MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Dollar amounts in millions, except per share data, unless otherwise stated)
Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) addresses the financial condition of The Hartford Financial Services Group, Inc. and its subsidiaries (The Hartford or the Company) as of December 31, 1999, compared with December 31, 1998, and its results of operations for the three years ended December 31, 1999, 1998 and 1997. This discussion should be read in conjunction with the Consolidated Financial Statements and related Notes beginning on page.
Consolidated Results of Operations: Operating Summary 11 North American Property & Casualty 13 Commercial 14 Personal 15 Reinsurance 16 Life 17 International 20 Other Operations 22 Reserves 22 Environmental and Asbestos Claims 23 Investments 25 Capital Markets Risk Management 28 Capital Resources and Liquidity 39 Regulatory Matters and Contingencies 41 Effect of Inflation 43 Accounting Standards 43
The Hartford defines "core earnings" as after-tax operational results excluding, as applicable, net realized capital gains or losses, the cumulative effect of accounting changes, allocated Distribution items (for additional information, see Note 17 of Notes to Consolidated Financial Statements) and certain other items. Core earnings is an internal performance measure used by the Company in the management of its operations. Management believes that this performance measure delineates the results of operations of the Company's ongoing businesses in a manner that allows for a better understanding of the underlying
trends in the Company's current business. However, core earnings should only be analyzed in conjunction with, and not in lieu of, net income and may not be comparable to other performance measures used by the Company's competitors.
In 1999, core earnings increased $21, or 3%, from 1998 primarily due to higher fee income in the Investment Products operation as a result of increasing assets under management. Partially offsetting this increase were a decrease in North American Property & Casualty net service fee and other income, due primarily to $55 of proceeds received in 1998 related to the Industrial Risk Insurance pool (IRI transaction), and lower International segment core earnings as a result of the sale of London & Edinburgh.
Revenues for 1998 increased $1.6 billion, or 12%, from 1997. This improvement was due primarily to higher aggregate fees earned on growth in account values in the Investment Products and Individual Life operations resulting from strong sales and equity market appreciation, the recapture of an in force block of COLI business (referred to as MBL Recapture) previously ceded to MBL Life Assurance Co. of New Jersey (MBL Life), an increase in earned premiums and service fee revenues in the Personal segment and higher net investment income. Partially offsetting these increases were lower net realized capital gains. In addition, revenues for 1998 also increased as a result of proceeds from the sale of renewal rights and other considerations related to the IRI transaction.
Minority interest in consolidated subsidiary represents an approximate 19% minority interest in HLI's operating results. (For additional information, see Note 2 of Notes to Consolidated Financial Statements and Capital Resources and Liquidity section under "The Offering".)
UNDERWRITING RESULTS 1999 1998 1997 - ----------------------------------------------------------------- Commercial $ (171) $ (213) $ (149) Personal 34 77 37 Reinsurance (48) (36) (14) - ----------------------------------------------------------------- TOTAL $ (185) $ (172) $ (126) - -----------------------------------------------------------------
NET INCOME 1999 1998 1997 - ----------------------------------------------------------------- N. A. Property & Casualty $ 448 $ 604 $ 583 Life 467 386 306 International 27 92 110 Other Operations [1] (80) (67) 333 - ----------------------------------------------------------------- NET INCOME $ 862 $ 1,015 $ 1,332 - ----------------------------------------------------------------- [1] 1997 includes a $368 equity gain resulting from the initial public offering of HLI.
As discussed above, The Hartford's management reviews and evaluates the performance of the three segments within North American Property & Casualty, Commercial, Personal and Reinsurance, primarily on an underwriting results basis. The combined underwriting results, along with items not directly allocable to the individual segments, are used in determining net income and core earnings of North American Property & Casualty. Items not directly allocable to the individual segments include net investment income, net realized capital gains or losses, other non-underwriting expenses, income taxes and certain other items.
(after-tax) 1999 1998 1997 - ---------------------------------------------------------------- Underwriting results $ (120) $ (112) $ (82) Net service fee and other income 12 52 3 Net investment income 684 656 619 Interest and other non-underwriting expenses[1] (142) (139) (107) - ---------------------------------------------------------------- CORE EARNINGS $ 434 $ 457 $ 433 - ---------------------------------------------------------------- [1] Excludes expenses related to service fees.
Core earnings in 1998 for North American Property & Casualty were $457, an increase of $24, or 6%, from 1997. The increase was primarily due to a $37, or 6%, increase in net investment income and a $49 increase in net service fee and other income (primarily as a result of the IRI transaction), partially offset by a $30, or 37%, decrease in after-tax underwriting results and a $32, or 30%, increase in interest and other non-underwriting expenses, which was primarily the result of an increase in certain corporate benefit and outside services expenses.
Written premiums decreased slightly in 1999 compared to 1998. Solid premium growth in The Hartford's small commercial businesses resulted in growth of 15%. These growth businesses represented 31% of the Commercial segment's written premiums in 1999 versus 27% in 1998. Enhanced product offerings, targeted geographic strategies and partnerships with other entities continued to be the primary drivers of these growth businesses. These increases, however, were more than offset by declines in the middle and large national account businesses primarily due to intense price competition in the casualty lines, where The Hartford's disciplined underwriting allowed business to move to other carriers rather than underpricing in order to retain accounts.
In 1998, written premiums decreased slightly compared to 1997. Small commercial business premiums grew 25%, and the bond and agricultural lines experienced 14% growth. Small commercial businesses represented 27% of the Commercial segment's written premiums in 1998 versus 21% in 1997. However, premium growth in these businesses was more than offset by declines in the middle and large national account businesses due to intense competition.
Difficult market conditions and intense price competition within many markets of the commercial sector are likely to continue into the foreseeable future despite some favorable trends. Each
market within the Commercial segment has implemented plans to achieve greater profitability in a marketplace that has experienced relatively flat growth overall. The segment has undertaken several major strategic actions, with some to be completed in 2000. Continued pricing and underwriting actions, primarily in the mid-to-large account marketplace should have a positive impact on overall profitability. Management expects the impacts of these efforts to continue into 2000 and beyond. Investments in such areas as technology, product research and development, advertising and staff training have continued, in an effort to heighten brand awareness, increase product offerings, further develop alternative distribution channels and improve productivity. Management believes the results of these and other actions taken may counterbalance the negative external factors in the commercial market and position the Commercial segment for improved written premium growth in 2000 and beyond, while maintaining core profitability.
Personal provides automobile, homeowners, home-based business and fire coverages to individuals across North America. Personal is organized to provide customized products and services to the following markets: the membership of AARP through a direct marketing operation; customers who prefer local agent involvement through a network of independent agents in the standard personal lines market and in the non-standard automobile market through Omni Insurance Group, Inc. (Omni), which was acquired in 1998; customers of Ford Motor Company and Ford Motor Credit Company (collectively, Ford) as well as customers of financial institutions through an affinity center which began in 1996 and is building from the AARP operation competencies; and customer service for all health insurance products offered through AARP's Health Care Options effective January 1, 1998. AARP's exclusive licensing arrangement continues through 2002 for automobile, homeowners and home-based business and through 2007 for Health Care Options. The Ford contract is for a five-year term through 2004. Management believes each of these agreements provides the Personal segment with an important competitive advantage.
Written premiums increased $250, or 11%, in 1999 compared with 1998. Omni written premiums increased $88, or 53%, contributing 4% to the segment's total written premium growth in 1999. As of December 31, 1999, non-standard automobile coverage through Omni was available in 33 states compared with 13 states at the time of acquisition in 1998. AARP written premiums increased $65, or 5%, contributing 3% to the segment's total written premium growth in 1999. Agency written premium growth was $31, or 5%, contributing 1% to the segment's total written premium growth in 1999. The Affinity unit experienced written premium growth of $66, or 120%, contributing 3% to the segment's total written premium growth in 1999. Written premium increases in all the units were achieved in light of very competitive pricing in the personal lines market, primarily in the personal automobile line. Servicing revenues from AARP's Health Care Options unit declined by $38 in 1999 due to revenues related to the transfer of business from the prior carrier in 1998.
Underwriting results decreased by $43, with a corresponding 2.5 point increase in the combined ratio, when compared to 1998. The decrease in underwriting results and increase in combined ratio resulted primarily from increased claim and claim adjustment expenses. Loss experience in the property line was higher in 1999 when compared to 1998 due to increases in both frequency and severity of claims. Claim adjustment expenses increased due to investments in claim initiatives for automobile bodily injury, physical damage and property to reduce loss costs in future periods. Catastrophe losses impacted the combined ratio by 2.9 points in 1999 compared to 3.5 points in 1998.
Underwriting results improved by $40, with a corresponding 1.5 point improvement in the combined ratio in 1998 compared
with 1997. The combined ratio decrease resulted from loss cost improvements in automobile and homeowners from expanded cost containment initiatives, effecting the combined ratio by 3.8 points. Offsetting this improvement were significantly higher property catastrophes in 1998 of $71 compared to $32 in 1997, impacting the combined ratio by 1.8 points, and increased underwriting expenses impacting the combined ratio by 0.5 points. Property catastrophe and other severe weather-related experience were unusually low in 1997. The increase in underwriting expenses was primarily from investments in growth initiatives, acquisition costs related to premium growth and from investment in the Affinity unit start-up organization, partially offset by lower dividends to policyholders.
Intense competition and consolidation in the personal market will remain in the foreseeable future. Management anticipates pricing will be moderately positive in 2000 versus the reductions that occurred in the last few years. Significant investments in claim initiatives in 1999 are expected to favorably impact loss cost trends in 2000 and beyond. Management believes the Personal segment is positioned for continued written premium growth through multiple distribution channels. Initiatives are being introduced, as a result of research findings, which are expected to attract more AARP members to the program. In 1999, Affinity entered into an agreement with Ford to market to its customers. The Hartford expects the Ford program to be a major market in the future. In the independent agency channel, investments in agency interface, new products and agency relations position The Hartford for premium growth. Omni will continue to expand into more states and penetrate a broader base of agents. Investments in such areas as advertising, product research and development, agency relations, technology and staff training will continue, in an effort to further heighten brand awareness, increase product offerings, further develop alternative distribution channels, improve productivity and reduce the expense ratio.
The Hartford assumes reinsurance worldwide through its thirteen Hartford Reinsurance Company (HartRe) offices located in the United States, Canada, the United Kingdom, France, Italy, Germany, Spain, Hong Kong and Taiwan. HartRe primarily writes treaty reinsurance through professional reinsurance brokers covering various property, casualty, specialty and marine classes of business.
Underwriting results for 1999 decreased $12, with a corresponding 1.5 point increase in the combined ratio from 1998. Excluding the finite risk account referred to above, which had no significant impact on underwriting results in 1998, the decrease in underwriting results was due primarily to loss development in 1999 from business written principally in 1998 in certain business classes, partially offset by recoveries under the aggregate stop loss treaty. Underwriting results for 1998 decreased $22, with a corresponding 3.1 point increase in the combined ratio, from 1997 due primarily to the impact of higher net property catastrophe losses of $47, which were somewhat offset by increased new business premiums in finite casualty which has a lower combined ratio than traditional casualty lines.
The Life segment consists of the following reportable operations: Investment Products, Individual Life, Employee Benefits and COLI. In addition, the Life segment includes in an Other category its international operations, which are primarily located in Latin America, and corporate items not directly allocable to any of its reportable operations.
On May 22, 1997, HLI, the holding company parent of The Hartford's significant life subsidiaries, completed the initial public offering of approximately 19% of its common stock. (For additional information, see the Capital Resources and Liquidity section under "The Offering".)
Revenues of $5.5 billion in 1999 decreased $252, or 4%, from 1998, primarily due to the declining block of leveraged COLI business. Excluding the COLI operation, revenues increased $484, or 11%, to $4.7 billion in 1999. This increase was driven primarily by the Investment Products and Employee Benefits operations where revenues increased $257 and $215, respectively. The Investment Products operation experienced higher fee income in the individual annuity and mutual fund businesses as a result of increased assets under management. The growth in assets under management was attributed to strong net cash flow, the result of higher sales and favorable persistency, as well as equity market appreciation. The Employee Benefits operation experienced higher premium revenue due to strong sales and persistency.
Core earnings of $467 in 1999 increased $81, or 21%, from 1998, primarily driven by the Company's increased fee income associated with higher assets under management in the Investment Products operation, as well as continued growth across its other reportable operations.
Revenues of $5.8 billion in 1998 increased $1.1 billion, or 23%, from 1997. The increase was due to the continued growth of revenues in the Investment Products operation of $274 and the Individual Life operation of $57 as a result of fees earned on higher assets under management which increased due to strong net cash flow and equity market appreciation. Additionally, revenues in the COLI operation increased $587 primarily due to the recapture in the fourth quarter of 1998 of an in force block of COLI business previously ceded to MBL Life. Higher revenues in the Employee Benefits operation of $109, primarily due to strong sales and renewals, also contributed to the revenue increase.
Core earnings of $386 in 1998 increased $80, or 26%, from 1997, primarily as a result of an increase in earnings in the Investment Products operation of $64 and in the Individual Life operation of $9, both of which were driven by higher fees associated with growth in assets under management. Additionally, earnings in the Employee Benefits operation increased $13 principally due to an increase in group insurance revenue and favorable mortality and morbidity experience.
The Investment Products operation 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 fixed and variable annuities, retail mutual funds, retirement plan services and other investment products. The Company was ranked the number one writer of individual variable annuities in the United States for 1999 according to Variable Annuity and Research Data Service (VARDS). In addition, during 1999, seven of the twelve retail mutual funds received Morningstar ratings and, as of December 31, 1999, all seven have three-, four- or five-star ratings.
Revenues in 1998 of $1.8 billion increased $274, or 18%, from 1997. This growth was driven by individual annuity revenues, which increased $268, or 31%, over the prior year due to higher fee income earned as a result of increased assets under management. Individual variable annuity account values increased $15.3 billion, or 33%, to $62.2 billion as of December 31, 1998, primarily due to continued strong net cash flow of individual variable annuities, as well as equity market appreciation. Individual variable annuity sales reached $9.9 billion and $9.7 billion in 1998 and 1997, respectively. Associated with the strong sales and continued growth in Investment Products, amortization of deferred policy acquisition costs increased $76, or 30%, and operating expenses increased $52, or 27%, over prior year levels. Substantial growth in assets under management in 1998, coupled with continued operating efficiencies, increased the operation's core earnings $64, or 32%, to $266 in 1998 from $202 in 1997.
Revenues of $567 in 1998 increased $57, or 11%, from 1997, due to growth in fee income associated with increases in life insurance in force and variable life account values. Life insurance in force increased 10% to $61.1 billion in 1998; and variable life account values increased $651, or 61%, to $1.7 billion in 1998 due to strong sales of $127 in 1998, a 30% increase over prior year levels, as well as equity market appreciation. Benefits, claims and claim adjustment expenses and amortization of deferred costs increased $18, or 7%, and
$21, or 24%, respectively, over prior year levels. The growth in the Individual Life operation's account values, particularly variable life, and life insurance in force resulted in an increase in core earnings of $9, or 16%, in 1998.
The Employee Benefits operation 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. According to the latest results published by Life Insurance Marketing and Research Association (LIMRA), the Company was the third largest provider of group disability insurance in the United States for the nine months ended September 30, 1999.
Revenues in the Employee Benefits operation of $2.0 billion in 1999 increased $215, or 12%, from 1998. Revenues, excluding buyouts, increased $191, or 11%, in 1999 as a result of increased premiums due to strong sales and persistency, as well as higher net investment income. Benefits, claims and expenses increased $211, or 12%, in 1999, primarily due to higher benefits, claims and claim adjustment expenses due to the growth in this operation. Excluding buyouts, total benefits, claims and expenses increased $187, or 11%, and as a percentage of revenues were consistent in 1999 as compared to 1998, indicating a continuation of favorable mortality and morbidity experience. The increased revenues resulted in an increase in core earnings of $8, or 11%, in 1999.
The COLI operation includes life insurance products sold primarily for funding of non-qualified benefit and other postemployment benefit programs provided by corporations, and also includes business sold on a leveraged basis.
COLI revenues of $831 in 1999 decreased $736, or 47%, from 1998. This decrease was primarily due to the downsizing of the leveraged COLI business associated with the Health Insurance Portability and Accountability Act of 1996 (HIPA Act of 1996), which phased out the deductibility of interest expense on policy loans. Leveraged COLI account values decreased $3.4 billion, or 37%, to $5.7 billion in 1999. Benefits, claims and expenses decreased $747, or 49%, to $784 for 1999 as compared to 1998, primarily attributable to the downsizing of the leveraged COLI business. Core earnings increased $6, or 25%, in 1999, primarily due to increases associated with higher variable COLI account values. Additionally, leveraged COLI core earnings increased due to earnings associated with the MBL business recaptured in November 1998, as discussed earlier, which was partially offset by decreases associated with the reduction of the overall leveraged COLI business.
earnings decreased 33% due to an increased loss ratio, lower net investment income and higher expenses associated with Year 2000 and Euro conversion initiatives. Life core earnings at Zwolsche increased with continued favorable operating performance in savings and asset management product areas. A core earnings loss at Hartford Seguros increased $5 from 1998 primarily due to a higher automobile loss ratio resulting from increased claims frequency. Various actions, including rate increases and a more strict underwriting policy, including agent cancellations, have been implemented to remediate the situation. The lower core earnings in International for 1999 have been offset primarily by lower home office expenses. Additionally, a negative foreign exchange impact of $1 on 1999 earnings resulted primarily from weakness in the Euro.
Core earnings of $42 in 1998 decreased $4, or 9%, from 1997. The decrease in core earnings from 1997 was due to declining automobile underwriting results at Hartford Seguros, a slightly higher casualty loss ratio and higher expenses related to Year 2000 and Euro conversion initiatives at Zwolsche and higher home office expenses in Other. Partially offsetting these decreases was a $6 increase at London & Edinburgh. The increase at London & Edinburgh was due to improved personal lines results, including automobile, offset by higher losses from weather events, losses related to professional liability claims and a lower effective tax rate. A negative foreign exchange impact of $1 resulted primarily from weakness in the Dutch Guilder.
Except for the uncertainties related to dispute resolution, reinsurance collection and those discussed in the Environmental and Asbestos Claims section, management does not anticipate the future financial performance of Other Operations to have a material effect on the future operating results of the Company.
In accordance with the insurance laws and regulations under which the Life segment operates, life insurance subsidiaries of The Hartford establish actuarially determined reserves to meet their obligations on their outstanding life and disability insurance contracts, as well as reserves for their universal life and investment contracts. Reserves for life insurance and disability contracts are based on mortality and morbidity tables in general use in the United States, modified to reflect The Hartford's experience. Management believes that these reserves, with additions from premiums to be received, and with interest on such reserves compounded annually at certain
assumed rates, will be sufficient to meet The Hartford's policy obligations at their maturities or in the event of an insured's death. Reserves for universal life insurance and investment products represent policy account balances before applicable surrender charges.
Within the property and casualty insurance industry in the mid-1990s, progress was made in developing sophisticated, alternative methodologies utilizing company experience and supplemental databases to assess environmental and asbestos liabilities. Consistent with The Hartford's practice of using the best techniques to estimate the Company's environmental and asbestos exposures, a study was initiated in April 1996. The Hartford, utilizing internal staff supplemented by outside legal and actuarial consultants, completed the study in October 1996.
In addition to estimating liabilities on reported environmental and asbestos claims, The Hartford estimated reserves for claims incurred but not reported (IBNR). The IBNR reserve was estimated using information on reporting patterns of known insureds, characteristics of insureds such as limits exposed, attachment points and number of coverage years involved, third party costs, and closed claims.
The Hartford believes that the environmental and asbestos reserves reported at December 31, 1999 are a reasonable estimate of the ultimate remaining liability for these claims based upon known facts, current assumptions and The Hartford's methodologies. Future social, economic, legal or legislative developments may alter the original intent of policies and the scope of coverage. The Hartford will continue to evaluate new developments and methodologies, as they become available for use in supplementing the Company's ongoing analysis and review of its environmental and asbestos exposures. These future reviews may result in a change in reserves, impacting The Hartford's results of operations in the period in which the reserve estimates are changed. While the effects of future changes in facts, legal and other issues could have a material effect on future results of operations, The Hartford does not expect such changes would have a material effect on its liquidity or financial condition.
An important element of the financial results of The Hartford is return on invested assets. The Hartford's investment portfolios are divided between North American Property & Casualty, Life, International and Other Operations. The investment portfolios are managed based on the underlying characteristics and nature of each operation's respective liabilities and within established risk parameters. (For a further discussion on The Hartford's approach to managing risks, see the Capital Markets Risk Management section.)
Fixed Maturities by Type - ------------------------------------------------------------------ 1999 1998 - ----------------------------------------------------------------- Type Fair Value Percent Fair Value Percent - ----------------------------------------------------------------- Municipal - tax-exempt $ 8,160 62.5% $ 8,804 61.5% Corporate 1,668 12.8% 2,119 14.8% Commercial MBS 696 5.3% 834 5.8% Gov't/Gov't agencies - For. 606 4.7% 501 3.5% ABS 419 3.2% 500 3.5% MBS - agency 413 3.2% 348 2.4% CMO 228 1.8% 415 2.9% Gov't/Gov't agencies - U.S. 34 0.3% 46 0.3% Municipal - taxable 17 0.1% 24 0.2% Short-term 697 5.3% 663 4.6% Redeemable preferred stock 109 0.8% 65 0.5% - ----------------------------------------------------------------- Total fixed maturities $ 13,047 100.0% $ 14,319 100.0% - -----------------------------------------------------------------
In 1999, total invested assets for North American Property & Casualty declined primarily as a result of the impact of rising interest rates. Among the portfolio actions taken during the year were a reduction in taxable bonds (primarily Corporate, Commercial MBS and CMO securities) and an increase in limited partnership investments.
For the year ended December 31, 1999, both before- and after-tax net investment income increased by 4% over 1998. These increases were primarily due to an increase in income from limited partnership investments, as well as the significant reallocation of assets in the fourth quarter of 1998 from equity securities to fixed maturities, which also positively impacted both before- and after-tax yields.
For the year ended December 31, 1998, both before- and after-tax net investment income increased by 6% over 1997. This increase was the result of higher invested asset levels as a result of repayment of allocated advances by HLI. In addition, the reallocation of assets from equities to fixed maturities throughout the year positively impacted both before- and after-tax net investment income. After-tax net investment income was also favorably impacted by the reallocation from taxable to tax-exempt bonds. The decline in before- and after-tax yields on average invested assets reflected declining interest rates, primarily impacting taxable bonds.
Net realized capital gains for 1998 were unchanged from 1997. During 1998, net gains from the sale of fixed maturities and
Invested assets, excluding separate accounts, totaled $21.8 billion at December 31, 1999 and were comprised of $17.0 billion of fixed maturities, $4.2 billion of policy loans and other investments of $529. At December 31, 1998, invested assets totaled $24.9 billion and were comprised of $17.7 billion of fixed maturities, $6.7 billion of policy loans and other investments of $503. The decrease in invested assets was primarily due to the decline in leveraged COLI business (as discussed in the COLI section) and a rise in interest rates. Policy loans are secured by the cash value of the life policy and do not mature in a conventional sense, but expire in conjunction with the related policy liabilities.
As of December 31, 1999 and 1998, approximately 21.5% and 22.8%, respectively, of the Life segment's fixed maturities were invested in private placement securities (including Rule 144A offerings). Private placement securities are generally less liquid than public securities. However, covenants for private placements are designed to compensate for liquidity risk. Most of the private placement securities in the segment's portfolio are rated by nationally recognized rating agencies.
For the year ended December 31, 1999, total before-tax net investment income decreased 20% from 1998, primarily due to a decrease in policy loan income resulting from the decrease in leveraged COLI business. The decline in yield on average invested assets was due to the decrease in policy loan income and the decline in policy loan weighted average interest rate to 7.5% for 1999 from 9.9% for 1998.
There were no net realized capital gains or losses for the year ended December 31, 1998, unchanged from 1997. During 1998, realized capital gains from the sale of fixed maturities and equity securities were offset by after-tax realized capital losses, including $21 related to an other than temporary impairment associated with the CFS securities.
The investment objectives of the International segment are to generate appropriate after-tax income and sufficient liquidity to meet corporate and policyholder obligations. Investments are made with durations and in currencies that reflect the nature of each company's liabilities.
Invested assets, excluding separate accounts, were $1.1 billion at December 31, 1999 and were comprised of fixed maturities of $734 and other investments of $361, primarily equity securities. At December 31, 1998, invested assets totaled $1.2 billion and were comprised of fixed maturities of $844 and other investments of $350, primarily equity securities.
Gov't/Gov't agencies - For. $ 475 64.7% $ 611 72.4% Corporate 130 17.7% 109 12.9% ABS 16 2.2% -- -- Short-term 113 15.4% 124 14.7% - ----------------------------------------------------------------- Total fixed maturities $ 734 100.0% $ 844 100.0% - -----------------------------------------------------------------
For the year ended December 31, 1999, before-tax net investment income decreased 60% from 1998, primarily due to the effects of the London & Edinburgh sale in November 1998. Excluding London & Edinburgh, net investment income decreased 6% compared to 1998, mainly due to weaknesses in the Dutch Guilder and overall lower yields in Asia. Yield on average invested assets decreased to 6.1%, mainly due to lower short-term interest rates in certain international markets.
Invested assets were $2.1 billion and $2.5 billion at December 31, 1999 and December 31, 1998, respectively, and were substantially comprised of fixed maturities.
Fixed Maturities by Type - ----------------------------------------------------------------- 1999 1998 - ----------------------------------------------------------------- Type Fair Value Percent Fair Value Percent - -----------------------------------------------------------------
Net investment income $ 147 $ 159 $ 157 Yield on average invested assets[1] 6.5% 6.6% 6.7% Net realized capital gains $ -- $ 3 $ 1 - ---------------------------------------------------------------- [1] Represents net investment income (excluding net realized capital gains) divided by average invested assets at cost (fixed maturities at amortized cost).
For the year ended December 31, 1999, before-tax net investment income decreased 8%, primarily due to the reduction in invested assets as a result of the funding of runoff liabilities. Yield on average invested assets also declined slightly compared to the prior period.
For the year ended December 31, 1998, both before-tax net investment income and yield on average invested assets remained relatively flat compared to the prior year.
The Hartford 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 specific classes of investments, while asset/liability management is the responsibility of separate and distinct risk management units supporting the property and casualty and life operations. Derivative instruments are utilized in accordance with established Company policy and regulatory requirements and are monitored internally and reviewed by senior management.
The Company's derivatives counterparty exposure policy establishes market-based credit limits, favors long-term financial stability and creditworthiness, and typically requires credit enhancement/credit risk reducing agreements. Credit risk is measured as the amount owed to the Company based on current market conditions and potential payment obligations between the Company and its counterparties. Credit exposures are quantified weekly and netted, and collateral is pledged to and held by, or on behalf of, the Company to the extent the current value of derivatives exceeds exposure policy thresholds.
Fixed Maturities by Credit Quality - ----------------------------------------------------------------- 1999 1998 - ----------------------------------------------------------------- Credit Quality Fair Value Percent Fair Value Percent - -----------------------------------------------------------------
U.S. Gov't/Gov't agencies $ 2,404 9.1% $ 2,596 9.3% AAA 3,868 14.7% 3,907 14.0% AA 3,219 12.2% 2,716 9.7% A 8,731 33.1% 8,878 31.8% BBB 5,816 22.1% 7,019 25.2% BB & below 559 2.1% 492 1.8% Short-term 1,772 6.7% 2,298 8.2% - ----------------------------------------------------------------- Total fixed maturities $ 26,369 100.0% $ 27,906 100.0% - -----------------------------------------------------------------
The Hartford has several objectives in managing market risk associated with its property and casualty and life operations. The property and casualty operations attempt to maximize economic value while generating appropriate after-tax income and sufficient liquidity to meet corporate and policyholder obligations. The property and casualty operations have material exposure to interest rate and equity market risk. The life operations are responsible for maximizing after-tax returns within acceptable risk parameters including the management of the interest rate sensitivity of invested assets to that of policyholder obligations. The life operations have material market exposure to interest rate risk associated with its fixed maturity portfolios. The Company continually monitors these exposures and makes portfolio adjustments to manage these risks within established limits.
The Hartford utilizes a variety of derivative instruments, including swaps, caps, floors, forwards and exchange traded futures and options, in accordance with Company policy and regulatory requirements in order to achieve one of three Company approved objectives: to hedge risk arising from interest rate, price or currency exchange rate volatility; to manage liquidity; or to control transaction costs. The Company does not make a market or trade derivatives for the express purpose of earning trading profits.
Derivative activities are monitored by an internal compliance unit, reviewed frequently by senior management and reported to the Company's Finance Committee. 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, 1999 and 1998, totaled $9.8 billion and $11.3 billion, respectively.
The primary exposure to interest rate risk in the property and casualty operations relates to its fixed maturity investments. Changes in market interest rates directly impact the market value of the fixed maturity securities. In addition, but to a lesser extent, interest rate risk exists on debt issued. Derivative instruments are used periodically to manage interest rate risk and as a result, their value will change as market rates change, generally in the opposite direction of the item being hedged. The total notional amounts of derivatives used for hedging interest rate risk as of December 31, 1999 and 1998, were $136 and $75, respectively.
The principal amounts of the fixed and variable rate fixed maturity portfolios, along with the respective weighted average coupons (WAC) by estimated maturity year at December 31, 1999, are reflected in the following table. Comparative totals are included as of December 31, 1998. Expected maturities differ from contractual maturities due to call or prepayment provisions. The weighted average coupon on variable rate securities is based on spot rates as of December 31, 1999 and 1998, and is based primarily on London Interbank Offered Rate (LIBOR). Callable bonds and notes are primarily municipal bonds, and are distributed to either call dates or maturity depending on which date produces the most conservative yield. Asset backed securities, collateralized mortgage obligations and mortgage backed securities are distributed to maturity year based on estimates of the rate of future prepayments of principal over the remaining life of the securities. These estimates are developed using prepayment speeds contained in broker consensus data. Such estimates are derived from prepayment speeds previously experienced at interest rate levels projected for the underlying collateral. Actual prepayment experience may vary from these estimates. Financial instruments with certain leverage features have been included in each of the fixed maturity categories. These instruments have not been separately displayed as they were immaterial to the property and casualty operations' investment portfolio.
The table below provides information as of December 31, 1999 on debt obligations and QUIPS and reflects principal cash flows and related weighted average interest rate by maturity year. Comparative totals are included as of December 31, 1998.
The property and casualty operations hold a diversified portfolio of investments in equity securities representing firms in various countries, industries and market segments ranging from small market capitalization stocks to Standard & Poor's 500 stocks. The risk associated with these securities relates to potential decreases in value resulting from changes in equity prices.
The operations occasionally use equity futures to hedge against a change in value on the anticipated purchase or sale of equity securities. As of December 31, 1999 and 1998, there were no outstanding derivative instruments hedging equity price risk.
1999 1998 ---------------------------------------- FAIR VALUE PERCENT FAIR VALUE PERCENT - --------------------------------------------------------------- EQUITY SECURITIES Domestic Large cap $ 519 45.8% $ 390 42.2% Midcap/small cap 114 10.0% 105 11.3% Foreign EAFE [1]/Canadian 465 41.0% 411 44.3% Emerging 36 3.2% 20 2.2% - --------------------------------------------------------------- TOTAL $ 1,134 100.0% $ 926 100.0% - --------------------------------------------------------------- [1] Europe, Australia, Far East countries index.
Impact of 10% Net Equity Changes Company Investment -10% +10% Currency [1] - ------------------- ------------- ------- -------- ------------- Zwolsche $279 $(28) $28 Euro Zwolsche $348 $(35) $35 Guilder - ------------------- ------------- ------- -------- ------------- [1] On January 1, 1999, the Netherlands became a member of the European Monetary Union and its currency, the Dutch Guilder, was replaced by the Euro.
Asset Hedging -- To meet the various life policyholder obligations and to provide cost-effective prudent investment risk diversification, the life operations may combine two or more financial instruments to achieve the investment characteristics of a fixed maturity security or that match an associated liability. The use of derivative instruments in this regard effectively transfers unwanted investment risks or attributes to others. The selection of the appropriate derivative instruments depends on the investment risk, the liquidity and efficiency of the market, and the asset and liability characteristics. The notional amounts of asset hedges as of December 31, 1999 and 1998, were $4.8 billion and $3.8 billion, respectively.
Portfolio Hedging -- The life operation periodically compares the duration and convexity of its portfolios of assets to their corresponding liabilities and enters into portfolio hedges to reduce any difference to desired levels. Portfolio hedges reduce the 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, 1999 and 1998, were $1.2 billion and $1.5 billion, respectively.
The following tables provide information as of December 31, 1999 with comparative totals for December 31, 1998 on derivative instruments used in accordance with the aforementioned hedging strategies. For interest rate swaps, caps and floors, the tables present notional amounts with weighted average pay and receive rates for swaps and weighted average strike rates for caps and floors by maturity year. For interest rate futures, the table presents contract amount and weighted average settlement price by expected maturity year. Life operations uses option contracts to hedge debt instruments that totaled $254 and $110 in notional amounts and $(50) and $(20) in carrying value as of December 31, 1999 and 1998, respectively.
The life operations have immaterial currency exposures to the Brazilian Real and Argentine Peso.
Fixed Rate -- Products in this category require the life operations 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.
Interest Credited -- Products in this category credit interest to policyholders, subject to market conditions and minimum guarantees. Policyholders may surrender at book value but are subject to surrender charges for an initial period. Product examples include universal life contracts and the general account portion of the life operations' variable annuity products. Liability duration is short- to intermediate-term.
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 life operations, 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 are shown in the following tables. These fixed liabilities represented about 55% of the life operations' general and guaranteed separate account liabilities at December 31, 1999 and 1998. The remaining liabilities generally allow the life operation 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 evaluated annually consistent with regulatory requirements.
The 26 million shares sold in the Offering represented approximately 19% of the equity ownership in HLI and approximately 4% of the combined voting power of HLI's Class A and Class B common stock. The Hartford owns all of the 114 million outstanding shares of Class B common stock of HLI, representing approximately 81% of the equity ownership in HLI and approximately 96% of the combined voting power of HLI's Class A and Class B common stock. Holders of Class A common stock generally have identical rights to the holders of Class B common stock except that the holders of Class A common stock are entitled to one vote per share while holders of Class B common stock are entitled to five votes per share on all matters submitted to a vote of HLI's stockholders. Also, each share of Class B common stock is convertible into one share of Class A common stock (a) upon the transfer of such share of Class B common stock by the holder thereof to a non-affiliate (except where the shares of Class B common stock so transferred represent 50% or more of all the outstanding shares of common stock, calculated without regard to the difference in voting rights between the classes of common stock) or (b) in the event that the number of shares of outstanding Class B common stock is less than the 50% of all the common stock then outstanding. As of December 31, 1999, The Hartford continued to maintain an approximate 81% equity ownership in HLI.
For a discussion of Company Obligated Mandatorily Redeemable Preferred Securities of Subsidiary Trusts Holding Solely Junior Subordinated Debentures, see Note 7 of Notes to Consolidated Financial Statements.
On October 21, 1999, The Hartford's Board of Directors approved a 4% increase in the quarterly dividend to $0.24 per share, payable January 3, 2000 to shareholders of record as of December 1, 1999.
The liquidity requirements of The Hartford have been and will continue to be met by funds from operations as well as the issuance of commercial paper, debt securities and its credit facility. The principal sources of operating funds are premiums and investment income as well as maturities and sales of invested assets. The Hartford Financial Services Group, Inc. is a holding company which receives operating cash flow in the form of dividends from its subsidiaries, enabling it to service debt, pay dividends on its common stock and pay business expenses.
The insurance holding company laws of the other jurisdictions in which The Hartford's insurance subsidiaries are incorporated (or deemed commercially domiciled) generally contain similar (although in certain instances somewhat more restrictive) limitations on the payment of dividends.
1999 1998 1997 - ---------------------------------------------------------------- Net cash provided by operating activities $ 891 $ 907 $ 2,045 Net cash provided by (used for) investing activities $ 2,279 $ 411 $ (2,247) Net cash (used for) provided by financing activities $ (3,104) $ (1,340) $ 239 Cash - end of year $ 182 $ 123 $ 140 - ----------------------------------------------------------------
Operating cash flow decreased slightly in 1999 compared to 1998. The change in both investing and financing cash flows was primarily the result of an increase in disbursements for investment type contracts related to the leveraged COLI block of business.
On August 26, 1998, HLI completed the purchase of all outstanding shares of PLANCO Financial Services, Inc. (PLANCO) and its affiliate, PLANCO, Incorporated. PLANCO, a primary distributor of HLI's annuity and investment products, is the nation's largest wholesaler of individual annuities and has played a significant role in HLI's growth over the past decade. As a wholesaler, PLANCO distributes HLI's annuity and investment products, including fixed and variable annuities, mutual funds and single premium variable life insurance, as well as providing sales support to registered representatives, financial planners and broker-dealers at brokerage firms and banks across the United States. The acquisition was accounted for as a purchase and accordingly, the results of PLANCO's operations have been included in The Hartford's consolidated financial statements from the closing date of the transaction.
On February 12, 1998, The Hartford completed the purchase of all outstanding shares of Omni, a holding company of two non-standard auto insurance subsidiaries licensed in 25 states and the District of Columbia. The Hartford paid cash of $31.75 per share, plus transaction costs, for a total of $189. The acquisition was reported as a purchase transaction and accordingly, the results of Omni's operations have been included in The Hartford's consolidated financial statements from the closing date of the transaction.
Current and proposed Federal measures which may significantly affect the life insurance business include tax law changes affecting the tax treatment of life insurance products and its impact on the relative desirability of various personal investment vehicles, medical testing for insurability, and proposed legislation to prohibit the use of gender in determining insurance and pension rates and benefits. In particular, President Clinton's 2000 federal budget proposal contains certain recommendations for modifying tax rules related to the treatment of COLI by contractholders which, if enacted as described, could have a material adverse impact on the Company's sales of these products. The budget proposal also includes provisions which would result in a significant increase in the "DAC tax" on certain of the Company's products, apply a tax to the Company's policyholder surplus account and increase taxes on property and casualty insurance companies. It is too early to determine whether these tax proposals, in their current form, will ultimately be enacted by Congress. Therefore, the potential impact to the Company's financial condition or results of operations cannot be reasonably estimated at this time.
The NAIC adopted the Codification of Statutory Accounting Principles (Codification) in September 1998. The proposed effective date for the statutory accounting guidance is January 1, 2001. It is expected that each of The Hartford's domiciliary states will adopt Codification and the Company will make the necessary changes required for implementation. The Company is in the process of determining the impact, if any, that Codification will have on the statutory financial statements of The Hartford's insurance subsidiaries.
The Year 2000 issue relates to the ability or inability of computer hardware, software and other information technology (IT) systems, as well as non-IT systems, such as equipment and machinery with imbedded chips and microprocessors, to properly process information and data containing or related to
The integrity and reliability of The Hartford's IT systems, as well as the reliability of its non-IT systems, are integral aspects of The Hartford's business. The Hartford issues insurance policies, annuities, mutual funds and other financial products to individual and business customers, nearly all of which contain date sensitive payment dates. In addition, various IT systems support communications and other systems that integrate The Hartford's various business segments and field offices, including The Hartford's foreign operations. The Hartford also has business relationships with numerous third parties that affect virtually all aspects of The Hartford's business, including, without limitation, suppliers, computer hardware and software vendors, insurance agents and brokers, securities broker-dealers, banks and other distributors and servicers of financial products, many of which provide date sensitive data to The Hartford, and whose operations are important to The Hartford's business.
As of February 29, 2000, The Hartford had not experienced any Year 2000-related business interruptions arising either from its own systems or those of third parties. However, The Hartford has developed certain contingency plans so that if, despite its Year 2000 efforts, Year 2000 problems ultimately arise, the impact of such problems may be avoided or minimized. The contingency planning process involved identifying reasonably likely business disruption scenarios that, if they were to occur, could create significant problems in the critical functions of each business segment. Each business segment has developed plans to respond to such problems so that critical business functions may continue to operate with minimal disruption. Contingency planning also included assessing the dependency of The Hartford's critical business on third parties and their Year 2000 readiness. These plans were reviewed and simulated on an integrated basis, where appropriate, and will continue to be evaluated. Furthermore, in many contexts, Year 2000 issues are dynamic, and ongoing assessments of business functions, vulnerabilities and risks must be made. As such, new contingency plans may be needed in the future and/or existing plans may need to be modified as circumstances warrant.
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 The Hartford during the three most recent fiscal years.