guaranteed benefits, primarily associated with variable annuity products, which increases the Company’s potential benefit exposure as the equity markets decline. For a further discussion, see Equity Risk under Key Market Risk Exposures section below.
The Company’s foreign currency exchange risk is related to non - U.S. dollar denominated investments, which primarily consist of fixed maturity investments and non-U.S. dollar denominated liability contracts, including its GMDB, GMAB, GMWB and GMIB benefits associated with its reinsurance of Japanese variable annuities, and a yen denominated individual fixed annuity product. A significant portion of the Company’s foreign currency exposure is mitigated through the use of derivatives.
Financial futures are standardized commitments to either purchase or sell designated financial instruments, at a future date, for a specified price and may be settled in cash or through delivery of the underlying instrument. Futures contracts trade on organized exchanges. Margin requirements for futures are met by pledging securities or cash, and changes in the futures’ contract values are settled daily in cash.
The Company’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 the Company’s profitability. In certain scenarios where interest rates are volatile, the Company 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 both written and assumed through reinsurance, including those containing GMWB, GMIB, 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 investment portfolios primarily consist of investment grade fixed maturity securities, including corporate bonds, ABS, CMBS, tax-exempt municipal securities and government bonds. The fair value of fixed maturities was $39.6 billion and $45.6 billion at December 31, 2008 and 2007, respectively. The fair value of fixed maturities and other invested assets fluctuates depending on the interest rate environment and other general economic conditions. The weighted average duration of the fixed maturity portfolio was approximately 5.2 and 4.5 years as of December 31, 2008 and 2007, respectively.
liability duration matching policy. Occasionally, swaps are also used to hedge the variability in the cash flow of a forecasted purchase or sale due to changes in interest rates.
At December 31, 2008 and 2007, notional amounts pertaining to derivatives utilized to manage interest rate risk totaled $14.2 billion and $14.3 billion, respectively ($12.3 billion and $10.6 billion, respectively, related to investments and $1.9 billion and $3.7 billion, respectively, related to life liabilities). The fair value of these derivatives was $247 and $35 as of December 31, 2008 and 2007, respectively.
The fixed liabilities included above represented approximately 59% and 69% of the Company’s general account liabilities as of December 31, 2008 and 2007, respectively. The assets supporting the fixed liabilities are monitored and managed within rigorous duration guidelines, and are evaluated on a monthly basis as well as annually using scenario simulation techniques in compliance with regulatory requirements.
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 due to the reinsurance of GMIB, GMAB, GMWB and GMDB benefits issued by HLIKK, an affiliate of the Company. Appreciation or depreciation in equity markets impacts certain assets and liabilities related to the Company’s variable products and the Company’s earnings derived from those products. The Company’s variable products include variable annuities and variable life insurance sold to retail and institutional customers. Substantially all of the Company’s variable annuity contracts contain a GMDB and a portion of those contracts also contain one or more living benefits. The Company’s maximum exposures disclosed below for death and living benefits are calculated independently; however, these exposures are substantially overlapping.
Generally, declines in equity markets , such as those experienced in 2008, will and did in 2008:
decrease the Company’s actual gross profits, resulting in a negative true-up to current period DAC amortization
The majority of the Company’s variable annuities are sold with a GMWB living benefit rider, which is accounted for under SFAS 133. Declines in the equity market may increase the Company’s exposure to benefits, under the GMWB contracts, leading to an increase in the Company’s existing liability for those benefits.
However, the only ways the GMWB contract holder can monetize the excess of the GRB over the account value of the contract is upon death or if their account value is reduced to a contractually specified minimum level, through a combination of a series of withdrawals that do not exceed a specific percentage of the premiums paid per year and market declines. If the account value is reduced to the contractually specified minimum level, the contract holder will receive an annuity equal to the remaining GRB and, for the Company’s “life-time” GMWB products, the annuity can continue beyond the GRB. As the amount of the excess of the GRB over the account value can fluctuate with equity market returns on a daily basis, and the ultimate life-time GMWB payments can exceed the GRB, the
The Company enters into various reinsurance agreements to reinsure GMDB benefits issued by an affiliated entity. For further discussion of transactions with affiliates, see Note 16.
reinsure GMWB risks associated with a block of business sold between the third quarter of 2003 and the second quarter of 2006. The Company’s GMWB reinsurance is accounted for as a freestanding derivative and is reported at fair value under SFAS 157. The Company also uses reinsurance to manage the risk exposure for a majority of the death benefit riders issued in the U.S.
In the fourth quarter of 2008, the global economy experienced severe weakening resulting from the dramatic decline in the equity markets, increasing equity index implied volatility, widening of credit spreads, significant declines in interest rates, and volatility in foreign currency exchanges rates. These significant and precipitous economic events increased, to varying degrees, the valuation of the Company’s exposure to death and living benefit guarantee liabilities, the statutory product guarantee liabilities, and the level of statutory surplus required to maintain the Company’s target RBC ratios.
See Capital Resources and Liquidity, Ratings for information on the equity risk impact on statutory results.
The Company’s exposure to foreign currency exchange risk exists with respect to non-U.S. dollar denominated investments and non-U.S. dollar denominated liability contracts, including the yen based individual fixed annuity product and its GMDB, GMAB, GMWB and GMIB benefits associated with its Japanese variable annuities, all of which are assumed from a related party. A portion of the Company’s foreign fixed maturity currency exposure is mitigated through the use of derivatives.
The risk associated with the non-U.S. dollar denominated fixed maturities relates to potential decreases in value and income resulting from unfavorable changes in foreign exchange rates. The fair value of the non-U.S. dollar denominated fixed maturities, which are primarily denominated in euro, sterling, yen and Canadian dollars, at December 31, 2008 and 2007, were approximately $2.9 billion and $1.5 billion, respectively. In order to manage its currency exposures, the Company enters into foreign currency swaps and forwards to hedge the variability in cash flows associated with certain foreign denominated fixed maturities. These foreign currency swap and forward agreements are structured to match the foreign currency cash flows of the hedged foreign denominated securities. At December 31, 2008 and 2007, the derivatives used to hedge currency exchange risk related to non-U.S. dollar denominated fixed maturities had a total notional value of $1.2 billion and $1.3 billion, respectively, and total fair value of $8 and $(284), respectively.
The yen based fixed annuity product is written by HLIKK and ceded to the Company. The underlying investment involves investing in U.S. securities markets, which offer favorable credit spreads. The yen denominated fixed annuity product (“yen fixed annuities”) assumed is recorded in the consolidated balance sheets with invested assets denominated in U.S. dollars while policyholder liabilities are denominated in yen and converted to U.S. dollars
Institutional 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. 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 maturities may extend up to 30 years and have contractual coupons based upon varying interest rates or indexes (e.g. consumer price index) and may include a call provision that allows the Company to extinguish the notes prior to its scheduled maturity date. 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. The aggregate limit is equal to the greater of $1 or 1% of the aggregate principal amount of the notes as of the end of the prior year. The individual limit is $250 thousand per individual. Derivative instruments are utilized to hedge the Company’s exposure to market risks in accordance with Company policy.
Consumer notes include principal payments, contractual interest for fixed rate notes, interest based on current rates for floating rate notes, and the market value of embedded derivatives for equity - linked notes. See Note 12 of Notes to Consolidated Financial Statements for additional discussion of consumer notes.
On December 23, 2008, A.M. Best affirmed the financial strength ratings for the Company and assigned a negative outlook. In the same action, the financial strength rating has been removed from under review with negative implications.
On February 9, 2009, S&P placed the Company’s ratings on CreditWatch with negative implications.
Certain assumptions used in the determination of Life benefit reserves are prescribed under US STAT and are intended to be conservative, while the assumptions used under US GAAP are generally the Company’s best estimates. In addition, the methodologies used for determining life reserve amounts are different between US STAT and U.S. GAAP. Annuity reserving and cash-flow testing for death and living benefit reserves under US STAT are generally addressed by the Commissioners’ Annuity Reserving Valuation Methodology and the related Actuarial Guidelines. Under these Actuarial Guidelines, in general, future cash flows associated with the variable annuity business are included in these methodologies with estimates of future fee revenues, claim payments, expenses, reinsurance impacts and hedging impacts. At December 31, 2008, in determining the cash-flow impacts related to future hedging, assumptions were made in the scenarios that generate reserve requirements, about the potential future decreases in the hedge benefits and increases in hedge costs which resulted in increased reserve requirements. Reserves for death and living benefits under U.S. GAAP are either considered embedded derivatives and recorded at fair value or they may be considered SOP 03-1 reserves.
US STAT for life insurance companies establishes a formula reserve for realized and unrealized losses due to default and equity risks associated with certain invested assets (the Asset Valuation Reserve), while US GAAP does not. Also, for those realized gains and losses caused by changes in interest rates, US STAT for life insurance companies defers and amortizes the gains and losses, caused by changes in interest rates, into income over the original life to maturity of the asset sold (the Interest Maintenance Reserve) while US GAAP does not.
State insurance regulators and the NAIC have adopted risk-based capital requirements for life insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks. The requirements provide a means of measuring the minimum amount of statutory surplus appropriate for an insurance company to support its overall business operations based on its size and risk profile.
A company’s risk-based statutory surplus is calculated by applying factors and performing calculations relating to various asset, premium, claim, expense and reserve items. Regulators can then measure the adequacy of a company’s statutory surplus by comparing it to the risk-based capital (“RBC”). Under RBC requirements, regulatory compliance is determined by the ratio of a company’s total adjusted capital, as defined by the insurance regulators, to its company action level of RBC (known as the RBC ratio), also as defined by insurance regulators. In addition, the rating agencies view RBC ratios along with their proprietary models as key factors in making ratings determinations. As of December 31, 2008, Hartford Life Insurance Company had more than sufficient capital to meet the NAIC’s minimum RBC requirements.
Our statutory surplus is also impacted by widening credit spreads as a result of the accounting for the assets and liabilities in our fixed market value adjusted (“MVA”) annuities. Statutory separate account assets supporting the fixed MVA annuities are recorded at fair value. In determining the statutory reserve for the fixed MVA annuities, we are required to use current crediting rates. In many capital market scenarios, current crediting rates are highly correlated with market rates implicit in the fair value of statutory separate account assets. As a result, the change in statutory reserve from period to period will likely substantially offset the change in the fair value of the statutory separate account assets. However, in periods of volatile credit markets, such as we are now experiencing, actual credit spreads on investment assets may increase sharply for certain sub-sectors of the overall credit market, resulting in statutory separate account asset market value losses. As actual credit spreads are not fully reflected in the current crediting rates, the calculation of statutory reserves will not substantially offset the change in fair value of the statutory separate account assets resulting in reductions in statutory surplus and create funding obligations to the statutory separate account.
For further information on other contingencies, see Note 10 of Notes to Consolidated Financial Statements.
Tax proposals and regulatory initiatives which have been or are being considered by Congress and/or the United States Treasury Department could have a material effect on the insurance business. These proposals and initiatives include, or could include, changes pertaining to the income tax treatment of insurance companies and life insurance products and annuities, repeal or reform of the estate tax and comprehensive federal tax reform. The nature and timing of any Congressional or regulatory action with respect to any such efforts is unclear.