Certain of the statements contained herein (other than statements of historical fact) are forward-looking statements. Such forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The forward-looking statements are made based upon management's expectations and beliefs concerning future developments and their potential effect upon ITT Hartford Group, Inc. ("The Hartford" or 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 Hartford will be those anticipated by management. Actual results could differ materially from those expected by The Hartford, depending on the outcome of certain factors, including those described with the forward-looking statements herein.
Net income, excluding the impact of accounting changes, net realized capital gains, after-tax, other charges and allocated Distribution items was $537 for 1996 compared with $478 for 1995 and $523 in 1994. The Hartford defines this presentation of after-tax operational results as "core earnings".
1995 core earnings decreased $45, or 9%, from 1994 due primarily to the impact of the Dow Corning breast implant claims settlement, a loss from a single industrial fire covered by the Industrial Risk Insurance ("IRI") pool and losses attributable to Hurricane Opal. Additionally, results in the closed book of guaranteed rate contract business ("Closed Book GRC") reflected losses due to lower investment earnings on mortgage-backed securities, the result of prepayment experience in excess of assumed levels. Improved property and casualty net investment income and growth in sales of annuities and corporate owned life insurance ("COLI") products partially offset the core earnings decline.
Items excluded from core earnings include the impact of the adoption of Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities", and the change in the method of discounting to present value certain workers' compensation reserves, the cumulative net effect of which totaled $12, after-tax, recorded as of January 1, 1994. Upon adoption of SFAS No. 115, the amortized cost basis of mortgage-backed interest-only investments were written down to fair value and reflected as a cumulative effect of accounting change of $(30) after-tax. A change in the method of discounting certain workers' compensation reserves from one that used statutory interest rates to one utilizing a "risk-free" market rate resulted in a $42 after-tax cumulative effect benefit.
The following table represents per common share data and return on equity for the past three years:
1996 1995 1994 - ----------------------------------------------------------------- Weighted average common shares outstanding [1] 117.3 117.1 117.1 Operating income (loss) $(2.71) $6.34 $7.28 Net income (loss) $(0.84) $4.77 $5.50 Return on equity [2] [3] (2.3)% 12.6% 15.4% - ---------------------------------------------------------------- [1] Actual number of common shares outstanding at December 31, 1995 of 117.1 million is retroactively presented for December 31, 1994. [2] Calculated by dividing net income by average equity excluding unrealized gain (loss), after-tax. [3] 1996 return on equity excluding the other charges noted above from net income was 13.8%.
The Hartford's reporting segments reflect the management structure of the Company. These segments consist of North American Property & Casualty, Life, and International, all of which represent ongoing operations, and Runoff. Runoff includes operations which have ceased writing new and renewal business.
Certain transactions between segments occur during the year that primarily relate to tax settlements, insurance coverage, expense reimbursements, services provided and capital contributions. Certain reinsurance stop loss agreements exist between the segments which specify that for consideration received, one segment will reimburse another for losses incurred in excess of a predetermined limit. Also, one segment may purchase group annuity contracts from another to fund pension costs and claim annuities to settle casualty claims.
1996 1995 1994 - ---------------------------------------------------------------- N. A. Property & Casualty $ 270 $ 251 $ 309 Life 251 221 149 International 87 91 62 Runoff (71) (85) 3 - ---------------------------------------------------------------- CORE EARNINGS $ 537 $ 478 $ 523 - ----------------------------------------------------------------
A description of each segment, as well as an analysis of the operating results summarized above, is included on the following pages. Reserves, Environmental and Asbestos Claims, and Investments are discussed in separate sections.
Core earnings for the North American Property & Casualty segment were $270, an increase of $19 from 1995, primarily due to a $53 increase in after-tax net investment income partially offset by a $37 increase in after-tax underwriting loss. The increased underwriting loss resulted from significantly higher catastrophe and winter storm losses in 1996 partially offset by two material items discussed in the following Summary Underwriting Results section, which adversely affected underwriting results in 1995. 1995 core earnings of $251 were down $58 from 1994 due to the two material items noted, as well as decreased income from third party servicing contracts and very favorable workers' compensation loss experience in 1994.
Within the North American Property & Casualty segment, management analyzes the results of operations by the following four major components on a before-tax basis:
The following discussion summarizes underwriting results by major operation (as defined below) and other miscellaneous expenses. As previously noted, net investment income and net realized capital gains are covered in a separate discussion in the Investments section. Other charges, consisting primarily of an increase in environmental and asbestos reserves, are discussed in the Environmental and Asbestos Claims section.
Underwriting results represent premiums earned less incurred claims, claim adjustment expenses and underwriting expenses. The following table shows written premiums, underwriting results and combined ratios for The Hartford's North American Property & Casualty segment.
Underwriting results for 1995 were $88 lower than the prior year largely due to the impact of two items: a $40 loss, net of reinsurance, in connection with the settlement of claims against Dow Corning Corporation alleging product defects arising from breast implants, and a net $32 loss resulting from a single industrial fire covered by the IRI pool. These non-recurring items increased the combined ratio by 1.3 points in 1995. The 1994 combined ratio of 102.5 was lower than both the adjusted (excluding the non-recurring items) 1995 and 1996 combined ratios by 0.7 points and 0.4 points, respectively, largely due to favorable loss experience in workers' compensation in 1994.
Commercial Insurance Operations (CIO) provides workers' compensation, property, automobile, liability, marine, agricultural and bond coverages to commercial accounts throughout the United States and Canada. Excess and surplus lines business not normally written by standard lines insurers is also provided. CIO is organized into three customer market segments: Commercial Business Insurance Operations (CBI), Commercial Affinity Segment (CAS), and Specialty Commercial Lines (SCL). CBI provides standard commercial business for small accounts (Select Customer) and mid-sized insureds (Key Accounts). Agricultural, livestock and marine products are also managed within CBI. CAS provides commercial risk management products and services to members of affinity groups and customers of financial institutions. SCL provides insurance through retailers and wholesalers to large commercial clients and insureds requiring a variety of specialized coverages. SCL's results include the bond lines and First State Management Group, a leading underwriter of excess and surplus lines business produced primarily through wholesale brokers.
Written premiums decreased 4% in 1996 to $3.2 billion, compared to a 3% decrease in the previous year. A decline in workers' compensation premium from less profitable involuntary workers' compensation pools and increasingly intense price competition are the primary causes for the 1996 decrease. The decrease in 1995 premium volume reflected the conversion of workers' compensation business to large deductible programs and a reduction in The Hartford's participation in the less profitable voluntary and involuntary workers' compensation pools.
1996 underwriting results improved $26 compared with the prior year, reflecting the impact in 1995 of a $40 loss, net of reinsurance, in connection with a settlement of claims against Dow Corning Corporation alleging product defects arising from breast implants. Excluding the impact of this settlement on the prior year comparison, 1996 underwriting results deteriorated $14 from 1995, reflecting a 0.3 increase in the combined ratio to 105.7 from the adjusted 1995 level. This decline was due to deterioration in property results which were adversely impacted by severe catastrophes and winter storms and several large losses. Despite intense competition, workers' compensation results partially offset the 1996 deterioration reflecting the impacts of legislative reforms, depopulation in residual pools and effective managed care related initiatives.
Personal - -------- 1996 1995 1994 - ---------------------------------------------------------------- Written premiums $ 1,864 $ 1,813 $ 1,740 Underwriting results $ (110) $ (21) $ (56) Combined ratio 105.2 100.9 102.7 - ----------------------------------------------------------------
Personal operations provides automobile, homeowners, home-based business and fire coverages to individuals throughout the United States and Canada. Personal operations are organized to provide customized products and services to three market opportunities: the membership of AARP through a direct marketing operation; customers who prefer local agent involvement through a network of independent agents; and members of other affinity groups through a new organization that is building from the AARP operation competencies. AARP's exclusive licensing arrangement continues through the year 2002, thus providing the Company with an important competitive advantage.
Underwriting results decreased by $89 in 1996, with a 4.3 point increase in the combined ratio. These results were due to severe catastrophe and winter storm losses, partially offset by improved automobile profitability resulting from expanded cost containment initiatives. Underwriting results improved by $35 in 1995 over 1994 with a corresponding 1.8 point improvement in the combined ratio due to lower catastrophe losses and improved automobile results.
Written premiums increased 17% in 1996 and 9% in 1995 primarily due to growth in U.S. casualty and specialty lines. This growth resulted from a combination of new business opportunities, an increased level of renewals, and continued new product development in specialty lines, partially offset by a reduction in domestic and international property and marine rates.
1996 underwriting results increased $7 compared with 1995. Excluding the impact of the 1995 IRI fire loss described previously, underwriting results decreased $25 in 1996 due to underwriting losses of $11, resulting from a strategic shift in the business mix to longer-tailed casualty and specialty lines, catastrophe and severe winter storm losses of $5 and several large individual risk losses of $9.
Other miscellaneous expenses, which also include miscellaneous income items, were $89 in 1996, up from $71 in 1995. This increase was primarily due to increased debt costs from additional borrowings partially offset by increased service fee income from third party administration and involuntary pool servicing contracts. Two major national servicing contracts, entered into in 1996, contributed to this increase in service fee income.
Difficult market conditions and intense price competition within the property and casualty industry show no signs of diminishing in the near term. However, two major actions were completed in 1996 which management believes will counterbalance these negative external factors and position the North American Property & Casualty segment for significant improvement in operating performance in 1997. First, the adverse impact on earnings from environmental and asbestos liabilities that had been experienced in prior years was addressed through the establishment of additional reserves upon completion of a thorough database review as described in the Environmental and Asbestos Claims section. In addition, the North American Property & Casualty segment was reorganized to maximize responsiveness to its customers by grouping market segments and product lines according to their respective markets and further strengthening an already strong, results-focused management team. As a result of these actions, as well as dedication to growing targeted market segments, rigorous expense management and utilization of alternative distribution channels, management believes the North American Property & Casualty segment stands poised to successfully overcome the challenges ahead.
Core earnings in the Life segment increased $30, or 14%, to $251 in 1996 from $221 in 1995 primarily reflecting (i) an increase in earnings of $32 in the Investment Products division principally driven by an increase in total account value due to sales of individual annuities and stock market appreciation, (ii) a $7 increase in the Individual Life Insurance division due to growth in individual life insurance in force and favorable mortality experience, (iii) an increase in earnings of $13 in the Employee Benefits division principally due to an increase in group insurance premiums and favorable morbidity experience and (iv) a decrease in core earnings of $22 in the Corporate Operation division due primarily to a guaranty fund adjustment of $10 in 1995 resulting from lower than expected insolvencies in the insurance industry as well as an increase in debt service costs in 1996.
The following describes each division, including products and services offered, and analyzes the above results.
The Investment Products division markets fixed and variable annuities, deferred compensation plan services for municipal governments and corporations, structured settlements and other special purpose annuity contracts, investment management contracts, and mutual funds. The Company was rated the number one writer of variable annuities for 1996 with a 13% market share according to the Variable Annuity and Research Data Service.
Revenues increased $257, or 34%, to $1.0 billion in 1996 from $761 in 1995. This increase was principally the result of a $216 increase in premiums and other considerations, reflecting a substantial increase in aggregate fees earned due to the division's growing block of separate account assets. The average separate account assets of this segment increased to $37.5 billion in 1996 from $26.3 billion in 1995 primarily due to sales of individual annuities of approximately $10 billion in 1996 and $7 billion in 1995, as well as significant market appreciation in both 1996 and 1995. In addition, the average general account assets of this segment increased to $7.7 billion in 1996 from $6.5 billion in 1995 largely as a result of growth in the general account portion of the individual variable annuity products of the Investment Products division. The growth in this division in 1996 also resulted in an increase in total benefits, claims and expenses of $199, or 34%, to $791 in 1996 from $592 in 1995. The 38% growth in average account value in 1996, coupled with an overall reduction in individual annuity expenses as a percentage of total individual annuity account value to 28 basis points in 1996 from 31 basis points in 1995, contributed to the growth in core earnings of $32, or 28%, to $146 in 1996 from $114 in 1995.
Individual Life Insurance products include variable life insurance, universal life insurance, interest-sensitive whole life insurance and term life policies. Individual Life Insurance business also includes modified guaranteed life and traditional whole life.
Employee Benefits consists of two areas of operation: Group Insurance and Specialty Insurance Operations. Through the Group Insurance Operation, the Company markets group long-term and short-term managed disability, group life, stop loss, and supplementary medical coverage to employers and employer-sponsored plans and accidental death and dismemberment, travel and special risk coverage to associations. The Specialty Insurance Operation unit consists of the Company's COLI business, life/health reinsurance operations, and international operations.
Revenues increased $311, or 12%, to $2.8 billion in 1996 from $2.5 billion in 1995. This increase was largely the result of (i) a $162 increase in premiums and other considerations, reflecting a $226 increase in group insurance premiums from strong group disability sales and renewals, partially offset by a decline in leveraged COLI premiums as a result of the Health Insurance Portability and Accountability Act of 1996 ("HIPA Act of 1996", as discussed below) legislation and (ii) a $149 increase in net investment income, primarily due to an increase in COLI account values. Total benefits, claims and expenses increased $295, or 12%, to $2.7 billion in 1996 from $2.4 billion in 1995. This increase generally reflected an increased block of group disability business and other group insurance and an increase in the Life segment's COLI block of business, partially offset by a $41 decrease in dividends to policyholders primarily due to the elimination of sales of leveraged COLI as a result of the enactment of the HIPA Act of 1996. In addition, expenses in the group insurance business, as a percentage of premiums, have declined over the past several years. This trend, along with favorable mortality and morbidity experience, as well as the factors mentioned above, resulted in an increase in core earnings in this division of $13, or 20%, to $79 in 1996 from $66 in 1995.
The HIPA Act of 1996 phases out the deductibility of interest on policy loans under COLI by 1998, thus eliminating all future sales of leveraged COLI. The leveraged COLI product has been an important contributor to the Life segment's profitability in recent years and will continue to contribute to the profitability of the Life segment in the future, although the level of profit will decline after 1998. However, the Employee Benefits division has growth opportunities through variable COLI and other non-qualified deferred compensation vehicles, reinsurance and international operations. The Company expects continued growth in core earnings for the Life segment in 1997. See the Capital Resources and Liquidity section under "Subsequent Events".
1995 revenues of $1.5 billion and core earnings of $91 were $266, or 21%, and $29, or 47%, respectively, higher than 1994, the result of significantly improved investment and underwriting performance, premium growth, and the acquisition of ITT Ercos. Favorable foreign exchange translation movements during 1995 accounted for approximately $89 and $2 of the increase in revenues and core earnings, respectively.
The International segment is organized into the following three business units: ITT London & Edinburgh, Zwolsche Algemeene and ITT Ercos. In addition, Other primarily represents home office expenses associated with managing international operations.
1996 revenues at ITT London & Edinburgh of $1.1 billion increased $17, or 2%, over 1995. Core earnings of $56 decreased $10, or 15%, from 1995 primarily the result of deteriorating underwriting results due to heightened competition in the United Kingdom, partially offset by growth in net investment income. Also, strengthening of the U.S. dollar resulted in negative foreign exchange impacts on revenues of $15 and core earnings of $2. The increase in revenues was due to improved investment income, partially offset by a shortfall in written premiums due to the intense competitive climate in the United Kingdom. Personal lines underperformed the prior year where shortfalls in automobile were partially offset by improvements in personal credit insurance, including life. Commercial lines sales were also dampened due to the increasingly competitive market.
1995 revenues at ITT London & Edinburgh of $1.1 billion and core earnings of $66 were $126, or 13%, and $20, or 44%, respectively, higher than 1994. These increases were due to significant improvement in investment performance, premium growth and foreign exchange rates, offset somewhat by slightly lower underwriting results. Commercial lines growth moderated during the year due to a more competitive market. Personal lines growth was mixed with continued improvement in automobile and creditor products.
Zwolsche Algemeene's 1996 revenues of $459 and core earnings of $32 improved $43, or 10%, and $7, or 28%, respectively, compared with 1995. These increases were due to improved premium growth and stronger underwriting results. Due to the strengthening U.S. dollar, foreign exchange had an adverse effect of $20 on revenues and a negligible impact on core earnings. Property and casualty growth in 1996 was relatively strong in motor as market pricing improved. Performance was also strong in life savings and mortgage products business.
The outlook at Zwolsche Algemeene for 1997 is for moderate written premium growth in property and casualty due to an increase in competition. Continued growth is also expected for life operations. Sales expectations of life savings and pension products in the Netherlands continue to be strong due to their associated tax advantages and expected continued low interest rate environment. The Company continues to explore the viability of opportunities in both life and property and casualty business in the Netherlands in 1997 as the government continues to review moving certain social security programs into the private sector.
The Runoff segment also consists of Closed Book GRC which had no new or renewal business as of the end of 1994. Substantially all of the products included in Closed Book GRC are guaranteed investment contracts with guaranteed fixed or indexed rates for a specific period. Prior to 1996, Closed Book GRC was reported as a component of the Life segment.
Closed Book GRC results have been negatively affected by lower investment rates and earnings in the related investment portfolio (primarily consisting of collateralized mortgage obligations and mortgage backed securities) due to prepayments experienced in excess of assumed levels in years prior to 1995. Closed Book GRC was also affected by the interest rate rise in 1994 when the duration of its assets lengthened relative to that of the liabilities. Due to the reduced investment earnings and duration mismatch, the portfolio had insufficient assets to fully fund its liability commitments. During the third quarter of 1996, the Life segment transferred assets in the amount of $200 to the Runoff segment to adequately fund Closed Book GRC so that future cash infusions would be minimal.
During the fourth quarter of 1996, an additional other than temporary impairment loss of $(6) after-tax was determined to have occurred, and has been included in realized losses.
Revenues decreased 76% in 1996 and 15% in 1995 as a result of a decline in net investment income for both periods and net realized capital losses for 1996 in Closed Book GRC. Runoff segment core earnings increased $14 in 1996 over 1995 and decreased $88 in 1995 from the prior year. These results reflect the core earnings of Closed Book GRC of $(51), $(68) and $1 for 1996, 1995 and 1994, respectively.
Management expects that the net income (loss) from Closed Book GRC in the years subsequent to 1996 will be immaterial based on current projections for the performance of the assets and liabilities associated with Closed Book GRC and expectations regarding future asset sales and the stabilizing effect of the hedge transactions. However, no assurance can be given that, under certain unanticipated economic circumstances, further losses in respect of Closed Book GRC will not occur in the future. Additionally, 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 the property and casualty operations of the Runoff segment to have a material effect on the operating results of the Company.
The Hartford continually reviews its estimated claims and claim adjustment expense reserves as additional experience and other relevant data become available and reserve levels are adjusted accordingly. Adjustments to previously established reserves, if any, will be reflected in the operating results of the period in which the adjustment is made. In the judgment of management, all information currently available has been properly considered in the reserves established for claims and claim adjustment expenses. For a discussion of environmental and asbestos claims and the uncertainties related to these reserves, refer to the next section.
================================================================================ ENVIRONMENTAL AND ASBESTOS CLAIMS ================================================================================ The Hartford continues to receive claims asserting damages from environmental exposures and for injuries from asbestos and asbestos-related products, both of which affect the North American Property & Casualty, International and Runoff segments. Environmental claims relate primarily to pollution and related clean-up costs. With regard to these claims, uncertainty exists which impacts the ability of insurers and reinsurers to estimate the ultimate reserves for unpaid losses and related settlement expenses. The Hartford finds that conventional reserving techniques cannot estimate the ultimate cost of these claims because of inadequate development patterns and inconsistent emerging legal doctrine. For the majority of environmental claims and many types of asbestos claims, unlike any other type of contractual claim, there is almost no agreement or consistent precedent to determine what, if any, coverage exists or which, if any, policy years and insurers or reinsurers may be liable. Further uncertainty arises with environmental claims since claims are often made under policies, the existence of which may be in dispute, the terms of which may have changed over many years, which may or may not provide for legal defense costs, and which may or may not contain environmental exclusion clauses that may be absolute or allow for fortuitous events. Courts in different jurisdictions have reached disparate conclusions on similar issues and in certain situations have broadened the interpretation of policy coverage and liability issues. In light of the extensive claim settlement process for environmental and asbestos claims, involving comprehensive fact gathering, subject matter expertise and intensive litigation, The Hartford established an environmental claims facility in 1992 to defend itself aggressively against unwarranted claims and to minimize costs.
Included in The Hartford's analysis of environmental and asbestos exposures was a review of applicable reinsurance
An international actuarial firm reviewed The Hartford's approach and concluded that the way the Company studied its exposures, the thoroughness of its analysis and the way The Hartford came to its estimates was reasonable and comprehensive.
The Hartford's pretax operating earnings have been impacted over the last three years by incurred environmental and asbestos claims and claim adjustment expenses as follows: $925 in 1996, $163 in 1995 and $145 in 1994 with all years reported net of reinsurance.
The investment objective of the North American Property & Casualty segment is the maximization of after-tax income consistent with long-term capital growth and maintenance of appropriate liquidity to meet corporate and policyholder obligations. Investment strategies are developed based on a variety of factors including business needs, regulatory requirements and tax considerations.
During 1996, the North American Property & Casualty segment continued its strategy of maximizing after-tax income through increased ownership of tax-exempt municipal bonds. On an after-tax basis, municipal bonds generally continued to provide significant incremental income over taxable securities. In 1996, net purchases of tax-exempt municipal bonds of $2.0 billion increased holdings to 55% of total invested assets compared to 44% and 26% as of December 31, 1995 and 1994, respectively. In addition to employing new cash flow to purchase municipal bonds, lower yielding taxable bonds were sold with proceeds reallocated to the higher after-tax yielding municipal market.
Another strategy employed in 1996, which increased income and provided diversification, was the purchase of additional high yield securities. The high yield sector also achieved excellent total return performance in 1996. Holdings of high yield investments increased to $708, or 6%, of total invested assets compared to $505, or 4%, at December 31, 1995. Included in December 31, 1996 high yield holdings were $135 in emerging market bonds compared to $60 at December 31, 1995.
Corporate $2,160 19.1% $2,427 22.8% CMO 655 5.8% 1,462 13.7% Municipal-tax-exempt 7,123 63.2% 5,171 48.5% Gov't/Gov't agencies-U.S. 15 0.1% 249 2.3% Asset backed securities ("ABS") 206 1.8% 239 2.2% Gov't/Gov't agencies-For. 279 2.5% 255 2.4% MBS-agency 213 1.9% 244 2.3% Commercial MBS 107 0.9% 14 0.1% Municipal-taxable 68 0.6% 75 0.7% Redeemable pref'd stock 47 0.4% -- -- Short-term 419 3.7% 531 5.0% - ------------------------------------------------------------------- TOTAL FIXED MATURITIES $11,292 100.0% $10,667 100.0% - -------------------------------------------------------------------
AAA $4,296 38.0% $4,570 42.8% AA 2,538 22.5% 2,137 20.0% A 1,683 14.9% 1,862 17.5% BBB 799 7.1% 649 6.1% Gov't 720 6.4% 252 2.4% BB & below 581 5.1% 459 4.3% Not rated 256 2.3% 207 1.9% Short-term 419 3.7% 531 5.0% - ----------------------------------------------------------------- TOTAL FIXED MATURITIES $11,292 100.0% $10,667 100.0% - -----------------------------------------------------------------
The taxable equivalent duration of the December 31, 1996 fixed maturity portfolio was 5.0 years compared to 4.4 years at December 31, 1995. Duration is defined as the market price sensitivity of the portfolio to parallel shifts in the yield curve.
The table below summarizes the North American Property & Casualty segment's results for the past three years.
For the year ended December 31, 1996, before-tax net investment income was $661 compared to $646 in 1995, an increase of 2%, while after-tax net investment income increased 11%. Although before-tax yields on average invested assets decreased to 5.52% in 1996 from 5.77% in 1995, the after-tax yield increased to 4.44% in 1996 from 4.28% in 1995. The increase in before-tax net investment income was primarily due to increased ownership of high yield securities, duration extension of 0.6 years and an increase in invested assets. While before-tax yield decreased due to an increased allocation to common stocks and municipal bonds and the sale of taxable bonds, increases in after-tax yield and income were primarily due to the strategic increase in allocation to tax-exempt municipal bonds.
For the year ended December 31, 1995, before-tax net investment income was $646 compared to $606 in 1994, an increase of 7%, while after-tax income increased 9%. Before-tax yields on average invested assets increased to 5.77% in 1995 from 5.65% in 1994. The after-tax yield increased to 4.28% in 1995 from 4.09% in 1994. The increases in net investment income and yields were primarily due to the transition from lower yielding taxable bonds and real estate along with increased ownership of tax-exempt municipal bonds.
The primary investment objective of the Life segment general account and guaranteed separate accounts is to maximize after-tax returns consistent with acceptable risk parameters (including the management of the interest rate sensitivity of invested assets to that of policyholder obligations). The segment is exposed to two primary sources of investment risk: credit risk, relating to the uncertainty associated with the continued ability of a given obligor to make timely payments of principal and interest, and interest rate risk, relating to the market price and/or cash flow variability associated with changes in market yield curves. Credit risk is managed through industry and issuer diversification and asset allocation. Interest rate risk is managed as part of the segment's asset/liability management strategies, including the use of certain hedging techniques (which may include the use of certain financial derivatives), product design, such as the use of the market value adjustment feature and surrender charges, and proactive monitoring and management of certain non-guaranteed elements of the segment's products (such as the resetting of credited interest rates for policies that permit such adjustments). For a further discussion of hedging strategies, including derivatives utilization, see the discussion on Asset and Liability Management Strategies below, as well as the Notes to Consolidated Financial Statements.
At December 31, 1996, approximately 10.3% of the segment's fixed maturity portfolio was 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 generally designed to mitigate the impact of such increased liquidity risk. Most of the private placement securities in the segment's portfolio are rated by rating agencies.
Invested assets, excluding separate accounts, totaled $16.3 billion at December 31, 1996 and were comprised of $12.2 billion of fixed maturities, $3.8 billion of policy loans, and other investments of $276. Policy loans, which carry a weighted-average interest rate of 11.9%, as of December 31, 1996, are secured by the cash value of the life policy. These loans do not mature in a conventional sense, but expire in conjunction with the related policy liabilities. The table below summarizes fixed maturity holdings by type.
For the year ended December 31, 1996, before-tax net investment income totaled $1.3 billion compared to $1.1 billion in 1995, an increase of 19%. Yields on average invested assets increased to 8.51% in 1996 from 8.30% in 1995. The increase in net investment income was primarily due to an increase in policy loans, new business cash flow invested in fixed maturities and asset mix changes. The increase in before-tax yield was primarily due to the increase in policy loan yields; excluding policy loans, the before-tax yield decreased to 7.09% from 7.37% in 1995. The decrease in before-tax yield excluding policy loans was the result of sales and maturities of higher yielding assets reinvested at lower average yields.
There were no net realized capital gains (losses) in 1996. Net realized capital losses decreased to a $(4) loss in 1995 from a $1 gain in 1994. During 1995, certain mortgage-backed securities were written down to fair value in accordance with generally accepted accounting principles. These writedowns amounted to $(45) and were substantially offset by gains generated on the sale of other fixed maturity investments.
Derivatives play an important role in facilitating the management of interest rate risk, creating opportunities to fund product obligations efficiently, hedging against risks that affect the value of certain liabilities and adjusting broad investment risk characteristics when dictated by significant changes in market risks. As an end user of derivatives, the segment uses a variety of derivatives, including swaps, caps, floors, forwards and exchange-traded financial futures and options in order to hedge exposure to price, foreign currency and/or interest rate risk on anticipated investment purchases or existing assets and liabilities. The notional amounts of derivative contracts represent the basis upon which pay and receive amounts are calculated and are not reflective of credit risk for derivative contracts. Credit risk for derivative contracts is limited to the amounts calculated to be due to the Company on such contracts. The Company maintains prudent policies regarding the financial stability and credit standing of its major counterparties and typically requires credit enhancement provisions to further limit its credit risk. Many of these derivative contracts are bilateral agreements that are not assignable without the consent of the relevant counterparty. Notional amounts pertaining to derivatives totaled $3.4 billion at December 31, 1996 ($2.7 billion related to life insurance investments and $749 related to life insurance liabilities) and $4.0 billion at December 31, 1995 ($3.4 billion related to life insurance investments and $565 related to life insurance liabilities). Management believes that the use of derivatives allows the Company to sell more innovative products, capitalize on market opportunities and execute a more flexible investment strategy for its general account portfolio. The strategies described below are used by the segment to manage the aforementioned risks associated with its obligations.
Asset Hedging -- To meet the various life policyholder obligations and to - -------------- provide prudent investment risk diversification, the Life segment may combine two or more financial instruments to achieve the investment characteristics that match the associated liability. The use of derivatives in this regard effectively transfers unwanted investment risks or attributes to others. The selection of the appropriate derivatives
Portfolio Hedging -- The Life segment 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 acceptable levels. Portfolio hedges reduce the mismatch between assets and liabilities and offset the potential cash flow impact caused by interest rate changes. The notional amount of portfolio hedges as of December 31, 1996 and 1995 was $755 and $1.0 billion, respectively.
Insurance liabilities, other than non-guaranteed separate accounts, totaled $27.3 billion, net of ceded reinsurance, at December 31, 1996 and were backed by $37.0 billion in total assets including investments of $26.7 billion. Matching of the duration of the investments with respective policyholder obligations is an explicit objective of the Life segment's management strategy. The segment's insurance policy liabilities, along with estimated duration periods based upon internal actuarial assumptions, can be summarized based on investment needs in the following five categories at December 31, 1996:
ESTIMATED DURATION YEARS [1] (IN BILLIONS) - -------------------------------------------------------------------- BALANCE AT LESS OVER DECEMBER THAN 1 1-5 6-10 10 DESCRIPTION 31, 1996 YEAR YEARS YEARS YEARS - --------------------------------------------------------------------
Fixed rate asset accumulation vehicles $10.3 $0.7 $5.9 $3.7 $- Indexed asset accumulation vehicles 0.2 0.2 - - - Interest credited asset accumulation vehicles 13.6 4.2 5.1 3.7 0.6 Long-term pay out liabilities 2.7 0.1 0.6 0.8 1.2 Short-term pay out liabilities 0.5 0.5 - - - - -------------------------------------------------------------------- TOTAL $27.3 $5.7 $11.6 $8.2 $1.8 - -------------------------------------------------------------------- [1] The duration of liabilities reflects management's assessment of the market price sensitivity of the liabilities to changes in market interest rates, and is not necessarily reflective of the projected liabilities' cash flows under any specific scenario.
Indexed Asset Accumulation Vehicles -- Products in this category are similar to - ------------------------------------ the fixed rate asset accumulation vehicles, but require the Life segment to pay a rate that is determined by an external index. The amount and/or timing of cash flows will therefore vary based on the level of the particular index. The primary risks inherent in these products are similar to the fixed rate asset accumulation vehicles, with an additional risk that changes in the index may adversely affect profitability. Product examples include indexed-guaranteed investment contracts with an estimated duration of up to two years. The weighted average credited rate for these contracts was 5.78% as of December 31, 1996, excluding policy loans.
Short-term Pay Out Liabilities -- These liabilities are short-term in nature - -------------------------------- with a duration of less than one year. The primary risks associated with these products are determined by the non-investment contingencies such as mortality or morbidity. Liquidity is of greater concern than for the long-term pay out liabilities. Products include individual and group term life insurance contracts and short-term disability contracts.
Consistent with the investment objectives of the North American Property & Casualty segment, the investment objectives of the International segment are to optimize after-tax returns on invested assets and preserve capital, while meeting obligations to policyholders. The International segment primarily comprises the investment activities of ITT London & Edinburgh, Zwolsche Algemeene and ITT Ercos, which are primarily engaged in property and casualty insurance.
Corporate $544 21.6% $261 10.8% Gov't/Gov't agencies-U.S. 121 4.8% 57 2.4% Gov't/Gov't agencies-For. 1,418 56.2% 1,203 49.8% Short-term 440 17.4% 893 37.0% - ------------------------ ---------- -------- --------- --------- TOTAL FIXED MATURITIES $2,523 100.0% $2,414 100.0% - ----------------------------------------------------------------
As of December 31, 1996, the fixed maturity portfolio consisted of 100% investment grade securities with no security rated lower than A. Minimal use is made of derivatives which, if purchased, are used for hedging market and foreign exchange risk. The table below summarizes fixed maturity holdings by credit quality.
FIXED MATURITIES BY CREDIT QUALITY - ----------------------------------------------------------------- 1996 1995 - ---------------------------------------------------------------- FAIR FAIR CREDIT QUALITY VALUE PERCENT VALUE PERCENT - ----------------------------------------------------------------
The table below summarizes the International segment's results for the past three years.
Net investment income, before-tax $205 $183 $135 Yield on average invested assets, before-tax [1] 7.05% 7.10% 6.10% Net realized capital gains, before-tax $79 $48 $23 --------------------------------------------------------------- [1] Represents net investment income (excluding net realized capital gains) divided by average invested assets at cost (fixed maturities at amortized cost).
Corporate $2,366 43.3% $2,587 39.0% CMO 1,140 20.8% 1,691 25.5% Gov't/Gov't agencies-U.S. 259 4.7% 362 5.4% ABS 625 11.5% 649 9.8% Gov't/Gov't agencies-For. 146 2.7% 145 2.2% MBS-agency 37 0.7% 218 3.3% Commercial MBS 179 3.3% 77 1.1% Municipal-taxable 85 1.6% 87 1.3% Short-term 620 11.4% 821 12.4% - ---------------------------------------------------------------- TOTAL FIXED MATURITIES $5,457 100.0% $6,637 100.0% - ----------------------------------------------------------------
The Runoff segment maintains a greater than 99% investment grade fixed maturity portfolio. The table below summarizes fixed maturity holdings by credit quality.
AAA $1,871 34.2% $2,804 42.2% AA 679 12.4% 691 10.4% A 1,722 31.6% 1,615 24.3% BBB 255 4.7% 357 5.4% Gov't 296 5.4% 272 4.1% BB & below 14 0.3% 12 0.2% Not rated -- -- 65 1.0% Short-term 620 11.4% 821 12.4% - ---------------------------------------------------------------- TOTAL FIXED MATURITIES $5,457 100.0% $6,637 100.0% - ----------------------------------------------------------------
The table below summarizes the Runoff segment's results for the past three years.
Net investment income, before-tax $334 $477 $596 Yield on average invested assets, before-tax [1] 5.27% 5.85% 7.13% Net realized capital gains (losses), before-tax $(220) $29 $(3) --------------------------------------------------------------- [1] Represents net investment income (excluding net realized capital gains (losses)) divided by average invested assets at cost (fixed maturities at amortized cost).
For the year ended December 31, 1995, before-tax net investment income totaled $477 compared to $596 in 1994, a decrease of 20%. Before-tax yields on average invested assets decreased to 5.85% in 1995 from 7.13% in 1994. The decrease in before-tax net investment income was primarily the result of sales and maturities of higher yielding securities and hedge costs in the Closed Book GRC. The decrease in yield resulted primarily from impact related to prepayments and hedge costs associated with the Closed Book GRC.
Net realized capital losses were $220 in 1996 compared to a $29 gain in 1995, primarily due to Closed Book GRC. (For additional information regarding Closed Book GRC see the Runoff section.) Net realized capital gains increased to $29 in 1995 from a $3 loss in 1994 primarily due to gains taken in Fencourt.
The Hartford has a disciplined approach to managing the risks arising from its assets and liabilities. Portfolio management is organized to bring together portfolios with similar investment criteria and objectives, group common styles and provide more consistent investment management. All investment activity, including setting policy and defining acceptable risk levels and counterparty qualifications, is subject to the regular review and approval by The Hartford's Finance Committee. The Hartford has a stringent investment credit policy that focuses on credit quality, limits credit concentrations, encourages diversification and requires frequent creditworthiness reviews. The Company has established exposure limits, diversification standards and review procedures for all credit risk whether borrower, issuer or counterparty. The Hartford analyzes interest rate risk using various models including a proprietary, multi-scenario cash flow projection model that forecasts liabilities and their supporting investments, including derivatives.
Separate account products are those for which a separate investment and liability account is maintained on behalf of the policyholder. Separate accounts reflect two categories of risk assumption: non-guaranteed separate accounts totaling $39.9 billion, wherein the policyholder assumes substantially all the risk and reward, and guaranteed separate accounts totaling $10.6 billion, wherein The Hartford contractually guarantees either a minimum return or account value to the policyholder. Investment strategy varies by fund choice, as outlined in the fund prospectus or separate account plan of operations. Non-guaranteed products include variable annuities and variable life contracts. Guaranteed separate account products primarily consist of modified guaranteed individual annuity and modified guaranteed life insurance, and generally include market value adjustment provisions to mitigate the disintermediation risk upon surrenders.
Additional investment risk is hedged using a variety of derivatives which totaled $86 and $133 in carrying value and $2.4 billion and $2.7 billion in notional amounts at December 31, 1996 and 1995, respectively. For a further discussion of strategies, including derivative utilization, see the previous discussion on Asset and Liability Management Strategies as well as the Notes to Consolidated Financial Statements.
Total debt in 1996 increased $624 compared to a $410 increase in the prior year. The Hartford used the proceeds of these additional borrowings to fund the insurance operations of its subsidiaries, and in 1995, to partially repay outstanding commercial paper and other short-term debt, redeem subsidiary preferred stock and pay dividends.
As of December 31, 1996, The Hartford had an unsecured aggregate $2.0 billion credit facility with twenty-nine participating banks which is comprised of a $1.5 billion five year revolving credit facility and a $500 short-term credit facility. This facility is available for general corporate purposes and to provide additional support to the Company's existing commercial paper program. At December 31, 1996, there were no outstanding borrowings under the facility. On February 10, 1997, Hartford Life, Inc. ("HLI"), a wholly-owned subsidiary of The Hartford, entered into a $1.3 billion unsecured short-term credit facility with four banks.
In connection with a shelf registration statement filed with and declared effective by the Securities and Exchange Commission ("SEC") in 1995, The Hartford registered for sale up to an aggregate $1.0 billion of debt securities and preferred stock. In 1995, the Company issued and sold $500 in senior debt securities. The intended use of the proceeds from the sale of such securities has been and will continue to be primarily for the repayment and/or replacement of outstanding commercial paper and other short-term debt. This reflects The Hartford's strategy of managing its capital within acceptable ranges of volatility and financial ratings while achieving the lowest long-run cost of capital that is reasonably possible. On October 2, 1996, this shelf registration statement was amended for an additional $1.25 billion of securities, making an aggregate of $1.75 billion available for sale. The amended registration statement also expanded the type of securities which could be offered under this shelf registration statement by including provisions for the offering of common stock, depositary shares, warrants, stock purchase contracts, stock purchase units and junior subordinated deferrable interest debentures of the Company, preferred securities of any of the Hartford Trusts (referred to below) and guarantees by the Company with respect to the preferred securities of any of the Hartford Trusts. After the issuance of QUIPS on October 30, 1996 discussed below, The Hartford had $1.25 billion remaining on this shelf registration at December 31, 1996.
On January 19, 1996, The Hartford and several wholly-owned special purpose trusts ("Hartford Trusts") formed by The Hartford filed with the SEC a shelf registration statement for the potential offering and sale of $500 of debt securities and preferred stock, including up to an aggregate $500 Junior Subordinated Deferrable Interest Debentures of The Hartford and Preferred Securities of the Hartford Trusts which were issued as discussed below. (For additional information, see Notes 5 and 6 of Notes to Consolidated Financial Statements.)
COMPANY OBLIGATED MANDATORILY REDEEMABLE PREFERRED SECURITIES OF SUBSIDIARY TRUSTS HOLDING SOLELY PARENT JUNIOR SUBORDINATED DEBENTURES ("QUIPS")
The following table summarizes The Hartford's significant U.S. member companies' financial ratings from the major independent rating organizations as of February 10, 1997:
On February 10, 1997, ratings from Duff & Phelps were reaffirmed for The Hartford's significant U.S. member companies. On February 10, 1997, A.M. Best placed the ratings of The Hartford's significant member companies under review with developing implications.
Dividends to ITT Hartford Group, Inc. from its subsidiaries are restricted. The payment of dividends by Connecticut-domiciled insurers is limited under the insurance holding
The primary uses of funds are to pay claims, policy benefits, operating expenses and commissions, and to purchase new investments. In addition, The Hartford carries a significant short-term investment position and accordingly does not anticipate selling intermediate and long-term fixed maturity investments to meet any liquidity needs. For a discussion of the Company's investment objectives and strategies, see Investments section.
The National Association of Insurance Commissioners ("NAIC") adopted regulations establishing minimum capitalization requirements based on risk-based capital ("RBC") formulas for both property and casualty companies (effective December 31, 1994) and life companies (effective December 31, 1993). The requirements consist of formulas which identify companies that are undercapitalized and require specific regulatory actions. RBC is calculated for property and casualty companies after adjusting capital for certain underwriting, asset, credit and off-balance sheet risks. The RBC formula for life companies establishes capital requirements relating to insurance, business, asset and interest rate risks. As of December 31, 1996, each of The Hartford's insurance subsidiaries within the North American Property & Casualty and Life segments have more than sufficient capital to meet the NAIC's RBC requirements.
1996 1995 1994 - ---------------------------------------------------------------- Cash provided by operating activities $ 994 $ 1,094 $ 823 Cash used for investing activities $ (1,035) $ (1,597) $ (3,336) Cash provided by financing activities $ 59 $ 533 $ 2,509 Cash - end of year $ 112 $ 95 $ 55 - ----------------------------------------------------------------
least 80% of HLI, but it is under no contractual obligation to do so.
In all states, insurers licensed to transact certain classes of insurance are required to become members of an insolvency fund. In most states, in the event of the insolvency of an insurer writing any such class of insurance in the state, all members of the fund are assessed to pay certain claims of the insolvent insurer. A particular state's fund assesses its members based on their respective written premiums in the state for the classes of insurance in which the insolvent insurer is engaged. Assessments are generally limited for any year to one or two percent of premiums written per year depending on the state. Such assessments paid by The Hartford approximated $14 in 1996, $15 in 1995 and $23 in 1994.