The Hartford owns the land and buildings comprising its Hartford location and other properties within the greater Hartford, Connecticut area which total approximately 2.1 million of the 2.5 million square feet owned by the Company in the aggregate. In addition, The Hartford leases approximately 5.7 million square feet throughout the United States of America and approximately 1.1 million square feet in other countries. All of the properties owned or leased are used by one or more of all eleven reporting segments, depending on the location. For more information on reporting segments, see Part I, Item 1, Business of The Hartford - Reporting Segments. The Company believes its properties and facilities are suitable and adequate for current operations.
2004 includes a $216 tax benefit related to agreement with the IRS on the resolution of matters pertaining to tax years prior to 2004.
As a result of the net loss in the year ended December 31, 2008, FASB No.128, “Earnings per Share” (“SFAS 128”) requires the Company to use basic weighted average common shares outstanding in the calculation of the year ended December 31, 2008 diluted earnings (loss) per share, since the inclusion of the assumed conversion of convertible preferred shares to common of 5.0 and shares for stock compensation plans of 1.3 would have been antidilutive to the earnings per share calculation. In the absence of the net loss, weighted average common shares outstanding and dilutive potential common shares would have totaled 313.0.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) addresses the financial condition of The Hartford Financial Services Group, Inc. and its subsidiaries (collectively, “The Hartford” or the “Company”) as of December 31, 2008, compared with December 31, 2007, and its results of operations for each of the three years in the period ended December 31, 2008. This discussion should be read in conjunction with the Consolidated Financial Statements and related Notes beginning on page. Certain reclassifications have been made to prior year financial information to conform to the current year presentation.
Certain of the statements contained herein are forward-looking statements. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include estimates and assumptions related to economic, competitive and legislative developments. These forward-looking statements are subject to change and uncertainty which are, in many instances, beyond the Company’s control and have been made based upon management’s expectations and beliefs concerning future developments and their potential effect upon the Company. There can be no assurance that future developments will be in accordance with management’s expectations or that the effect of future developments on The Hartford will be those anticipated by management. Actual results could differ materially from those expected by the Company, depending on the outcome of various factors, including, but not limited to, those set forth in Part II, Item 1A, Risk Factors. These important risks and uncertainties include, without limitation, uncertainties related to the depth and duration of the current recession and related financial crisis, and the impact of these volatile market conditions on, among other things, our investment portfolio, liabilities from variable annuity products and capital position; the success of our efforts to preserve capital and reduce risk, and the costs and charges associated therewith; our ability to participate in programs under the Emergency Economic Stabilization Act of 2008 and similar initiatives and the terms of such participation; changes in financial and capital markets, including changes in interest rates, credit spreads, equity prices and foreign exchange rates; the inability to effectively mitigate the impact of equity market volatility on the Company’s financial position and results of operations arising from obligations under annuity product guarantees; the amount of statutory capital that the Company has, changes to the statutory reserves and/or risk based capital requirements, and the Company’s ability to hold sufficient statutory capital to maintain financial strength and credit ratings; risks related to the Company’s potential participation in the U.S. Treasury’s Capital Purchase Program; a downgrade in the Company’s financial strength or credit ratings; the potential for differing interpretations of the methodologies, estimations and assumptions that underlie the valuation of the Company’s financial instruments that could result in changes to investment valuations; the subjective determinations that underlie the Company’s evaluation of other-than-temporary impairments on available-for-sale securities; losses due to nonperformance or defaults by others; the availability of our commercial paper program; the potential for acceleration of DAC amortization; the potential for an impairment of our goodwill; the difficulty in predicting the Company’s potential exposure for asbestos and environmental claims; the possible occurrence of terrorist attacks; the response of reinsurance companies under reinsurance contracts and the availability, pricing and adequacy of reinsurance to protect the Company against losses; the possibility of unfavorable loss development; the incidence and severity of catastrophes, both natural and man-made; stronger than anticipated competitive activity; unfavorable judicial or legislative developments; the potential effect of domestic and foreign regulatory developments, including those which could increase the Company’s business costs and required capital levels; the Company’s ability to distribute its products through distribution channels, both current and future; the uncertain effects of emerging claim and coverage issues; the ability of the Company’s subsidiaries to pay dividends to the Company; the Company’s ability to adequately price its property and casualty policies; the ability to recover the Company’s systems and information in the event of a disaster or other unanticipated event; potential for difficulties arising from outsourcing relationships; potential changes in federal or state tax laws, including changes impacting the availability of the separate account dividend received deduction; the Company’s ability to protect its intellectual property and defend against claims of infringement; and other factors described in such forward-looking statements.
Life is organized into four groups which are comprised of six reporting segments: The Retail Products Group (“Retail”) and Individual Life segments make up the Individual Markets Group. The Retirement Plans and Group Benefits segments make up the Employer Markets Group. The Institutional Solutions Group (“Institutional”) and International segments each make up their own group. Through Life the Company provides retail and institutional investment products such as variable and fixed annuities, mutual funds, private placement life insurance and retirement plan services, individual life insurance products including variable universal life, universal life, interest sensitive whole life and term life; and group benefit products, such as group life and group disability insurance.
The Company has identified the following estimates as critical in that they involve a higher degree of judgment and are subject to a significant degree of variability: property and casualty reserves, net of reinsurance; life estimated gross profits used in the valuation and amortization of assets and liabilities associated with variable annuity and other universal life-type contracts; living benefits required to be fair valued; valuation of investments and derivative instruments; evaluation of other-than-temporary impairments on available-for-sale securities; pension and other postretirement benefit obligations; contingencies relating to corporate litigation and regulatory matters; and goodwill impairment. In developing these estimates management makes subjective and complex judgments that are inherently uncertain and subject to material change as facts and circumstances develop. Although variability is inherent in these estimates, management believes the amounts provided are appropriate based upon the facts available upon compilation of the financial statements.
The following table shows loss and loss adjustment expense reserves by line of business and by operating segment as of December 31, 2008, net of reinsurance:
Company reserving actuaries, who are independent of the business units, regularly review reserves for both current and prior accident years using the most current claim data. These reserve reviews incorporate a variety of actuarial methods and judgments and involve rigorous analysis. Most non-A&E reserves are reviewed fully each quarter, including loss reserves for property, auto physical damage, auto liability, package business, workers’ compensation, most general liability, professional liability and fidelity and surety. Other non-A&E reserves are reviewed semi-annually (twice per year) or annually. These include, but are not limited to, reserves for losses incurred before 1988, allocated loss adjustment expenses, assumed reinsurance, latent exposures such as construction defects, unallocated loss adjustment expense and all other non-A&E exposures within Other Operations. For reserves that are reviewed semi-annually and annually, management monitors the emergence of paid and reported losses in the intervening quarters to either confirm that its estimate of ultimate losses should not change or, if necessary, perform a reserve review to determine whether the reserve estimate should change.
Expected Loss Ratio method. Loss ratios for prior accident years are used to determine the appropriate expected loss ratio for the current accident year after applying anticipated changes in rates, pricing and loss costs. The current accident year expected loss ratio is multiplied by earned premium to calculate estimated ultimate losses.
Bornhuetter-Ferguson method. This method is a combination of the expected loss ratio method and the paid development or reported development method, where the paid or reported loss development method is given more weight as an accident year matures.
Berquist-Sherman method. This method is used in cases where historical development patterns may be inappropriate for use in estimating ultimate losses of recent accident years. Under this method, the pattern of historical reported losses is adjusted for changes in case reserve adequacy and the pattern of historical paid losses is adjusted for changes in claim settlement rates.
Property and Auto Physical Damage. These lines are fast-developing and paid and reported development techniques are used. The Company performs and relies primarily on reported development techniques and frequency/severity and Bornhuetter-Ferguson techniques for the most immature accident months.
In Personal Lines, reserving estimates are generally less variable than for the Company’s other property and casualty segments. This is largely due to the coverages having relatively shorter periods of loss emergence. Estimates, however, can still vary due to a number of factors, including interpretations of frequency and severity trends and their impact on recorded reserve levels. Severity trends can be impacted by changes in internal claim handling and case reserving practices in addition to changes in the external environment. These changes in claim practices increase the uncertainty in the interpretation of case reserve data, which increases the uncertainty in recorded reserve levels. In addition, the introduction of new products has lead to a different mix of business by type of insured than the Company experienced in the past. Beginning in 2004, the Company introduced its Dimensions auto and homeowners product for Agency business and beginning in 2007, the Company introduced its Next Generation Auto product for AARP customers. In general, the Company now has a lower proportion of preferred risks than in the past. Such a change in mix increases the uncertainty of the reserve projections, since historical data and reporting patterns may not be applicable to the new business.
In the Specialty Commercial segment, many lines of insurance, such as excess insurance and large deductible workers’ compensation insurance, are “long-tail” lines of insurance. For long-tail lines, the period of time between the incidence of the insured loss and either the reporting of the claim to the insurer, the settlement of the claim, or the payment of the claim can be substantial, and in some cases, several years. As a result of this extended period of time for losses to emerge, reserve estimates for these lines are more uncertain (i.e., more variable) than reserve estimates for shorter-tail lines of insurance. Estimating required reserve levels for large deductible workers’ compensation insurance is further complicated by the uncertainty of whether losses that are attributable to the deductible amount will be paid by the insured; if such losses are not paid by the insured due to financial difficulties, the Company would be contractually liable. Another example of reserve variability relates to reserves for directors and officers insurance. There is potential volatility in the required level of reserves due to the continued uncertainty regarding the number and severity of class action suits, including uncertainty regarding the Company’s exposure to losses arising from the collapse of the sub-prime mortgage market. Additionally, the Company’s exposure to losses under directors and officers insurance policies is primarily in excess layers, making estimates of loss more complex. The current financial market turmoil has increased the number of shareholder class action lawsuits against our insureds or their directors and officers and this trend could continue for some period of time.
Recorded reserves for general liability, net of reinsurance, are $2.3 billion in total for Ongoing Operations. Reported loss development patterns are a key assumption for this line of business, particularly for more mature accident years. Historically, assumptions on reported loss development patterns have been impacted by, among other things, emergence of new types of claims (e.g., construction defect claims) or a shift in the mixture between smaller, more routine claims and larger, more complex claims. The Company has reviewed the historical variation in reported loss development patterns. If the reported loss development patterns change by 11%, the estimated net reserve need would change by $300, in either direction. An 11% change in reported loss development patterns is within historical variation, as measured by the variation around the average development factors as reported in statutory accident year reports.
Similar to general liability, assumed casualty reinsurance is affected by reported loss development pattern assumptions. In addition to the items identified above that would affect both direct and reinsurance liability claim development patterns, there is also an impact to assumed reporting patterns for any changes in claim notification from ceding companies to the reinsurer. Recorded net reserves for HartRe assumed reinsurance business, excluding asbestos and environmental liabilities, within Other Operations were $562 as of December 31, 2008. If the reported loss development patterns underlying the Company’s net reserves for HartRe assumed casualty reinsurance change by 10%, the estimated net reserve need would change by $245, in either direction. A 10% change in reported loss development patterns is within historical variation, as measured by the variation around the average development factors as reported in statutory accident year reports.
Having evaluated its insureds’ probable liabilities for asbestos and/or environmental claims, the Company then evaluates its insureds’ insurance coverage programs for such claims. The Company considers its insureds’ total available insurance coverage, including the coverage issued by the Company. The Company also considers relevant judicial interpretations of policy language and applicable coverage defenses or determinations, if any.
In the case of the reserves for environmental exposures, factors contributing to the high degree of uncertainty include expanding theories of liability and damages, the risks inherent in major litigation, inconsistent decisions concerning the existence and scope of coverage for environmental claims, and uncertainty as to the monetary amount being sought by the claimant from the insured.
For most contracts, the Company estimates gross profits over a 20 year horizon as estimated profits emerging subsequent to that timeframe are immaterial. The Company uses other amortization bases for amortizing DAC, such as gross costs (net of reinsurance), as a replacement for EGPs when EGPs are expected to be negative for multiple years of the contract’s life. Actual gross profits, in a given reporting period, that vary from management’s initial estimates result in increases or decreases in the rate of amortization, commonly referred to as a “true-up”, which are recorded in the current period. The true-up recorded for the years ended December 31, 2008, 2007, and 2006 was an increase (decrease) to amortization of $404 (of which $194 is attributed to accelerated DAC amortization for the Company’s 3Win product in Japan as further discussed under the “Japan Variable Annuities” section below), $(6), and $41, respectively.
Decrease: Expected fee income would decrease because the time period in which fees would be collected would be reduced and claims would increase
The Company plans to complete a comprehensive assumption study and refine its estimate of future gross profits during the third quarter of each year. Upon completion of an assumption study, the Company revises its assumptions to reflect its current best estimate, thereby changing its estimate of projected account values and the related EGPs in the DAC, sales inducement and unearned revenue reserve amortization models as well as SOP 03-1 reserving models. The DAC asset, as well as the sales inducement asset, unearned revenue reserves and SOP 03-1 reserves are adjusted with an offsetting benefit or charge to income to reflect such changes in the period of the revision, a process known as “Unlocking”. An Unlock that results in an after-tax benefit generally occurs as a result of actual experience or future expectations of product profitability being favorable compared to previous estimates. An Unlock that results in an after-tax charge generally occurs as a result of actual experience or future expectations of product profitability being unfavorable compared to previous estimates.
As a result of the Unlock, death benefit reserves in Retail, increased $389, pre-tax, offset by an increase of $273, pre-tax, in reinsurance recoverables. In International, death benefit reserves increased $164, pre-tax, offset by an increase of $25, pre-tax, in reinsurance recoverables.
The following were the most significant contributors to the Unlock amounts recorded during the third quarter of 2008:
The Company performs sensitivity analyses with respect to the effect certain assumptions have on EGPs and the related DAC, sales inducement, unearned revenue reserve and SOP 03-1 reserve balances. Each of the sensitivities illustrated below are estimated individually, without consideration for any correlation among the key assumptions. Therefore, it would be inappropriate to take each of the sensitivity amounts below and add them together in an attempt to estimate volatility for the respective EGP-related balances in total. In addition, the tables below only provide sensitivities on separate account returns and lapses. While those two assumptions are critical in projecting EGPs, as described above, many additional assumptions are necessary to project EGPs and to determine an Unlock amount. As a result, actual Unlock amounts may vary from those calculated by using the sensitivities below. The following tables depict the estimated sensitivities for U.S. variable annuities and Japan variable annuities:
The overall actual return generated by the Japan variable annuity separate accounts is influenced by the variable annuity products offered in Japan as well as the wide variety of funds offered within the sub-accounts of those products. The actual return is also dependent upon the relative mix of the underlying sub-accounts among the funds. Unlike in the U.S., there is no global index or market that reasonably correlates with the overall Japan actual separate account fund performance. Since September 30, 2008, the date of the last unlock, the actual return on Japan variable annuity assets has been 15.5% below our estimated aggregate return. The Company estimates the actual return would need to drop by an additional 7.5% since December 31, 2008, before EGPs in the Company’s models fall outside of the statistical ranges of reasonable EGPs.
An “Unlock” only revises EGPs to reflect current best estimate assumptions. With or without an Unlock, and even after an Unlock occurs, the Company must also test the aggregate recoverability of the DAC and sales inducement assets by comparing the existing DAC balance to the present value of future EGPs. In addition, the Company routinely stress tests its DAC and sales inducement assets for recoverability against severe declines in its separate account assets, which could occur if the equity markets experienced a significant sell-off, as the majority of policyholders’ funds in the separate accounts is invested in the equity market. As of December 31, 2008, the Company believed U.S. individual and Japan individual variable annuity EGPs could fall, through a combination of negative market returns, lapses and mortality, by at least 6% and 49%, respectively, before portions of its DAC and sales inducement assets would be unrecoverable. The extent of the charge against earnings upon the DAC and sales inducement assets becoming unrecoverable is dependent upon how much further beyond the thresholds listed above variable annuity EGPs decline. The Company estimates that for every 1% decline in variable annuity EGPs beyond the thresholds listed above, the DAC and sales inducements write-off would be $65 and $12, after-tax, for U.S. variable annuity and Japan variable annuity, respectively. If, at the end of any quarter, the EGPs in the Company’s models fall outside of the statistical ranges of reasonable EGPs, see footnote [3] above, and the Company has exceeded the threshold for recoverability, the Company will first “Unlock” the future EGPs to reflect the Company’s revised best estimates and second will re-test for recoverability.
The Company offers certain variable annuity products with a guaranteed minimum withdrawal benefit (“GMWB”) rider in the U.S., Japan and the U.K. The Company also offers a guaranteed minimum accumulation benefit (“GMAB”) with a variable annuity product offered in Japan. As of December 31, 2008 and December 31, 2007, the fair values of the GMWB liabilities are $6.6 billion and $715, respectively. As of December 31, 2008 the fair value of the GMAB liability is $0. As of December 31, 2007 the fair value of the GMAB was an asset of $2 because the present value of the fees expected to be earned in the future exceeded the present value claims expected to be paid in the future. Due to significant market declines in the fourth quarter of 2008, a large majority of the Company’s in force Japan 3 Win policies, which include a GMAB feature, annuitized or surrendered free of charge in the fourth quarter of 2008. See Note 4 of Notes to Consolidated Financial Statements for a description of the Japan GMAB.
Fair values for GMWB and GMAB contracts are calculated based upon internally developed models because active, observable markets do not exist for those items. Below is a description of the Company’s fair value methodologies for guaranteed benefit liabilities, the related reinsurance and customized derivatives, all accounted for under SFAS 133, prior to the adoption of SFAS 157 and subsequent to adoption of SFAS 157.
Prior to January 1, 2008, the Company used the guidance prescribed in SFAS 133 and other related accounting literature on fair value which represented the amount for which a financial instrument could be exchanged in a current transaction between knowledgeable, unrelated willing parties. However, under that accounting literature, when an estimate of fair value was made for liabilities where no market observable transactions existed for that liability or similar liabilities, market risk margins were only included in the valuation if the margin was identifiable, measurable and significant. If a reliable estimate of market risk margins was not obtainable, the present value of expected future cash flows under a risk neutral framework, discounted at the risk free rate of interest, was the best available estimate of fair value in the circumstances (“Pre-SFAS 157 Fair Value”). The Pre-SFAS 157 Fair Value was calculated based on actuarial and capital market assumptions related to projected cash flows, including benefits and related contract charges, over the lives of the contracts, incorporating expectations concerning policyholder behavior such as lapses, fund selection, resets and withdrawal utilization (for the customized derivatives, policyholder behavior is prescribed in the derivative contract). Because of the dynamic and complex nature of these cash flows, best estimate assumptions and a Monte Carlo stochastic process involving the generation of thousands of scenarios that assume risk neutral returns consistent with swap rates and a blend of observable implied index volatility levels were used. Estimating these cash flows involved numerous estimates and subjective judgments including those regarding expected markets rates of return, market volatility, correlations of market index returns to funds, fund performance, discount rates and policyholder behavior. At each valuation date, the Company assumed expected returns based on:
Behavior Risk Margin. This component adds a margin that market participants would require for the risk that the Company’s assumptions about policyholder behavior used in the Pre-SFAS 157 model could differ from actual experience. The Behavior Risk Margin is calculated by taking the difference between adverse policyholder behavior assumptions and the best estimate assumptions used in the Pre-SFAS 157 model using interest rate and volatility assumptions that the Company believes market participants would use in developing risk margins.
The Hartford’s investments in fixed maturities include bonds, redeemable preferred stock and commercial paper. These investments, along with certain equity securities, which include common and non-redeemable preferred stocks, are classified as “available-for-sale” and are carried at fair value. The after-tax difference from cost or amortized cost is reflected in stockholders’ equity as a component of Accumulated Other Comprehensive Income (“AOCI”), after adjustments for the effect of deducting the life and pension policyholders’ share of the immediate participation guaranteed contracts and certain life and annuity deferred policy acquisition costs and reserve adjustments. The equity investments associated with the variable annuity products offered in Japan are recorded at fair value and are classified as “trading” with changes in fair value recorded in net investment income. Policy loans are carried at outstanding balance. Mortgage loans on real estate are recorded at the outstanding principal balance adjusted for amortization of premiums or discounts and net of valuation allowances, if any. Short-term investments are carried at amortized cost, which approximates fair value. Limited partnerships and other alternative investments are reported at their carrying value with the change in carrying value accounted for under the equity method and accordingly the Company’s share of earnings are included in net investment income. Recognition of limited partnerships and other alternative investment income is delayed due to the availability of the related financial statements, as private equity and other funds are generally on a three-month delay and hedge funds are on a one-month delay. Accordingly, income at December 31, 2008 may not include the full impact of current year changes in valuation of the underlying assets and liabilities. Other investments primarily consist of derivatives instruments which are carried at fair value.
Prices from third party pricing services are often unavailable for securities that are rarely traded or are traded only in privately negotiated transactions. As a result, certain securities are priced via independent broker quotations which utilize inputs that may be difficult to corroborate with observable market based data. Additionally, the majority of these independent broker quotations are non-binding. A pricing matrix is used to price securities for which the Company is unable to obtain either a price from a third party pricing service or an independent broker quotation. The pricing matrix used by the Company begins with current spread levels to determine the market price for the security. The credit spreads, as assigned by a knowledgeable private placement broker, incorporate the issuer’s credit rating and a risk premium, if warranted, due to the issuer’s industry and the security’s time to maturity. The issuer-specific yield adjustments, which can be positive or negative, are updated twice per year, as of June 30 and December 31, by the private placement broker and are intended to adjust security prices for issuer-specific factors. The Company assigns a credit rating to these securities based upon an internal analysis of the issuer’s financial strength.
The Company performs a monthly analysis on the prices and credit spreads received from third parties to ensure that the prices represent a reasonable estimate of the fair value. This process involves quantitative and qualitative analysis and is overseen by investment and accounting professionals. Examples of procedures performed include, but are not limited to, initial and on-going review of third party pricing services methodologies, review of pricing statistics and trends, back testing recent trades and monitoring of trading volumes. In addition, the Company ensures whether prices received from independent brokers represent a reasonable estimate of fair value through the use of internal and external cash flow models developed based on spreads, and when available, market indices. As a result of this analysis, if the Company determines that there is a more appropriate fair value based upon the available market data, the price received from the third party is adjusted accordingly. At December 31, 2008, the Company made fair value determinations which lowered prices received from third party pricing services and brokers by a total of $139. The securities adjusted had an amortized cost and fair value after the adjustment of $623 and $232, respectively, and were primarily commercial mortgage-backed securities (“CMBS”).
In accordance with SFAS 157, the Company has analyzed the third party pricing services valuation methodologies and related inputs, and has also evaluated the various types of securities in its investment portfolio to determine an appropriate SFAS 157 fair value hierarchy level based upon trading activity and the observability of market inputs. The SFAS 157 fair value hierarchy prioritizes the inputs in the valuation techniques used to measure fair value into three broad levels (Level 1 - quoted prices in active markets for identical assets, Level 2 - significant observable inputs, or Level 3 - significant unobservable inputs). For further discussion of SFAS 157, see Note 4 of the Notes to the Consolidated Financial Statements. Based on this, each price was classified into Level 1, 2, or 3. Most prices provided by third party pricing services are classified into Level 2 because the inputs used in pricing the securities are market observable.
Securities not subject to Emerging Issues Task Force (“EITF”) Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continued to Be Held by a Transferor in Securitized Financial Assets” (“non-EITF Issue No. 99-20 securities”) that are in an unrealized loss position, are reviewed at least quarterly to determine if an other-than-temporary impairment is present based on certain quantitative and qualitative factors. The primary factors considered in evaluating whether a decline in value for non-EITF Issue No. 99-20 securities is other-than-temporary include: (a) the length of time and extent to which the fair value has been less than cost or amortized cost of the security, (b) the financial condition, credit rating and future prospects of the issuer, (c) whether the debtor is current on contractually obligated interest and principal payments and (d) the intent and ability of the Company to retain the investment for a period of time sufficient to allow for recovery.
The Company maintains a U.S. qualified defined benefit pension plan (the “Plan”) that covers substantially all employees, as well as unfunded excess plans to provide benefits in excess of amounts permitted to be paid to participants of the Plan under the provisions of the Internal Revenue Code. The Company has also entered into individual retirement agreements with certain retired directors providing for unfunded supplemental pension benefits. In addition, the Company provides certain health care and life insurance benefits for eligible retired employees. The Company maintains international plans which represent an immaterial percentage of total pension assets, liabilities and expense and, for reporting purposes, are combined with domestic plans.
As of December 31, 2008, a 25 basis point increase/decrease in the discount rate would decrease/increase the pension and other postretirement obligations by $116 and $9, respectively. However, because the Company employs a duration overlay program to adjust the duration of the fixed income component of the Plan assets to better match the duration of the liabilities, the funded status of the pension benefits would only increase/decrease by $43.
The Company determines the expected long-term rate of return assumption based on an analysis of the Plan portfolio’s historical compound rates of return since 1979 (the earliest date for which comparable portfolio data is available) and over 5 year and 10 year periods. The Company selected these periods, as well as shorter durations, to assess the portfolio’s volatility, duration and total returns as they relate to pension obligation characteristics, which are influenced by the Company’s workforce demographics. In addition, the Company also applies long-term market return assumptions utilized in Life’s DAC analysis to an investment mix that generally anticipates 60% fixed income securities, 20% equity securities and 20% alternative assets to derive an expected long-term rate of return. Based upon these analyses, management maintained the long-term rate of return assumption at 7.30% as of December 31, 2008. This assumption will be used to determine the Company’s 2009 expense. The long-term rate of return assumption at December 31, 2007, that was used to determine the Company’s 2008 expense, was also 7.30%.
In 2008, the deterioration of the global economy, together with the current credit crisis, caused significant volatility in interest rates and equity prices, which caused actual asset returns of the Plan’s investment portfolios to be less than expected. As provided for under SFAS No. 87, the Company uses a five-year averaging method to determine the market-related value of Plan assets, which is used to determine the expected return component of pension expense. Under this methodology, asset gains/losses that result from returns that differ from the Company’s long-term rate of return assumption are recognized in the market-related value of assets on a level basis over a five year period. The difference between actual asset returns for the plans of $(441) and $331 for the years ended December 31, 2008 and 2007, respectively, as compared to expected returns of $279 and $283 for the years ended December 31, 2008 and 2007, respectively, will be fully reflected in the market-related value of plan assets over the next five years using the methodology described above. The level of actuarial net losses continues to exceed the allowable amortization corridor as defined under SFAS No. 87. Based on the 6.25% discount rate selected as of December 31, 2008 and taking into account estimated future minimum funding, the difference between actual and expected performance in 2008 will increase annual pension expense in future years. The increase in pension expense will be approximately $30 in 2009 and will increase ratably to an increase of approximately $205 in 2014.
SFAS No. 142, “Goodwill and Other Intangible Assets,” requires that goodwill balances be reviewed for impairment at least annually or more frequently if events occur or circumstances change that would indicate that a triggering event, as defined in SFAS 142, has occurred. A reporting unit is defined as an operating segment or one level below an operating segment. Most of the Company’s reporting units, for which goodwill has been allocated, are equivalent to the Company’s operating segments as there is no discrete financial information available for the separate components of the segment or all of the components of the segment have similar economic characteristics. The fixed and variable annuity components of Individual Annuity have been aggregated into one reporting unit; the 401(k), 457 and 403(b) components of Retirement have been aggregated into one reporting unit; the variable life, universal life and term life components of Individual Life have been aggregated into one reporting unit; the private placement life insurance and institutional investment products components of the Institutional Solutions Group have been aggregated into one reporting unit; the group disability and group life components of Group Benefits have been aggregated into one reporting unit; the Japan, Brazil and U.K. components of International have been aggregated into one reporting unit, and the homeowners and automobile components of Personal Lines have been aggregated into one reporting unit. In circumstances where the components of an operating segment constitute a business for which discrete financial information is available and segment management regularly reviews the operating results of that component such as with Other Retail, which combined with Individual Annuity constitutes the Retail operating segment, and Hartford Financial Products, the Company has classified those components as reporting units.
The Company believes one of the significant drivers in the decline of its traded per share price is the risks associated with the death and living benefit guarantees offered with the products sold by the Individual Annuity and International reporting units and the related U.S. GAAP and statutory requirements.
The goodwill impairment charge of $745 included $323 that had resulted from the Company’s buyback of the Life operations in 2000. The buyback goodwill was reported in Corporate but had been allocated to Life reporting units for purposes of goodwill impairment testing, including $308 to Individual Annuity and $15 to International. This portion of the impairment was recorded in Corporate. The remaining impairment charge of $422 was recorded in Individual Annuity and related to the Company’s prior acquisitions of Planco, Inc. and Fortis Financial Group, Inc.
If current market conditions persist during 2009, in particular, if the Company’s share price remains below book value per share, or if the Company’s actions to limit risk associated with its products or investments causes a significant change in any one reporting unit’s fair value, the Company may need to reassess goodwill impairment at the end of each quarter as part of an annual or interim impairment test. Subsequent reviews of goodwill could result in additional impairment of goodwill during 2009.
The effect of the triggering of the guaranteed minimum income benefit for the 3 Win product was $151, after-tax.
Property & Casualty results changed from net income of $1.5 billion in 2007 to net income of $92 in 2008, largely due to a $1.1 billion after-tax increase in net realized capital losses on investments, a $325 after-tax decrease in net investment income and a $238 after-tax increase in current accident year catastrophes, partially offset by a $147 after-tax net release of prior accident year reserves in 2008.
Realized losses increased for the year ended December 31, 2007 as compared to the comparable prior year periods primarily due to net losses on GMWB derivatives and impairments.
Property & Casualty net income decreased by $12 for the year ended December 31, 2007. Ongoing Operations’ net income decreased by $77 for the year, while Other Operations improved its results by $65, primarily due to a reduction in unfavorable loss reserve development.
Ongoing Operations’ net income decreased by $77, primarily due to a $92 after-tax decrease in underwriting results and a change from net realized capital gains of $29, after-tax, in 2006 to net realized capital losses of $104, after-tax, in 2007. The decrease in underwriting results and the change to net realized capital losses was partially offset by a $150 after-tax increase in net investment income. The decrease in underwriting results was primarily driven by an increase in the loss and loss adjustment expense ratio before catastrophes and prior accident year development and an increase in insurance and operating costs and dividends, partially offset by a reduction in prior accident year reserves for workers’ compensation business.
The separate account dividends-received deduction (“DRD”) is estimated for the current year using information from the prior year-end, adjusted for current year equity market performance and other appropriate factors, including estimated levels of corporate dividend payments. The estimated DRD was updated in the third quarter for the provision-to-filed-return adjustments, and in the fourth quarter based on current year ultimate mutual fund distributions and fee income from the Company’s variable insurance products. The actual current year DRD varied from earlier estimates based on, but not limited to, changes in eligible dividends received by the mutual funds, amounts of distributions from these mutual funds, amounts of short-term capital gains and asset values at the mutual fund level and the Company’s taxable income before the DRD. Given recent financial markets’ volatility, the Company intends to review its DRD computations on a quarterly basis, beginning in 2009. The Company recorded benefits of $176, $155 and $174 related to the separate account DRD in the years ended December 31, 2008, December 31, 2007 and December 31, 2006, respectively. The 2008 benefit included a benefit of $9 related to a true-up of the prior year tax return, the 2007 benefit included a charge of $1 related to a true-up of the prior year tax return, and the 2006 benefit included a benefit of $6 related to true-ups of prior years’ tax returns.
The Company receives a foreign tax credit (“FTC”) against its U.S. tax liability for foreign taxes paid by the Company including payments from its separate account assets. The separate account FTC is estimated for the current year using information from the most recent filed return, adjusted for the change in the allocation of separate account investments to the international equity markets during the current year. The actual current year FTC can vary from the estimates due to actual FTCs passed through by the mutual funds. The Company recorded benefits of $16, $11 and $17 related to separate account FTC in the years ended December 31, 2008, December 31, 2007 and December 31, 2006, respectively. These amounts included benefits related to true-ups of prior years’ tax returns of $4, $0 and $7 in 2008, 2007 and 2006 respectively.
The Company’s unrecognized tax benefits increased by $15 during 2008 as a result of tax positions taken on the Company’s 2007 tax return and expected to be taken on its 2008 tax return, bringing the total unrecognized tax benefits to $91 as of December 31, 2008. This entire amount, if it were recognized, would affect the effective tax rate.
Near-term, the industry and the Company are experiencing lower variable annuity sales as a result of recent market turbulence and uncertainty in the U.S. financial system. Current market pressures are also increasing the expected claim costs, the cost and volatility of hedging programs, and the level of capital needed to support living benefit guarantees. Some companies have already begun to increase the price of their guaranteed living benefits and change the level of guarantees offered. In 2009, the Company intends to adjust pricing levels and take certain actions to reduce the risks in its variable annuity product features in order to address the risks and costs associated with variable annuity benefit features in the current economic environment and explore other risk limiting techniques such as increased hedging or other reinsurance structures. Competitor reaction, including the extent of competitor risk limiting strategies, is difficult to predict and may result in a decline in Retail’s market share.
The decline in assets under management as a result of continued declines in the equity markets throughout 2008 have decreased the extent of the scale efficiencies that Retail has benefited from in recent years. The significant reduction in assets under management has resulted in revenues declining faster than expenses causing lower earnings during the fourth quarter of 2008 and management expects this strain to continue in 2009. Management will continue to actively evaluate its expense structure to ensure the business is controlling costs while maintaining its level of service to our customers.
Sales and account values for variable universal life products have been under pressure due to continued equity market volatility and declines. For the year ended December 31, 2008, variable universal life sales and account values decreased 30% and 34%, respectively, compared to prior year. Continued volatility and declines in the equity markets may reduce the attractiveness of variable universal life products and put additional strain on future earnings as variable life fees earned by the Company are driven by the level of assets under management. The variable universal life mix was 40% of total life insurance in-force for the year ended December 31, 2008.
Future sales for all products will be influenced by the Company’s management of current distribution relationships, including recent merger and consolidation activity, and the development of new sources of distribution, while offering competitive and innovative new products and product features. The current economic environment poses both opportunities and challenges for future sales; while life insurance products respond well to consumer demand for financial security and wealth accumulation solutions, individuals may be reluctant to transfer funds when market volatility has recently resulted in significant declines in investment values. In addition, the availability and terms of capital solutions in the marketplace, as discussed below, to support universal life products with secondary guarantees, may influence future growth.
Effective November 1, 2007, Individual Life reinsured the policy liability related to statutory reserves in universal life with secondary guarantees to a captive reinsurance subsidiary. These reserves are calculated under prevailing statutory reserving requirements as promulgated under Actuarial Guideline 38, “The Application of the Valuation of Life Insurance Policies Model Regulation”. An unaffiliated standby third party letter of credit supports a portion of the statutory reserves that have been ceded to this subsidiary. As of December 31, 2008, the transaction provided approximately $429 of statutory capital relief associated with the Company’s universal life products with secondary guarantees. The Company expects this transaction to accommodate future statutory capital needs for in-force business and new business written through approximately December 31, 2009. The use of the letter of credit will result in a decline in net investment income and increased expenses in future periods for Individual Life. As its business evolves in this product line, Individual Life will evaluate the need for, and availability of, an additional capital transaction, which may impact the capacity to write these policies in the future.
Group Benefits’ sales may fluctuate based on the competitive pricing environment in the marketplace. In 2008, the Company generated fully insured ongoing premium growth in the group life and disability operations. During 2007, the Company completed a renewal rights transaction associated with its medical stop loss business, which caused lower earned premium and sales growth in 2008. The Company anticipates relatively stable loss ratios and expense ratios based on underlying trends in the in-force business and disciplined new business and renewal underwriting. The Company has not seen a meaningful impact in disability loss ratios as a result of the recent economic downturn. While claims incidence may increase during a recession, the Company would expect the impact to the disability loss ratio to be within the normal range of volatility.
Due to significant market declines in the fourth quarter, approximately 97% of our in-force 3 Win policies, or $3.1 billion in account value, have triggered the associated GMIB. As a result of the GMIB trigger, the majority of our 3 Win policies annuitized or surrendered free of charge in the fourth quarter of 2008. This significantly and negatively impacted fourth quarter net flows and will continue to reduce future profitability. For further details on the trigger of the GMIB associated with the 3 Win product, see Unlock and Sensitivity Analysis within Critical Accounting Estimates.
Competition has increased dramatically in the Japanese market from both domestic and foreign insurers. In addition to seeing new entrants in the Japanese market, our existing competitors are rapidly introducing new products, some of which include shorter guarantee periods as well as ratcheting guarantee features and higher equity asset allocation. This increase in competition has impacted current deposits and is expected to negatively impact future deposit levels. In addition, the Company continues to evaluate product designs that meet customers’ needs while maintaining prudent risk management. During the second and third quarters of 2008, the Company launched a new product called “Rising Income/Care Story,” which is a GMWB variable annuity combined with a nursing care rider, as well as the new product “Plus 5,” which is a 10-year GMAB variable annuity with a 5% bonus at year 10. The success of the Company’s product offerings will ultimately be based on customer acceptance in an increasingly competitive environment.
During 2008 the Company has experienced lower than expected surrenders and related surrender fees. In addition, the Company has experienced significant market declines and therefore some of the product guarantees have increased in cost. Specifically, the trigger of the 3 Win product, referenced above, has reduced variable annuity assets under management and will negatively impact overall financial results and is expected to result in a lower return on assets than in prior years.
Institutional’s markets are highly competitive from a pricing perspective, and a small number of cases often account for a significant portion of deposits. Most Institutional product issuances depend on pricing levels as well as the Company’s credit ratings and perceived financial stability and may be negatively impacted by rating agency downgrades of the Company that have occurred during February 2009 or could occur in the future.
During 2008, the Company ceased issuance of retail and institutional funding agreement backed notes, largely due to the change in customer preference to FDIC-insured products. Prospectively, the Company will issue only Guaranteed Investment Contracts (GIC) and on a limited basis, funding agreements. The Company will be disciplined and opportunistic in capturing new GIC and funding agreement opportunities, and accordingly, deposits in 2009 are expected to be substantially lower than 2008 amounts. The Company expects stable value products will experience negative net flows in 2009 as contractual maturities and the payments associated with certain contracts which allow an investor to accelerate principal repayments (after a defined notice period of typically thirteen months). Approximately $3.9 billion of account value will be paid out on stable value contracts during 2009. As of December 31, 2008, Institutional has no remaining contracts that contain an unexercised investor option feature that allows for contract surrender at book value. The Company has the option to accelerate the repayment of principal for certain other stable value products and will evaluate calling these contracts individually based upon the financial benefits to the Company.
In 2009, management expects Ongoing Operations written premium to be flat to slightly lower, reflecting the continuation of competitive market conditions. However, written premium growth in 2009 may be significantly lower if the economy deteriorates more than management expects or if the market perceives greater uncertainty about the financial strength of the Company as a result of reductions in the financial strength ratings of the Company’s property and casualty subsidiaries that have occurred or could occur.
While carriers in the personal lines industry will continue to compete on price, management expects that written pricing in Personal Lines will continue to increase modestly in 2009 in response to rising loss costs. For the Company, written pricing in 2008 increased 2% in both auto and homeowners.
Within Small Commercial, management expects written premium in 2009 to be flat to slightly lower, primarily driven by an increase in workers’ compensation written premium with an expected decline in commercial auto written premium. Contributing to the expected increase in workers’ compensation written premium will be an expansion of underwriting appetite in selected industries and an expansion of business written through payroll service providers. In 2008, average premium per policy in Small Commercial is expected to continue to decline due to written pricing decreases, a lower average premium on Next Generation Auto business and the potential for an increase in mid-term endorsements as insureds reduce coverage due to the economic downturn. Written pricing in Small Commercial decreased by 2% in 2008.
Management expects that 2009 written premium for Middle Market will be lower as the Company takes a disciplined approach to evaluating and pricing risks in the face of declines in written pricing. Written pricing for Middle Market business declined by 5% in 2008 and while management expects written pricing to begin to stabilize in 2009, management expects carriers will continue to price new business more aggressively than renewals. Management expects to compete for new business and protect renewals in Middle Market by, among other actions, refining its pricing models, increasing its willingness to write more workers’ compensation business on a mono-line basis and writing larger property policies and umbrella general liability policies.
Excluding catastrophes and prior accident year development, Ongoing Operations underwriting margins will likely decline in 2009 due primarily to increases in both the loss and loss adjustment expense ratio as well as the expense ratio, partially offset by lower anticipated policyholder dividends. The Ongoing Operations’ 2009 accident year loss and loss adjustment expense ratio before catastrophes is expected to increase due to mid single-digit increases in claim cost severity and continued earned pricing decreases in commercial lines, partially offset by moderately favorable claim frequency.
For auto business, emerged claim frequency in 2008 was favorable to the prior year and claim severity was slightly higher. In 2009, management expects claim severity will increase and claim frequency will be less favorable than it was in 2008. Non-catastrophe loss costs of homeowners claims increased in 2008 due to higher claim frequency and severity and management expects loss costs to continue to increase in 2009, driven by higher claim severity.
For Middle Market, management expects an increase in claim cost severity in 2009 across all lines, although the increase in claim severity for non-catastrophe property claims will not likely be as high as it was in 2008 when the Company experienced a number of individually large property losses. Partially offsetting the expected increase in severity is an expectation of moderately lower frequency.
The Ongoing Operations expense ratio is expected to increase in 2009, in part, due to a lower expected earned premium in Middle Market, the amortization of a higher amount of acquisition costs on AARP business and an increase in the cost of investments in technology to support future growth. The policyholder dividend ratio was unusually high in 2008 due to the accrual of $26 in dividends due to certain workers’ compensation policyholders as a result of underwriting profits. (See the Property and Casualty MD&A section for further discussion.)
Institutional provides customized investment, insurance, and income solutions to select markets. Products include structured settlements, institutional annuities (primarily terminal funding cases), stable value products, and income annuities. Furthermore, Institutional offers variable private placement life insurance (“PPLI”) owned by corporations and high net worth individuals, as well as mutual funds owned by institutional investors.
Life charges direct operating expenses to the appropriate segment and allocates the majority of indirect expenses to the segments based on an intercompany expense arrangement. Inter-segment revenues primarily occur between Life’s Other category and the reporting segments. These amounts primarily include interest income on allocated surplus and interest charges on excess separate account surplus.
Life’s financial results in its variable annuity, mutual fund and, to a lesser extent, variable universal life businesses, depends largely on the amount of the contract holder account value or assets under management on which it earns fees and the level of fees charged. Changes in account value or assets under management are driven by two main factors: net flows, which measure the success of the Company’s asset gathering and retention efforts, and the market return of the funds, which is heavily influenced by the return realized in the equity markets. Net flows are comprised of new sales and other deposits less surrenders, death benefits, policy charges and annuitizations of investment type contracts, such as variable annuity contracts. In the mutual fund business, net flows are known as net sales. Net sales are comprised of new sales less redemptions by mutual fund customers. Life uses the average daily value of the S&P 500 Index as an indicator for evaluating market returns of the underlying account portfolios in the United States. Relative financial results of variable products is highly correlated to the growth in account values or assets under management since these products generally earn fee income on a daily basis. Equity market movements could also result in benefits for or charges against deferred acquisition costs. See the Critical Accounting Estimates section of the MD&A for further information on DAC unlocks. During 2008, primarily as a result of current market conditions, the Company recorded an unlock charge of $932.
Fee income is largely driven from amounts collected as a result of contractually defined percentages of assets under management. These fees are generally collected on a daily basis. For individual life insurance products, fees are contractually defined as percentages based on levels of insurance, age, premiums and deposits collected and contract holder value. Life insurance fees are generally collected on a monthly basis. Therefore, the growth in assets under management either through positive net flows or net sales, or favorable equity market performance will have a favorable impact on fee income. Conversely, either negative net flows or net sales, or unfavorable equity market performance will reduce fee income.
Retail U.S. individual variable annuity recorded increased negative net flows as a result of increased competition and equity market volatility.
Retail Mutual funds has seen positive net sales as a result of diversified sales growth.
Management evaluates performance of certain products based on net investment spread. These products include those that have insignificant mortality risk, such as fixed annuities, certain general account universal life contracts and certain institutional contracts. Net investment spread is determined by taking the difference between the earned rate and the related crediting rates on average general account assets under management. The net investment spreads shown below are for the total portfolio of relevant contracts in each segment and reflect business written at different times. When pricing products, the Company considers current investment yields and not the portfolio average. Net investment spread can be volatile period over period, which can have a significant positive or negative effect on the operating results of each segment. Investment earnings can also be influenced by factors such as the actions of the Federal Reserve and a decision to hold higher levels of short-term investments. The volatile nature of net investment spread is driven primarily by prepayment premiums on securities and earnings on limited partnership and other alternative investments.
Net investment spread is calculated as a percentage of general account assets and expressed in basis points (“bps”):
Retail - Individual Annuity, Individual Life, Retirement Plans and Institutional net investment spread decreased primarily due to negative earnings on limited partnership and other alternative investment income in 2008 compared to strong earnings in these classes in 2007 and lower yields on fixed maturities, partially offset by reduced credited rates.
Retail - Individual Annuity, Individual Life, Retirement Plans and Institutional net investment spreads increased primarily due to a higher allocation of investments in higher yield/higher risk investment classes, including limited partnerships and other alternative investments and relative strong performance of this asset class in 2007.
Earned premiums and other considerations include $1, $27 and $12 in buyout premiums for the years ended December 31, 2008, 2007 and 2006, respectively. Total premiums and other considerations, excluding buyouts, increased in 2008 compared to 2007 due to increases in sales and persistency that were offset by lower premiums in the medical stop loss business as a result of the renewal rights transaction that closed during the second quarter of 2007. The increase in premiums and other considerations for Group Benefits in 2007 compared to 2006 was driven by growth in the block of business.
The Retail DAC amortization ratio (individual annuity), excluding the effects of the 2008 Unlock and realized losses, increased due to the impairment of goodwill in the fourth quarter of 2008, which reduced pre tax earnings but did not affect EGPs. Excluding the impacts of the goodwill impairment, realized losses, and DAC Unlock, the DAC amortization ratio was 43.3%, which reflects the 2008 effect of changes in assumptions made as part of the 2007 and 2008 Unlocks.
The Retail general insurance expense ratio increased due to the impact of a declining asset base on relatively consistent expenses.
Year ended December 31, 2007 compared to year ended December 31, 2006
The Retail DAC amortization ratio (individual annuity) excluding DAC Unlock declined in 2007, primarily due to increased net investment income on allocated capital and an increase in limited partnership and other alternative investment income.
Individual Life death benefits increased in 2007 primarily due to growth of life insurance in-force and unfavorable mortality.
Management evaluates the rates of return various businesses can provide as an input in determining where additional capital should be invested to increase net income and shareholder returns. The Company uses the return on assets for the individual annuity business for evaluating profitability. In Group Benefits and Individual Life, after-tax margin is a key indicator of overall profitability.
The decrease in Individual Annuity’s ROA, excluding realized gains (losses) and the effect of the DAC Unlock, reflects the write-off of goodwill of $274 after-tax, or 19.4 bps; lower limited partnership and other alternative investment income; and the net effect of lower fees.
The decrease in Retirement Plans ROA, excluding realized gains (losses) and the effect of the DAC Unlock, was primarily driven by an increase in assets under management due to the acquired rights to service $18.7 billion in mutual funds, comprised of $15.8 billion in mutual funds from Sun Life Retirement Services, Inc., and $2.9 billion in mutual funds from Princeton Retirement Group, both of which closed in the first quarter of 2008. The acquired blocks of assets produce a lower ROA as they are comprised of mutual fund assets and assets under administration as opposed to traditional annuity contracts. Also contributing to the decrease was lower yields on fixed maturity investments and a decline in limited partnership and other alternative investment income, higher service and technology costs and additional expenses associated with the acquisitions. Partially offsetting these decreases were tax benefits primarily associated with DRD.
The decrease in Retirement Plan’s ROA, excluding realized gains (losses) and DAC Unlock, was primarily due to a shift in product mix resulting in lower fees as a percent of assets.
The transition impact related to the SFAS 157 adoption was a reduction in revenues of $650 for the year ended December 31, 2008. For further discussion of the SFAS 157 transition impact, refer to Note 4 of the Notes to the Consolidated Financial Statements.
Gross gains on sales for the year ended December 31, 2006 were primarily within fixed maturities and were concentrated in U.S. government, corporate and foreign government securities. Gross losses on sale for the year ended December 31, 2006 were primarily within fixed maturities and were concentrated in the corporate and CMBS sectors.
For the year ended December 31, 2008, the transition impact related to the SFAS 157 adoption was a reduction in net income of $209. For further discussion of the SFAS 157 transition impact, refer to Note 4 in the Notes to the Consolidated Financial Statements.
Fee income and other decreased $360 primarily as a result of lower variable annuity fee income due to a decline in average account values. The decrease in average variable annuity account values can be attributed to market depreciation of $38.2 billion and net outflows of $6.2 billion during the year. Net outflows were driven by surrender activity resulting from the aging of the variable annuity in-force block of business; increased sales competition, particularly competition related to guaranteed living benefits, and volatility in the equity markets. Also contributing to the decrease in fee income was lower mutual fund fees due to declining assets under management primarily driven by market depreciation of $20.1 billion, partially offset by $2.8 billion of net flows.
Earned Premiums increased primarily due to an increase in life contingent premiums combined with a decrease in reinsurance premiums as a result of the lapsing of business covered by reinsurance and the significant decline in the equity markets.
Amortization of deferred policy acquisition costs and present value of future profits (“DAC”)
Net income in Retail increased for the year ended December 31, 2007, primarily driven by lower amortization of DAC resulting from the unlock benefit in the third quarter of 2007, fee income growth in the variable annuity and mutual fund businesses, partially offset by increased non-deferrable individual annuity asset based commissions and mutual fund commissions. In addition, realized capital losses increased $294 for the year ended December 31, 2007 as compared to 2006. For further discussion, see Realized Capital Gains and Losses by Segment table under Life’s Operating Section of the MD&A. A more expanded discussion of income growth is presented below:
Fee income increased for the year ended December 31, 2007 primarily as a result of growth in variable annuity average account values. The year-over-year increase in average variable annuity account values can be attributed to market appreciation of $7.4 billion during the year. Variable annuities had net outflows of $2.7 billion in 2007. Net outflows were driven by surrender activity due to the aging of the variable annuity in force block of business and increased sales competition, particularly competition related to guaranteed living benefits.
The effective tax rate increased from 7% to 21% for the year ended December 31, 2007 from the prior year due to an increase in income before income taxes and revisions in the estimates of the separate account DRD which resulted in an incremental tax of $17, and foreign tax credits.
Fee income and other increased primarily due to an increase in cost of insurance charges of $45 as a result of growth in guaranteed universal life insurance in-force and fees on higher surrenders of $12 due to internal exchanges from non-guaranteed universal life insurance to variable universal life insurance. Partially offsetting these increases are the impacts of the 2008 and 2007 Unlocks as well as lower variable life fees as a result of equity market declines.
Net investment income decreased primarily due to lower income from limited partnership and other alternative investments, lower yields on fixed maturity investments, and reduced net investment income associated with a more efficient capital approach for our secondary guarantee universal life business, which released assets supporting capital and the related net investment income earned on those assets (described further in the “Outlook” section), partially offset by growth in general account values.
Amortization of DAC increased primarily as a result of the unlock expense in 2008 as compared to the unlock benefit in 2007, partially offset by reduced DAC amortization primarily attributed to net realized capital losses. This increase in DAC amortization had a partial offset in amortization of deferred revenues, included in fee income.
Net investment income increased consistent with growth in general account values. Individual Life earned additional net investment income throughout 2007 associated with higher returns from limited partnerships and other alternative investments.
In 2007, Life began selling mutual fund based products in the 403(b) market.
Net income in Retirement Plans decreased due to higher net realized capital losses, the DAC Unlock in 2008 as compared to 2007 and increased operating expenses partially offset by growth in fee income. For further discussion of net realized capital losses, see Realized Capital Gains and Losses by Segment table under Life’s Operating section of the MD&A. For further discussion of the 2008 and 2007 Unlocks see Critical Accounting Estimates section of the MD&A. The following other factors contributed to the changes in net income:
Net investment income declined due to a decrease in the returns from limited partnership and other alternative investment income of $33, partially offset by growth in general account assets.
Insurance operating costs and other expenses increased for the year ended December 31, 2007, primarily attributable to greater assets under management aging beyond their first year resulting in higher trail commissions. Also contributing to higher insurance operating costs for the year ended December 31, 2007 were higher service and technology costs.
Group Benefits has a block of financial institution business that is experience rated. This business comprised approximately 9% to 10% of the segment’s 2008, 2007 and 2006 premiums and other considerations (excluding buyouts) respectively, and, on average, 4% to 5% of the segment’s 2008, 2007 and 2006 net income, excluding realized capital gains and losses.
Net investment income decreased primarily as a result of lower yields on fixed maturity investments and lower limited partnership and other alternative investment returns of $33.
The segment’s loss ratio (defined as benefits, losses and loss adjustment expenses as a percentage of premiums and other considerations excluding buyouts) decreased due to favorable disability and medical stop loss experience partially offset by unfavorable mortality.
The segment’s expense ratio, excluding buyouts decreased compared to the prior year due primarily to lower commission expenses.
Japan fixed annuity and other account values includes an increase due to the net triggering impact of the GMIB pay-out annuity account value for the 3 Win product of $2.0 billion.
Net income decreased for the year ended December 31, 2008 as a result of the 2008 Unlock versus the 2007 Unlock along with increased realized capital losses from the adoption of SFAS 157, which resulted in a net realized capital loss of $34 during the first quarter of 2008, the impact of the 3 Win trigger, impairment charges, increases in insurance operating costs and other expenses, partially offset by an increase in fee income. For further discussion on the Unlock and 3 Win trigger, see Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A. For further discussion of the SFAS 157 transition impact, see Note 4 of the Notes to the Consolidated Financial Statements. For further discussion of realized capital losses, see Realized Capital Gains and losses by Segment table under Life’s Operating Section of the MD&A. The following other factors contributed to the changes in net income:
Net income decreased for the year ended December 31, 2007 due to a lower unlock benefit in 2007 compared with 2006 and an increase in realized capital losses of $28 for the year ended December 31, 2007 as compared to the prior year period. Losses were partially offset by increased fee income driven by growth in assets under management. For further discussion, see Realized Capital Gains and Losses by Segment table under Life’s Operating Section of the MD&A. The following other factors contributed to the change in income:
Insurance operating costs and other expenses increased for the year ended December 31, 2007 due to the growth in the Japan operation.
• Fee income and other decreased primarily due to lower front-end loads on private placement life insurance (“PPLI”) cases during 2008. PPLI collects front-end loads recorded in fee income, offset by corresponding premium taxes reported in insurance operating costs and other expenses. For 2008 and 2007, PPLI deposits of $247 and $5.2 billion, respectively, resulted in fee income due to front-end loads of $2 and $107, respectively.
• Fee income increased for the year ended December 31, 2007 primarily due to higher Mutual Fund and PPLI assets under management on net flows and change in market appreciation of $5.8 billion and $2.1 billion, respectively, during the year. In addition, PPLI collects front-end loads recorded in fee income, offset by corresponding premium taxes reported in insurance operating costs and other expenses. During the year ended December 31, 2007, PPLI had deposits of $5.2 billion, which resulted in an increase in fee income due to front-end loads of $107.
• Earned premiums increased for the year ended December 31, 2007 primarily as a result of increased structured settlement life contingent sales, and one large terminal funding life contingent case sold in the third quarter. This increase in earned premiums was offset by a corresponding increase in benefits, losses and loss adjustment expenses.
• The change in income taxes was due to lower income before income taxes primarily driven by the increase in realized capital losses.
• Also contributing to the increase in insurance operating costs and other expenses was $18, after-tax, of interest charged by Corporate on the amount of capital held by the Life operations in excess of the amount needed to support the capital requirements of the Life Operations for the year ended December 31, 2007
• Refer to Realized Capital Gains and Losses by Segment table under Life’s Operating section of the MD&A.
Property & Casualty is organized into five reporting segments: the underwriting segments of Personal Lines, Small Commercial, Middle Market and Specialty Commercial (collectively “Ongoing Operations”); and the Other Operations segment. Property & Casualty provides a number of coverages, as well as insurance related services, to businesses throughout the United States, including workers’ compensation, property, automobile, liability, umbrella, specialty casualty, marine, livestock, fidelity, surety, professional liability and directors and officers’ liability coverages. Property & Casualty also provides automobile, homeowners and home-based business coverage to individuals throughout the United States as well as insurance-related services to businesses.
Earned premium growth is an objective for Personal Lines, Small Commercial and Middle Market. Earned premium growth is not a specific objective for Specialty Commercial since Specialty Commercial is largely comprised of transactional businesses where premium writings may fluctuate based on the segment’s view of perceived market opportunity. Written premiums are earned over the policy term, which is six months for certain Personal Lines auto business and 12 months for substantially all of the remainder of the Company’s business. Written pricing, new business growth and premium renewal retention are factors that contribute to growth in written and earned premium.
Total Property & Casualty earned premiums decreased $158, or 2%, primarily due to lower earned premiums in Middle Market and Specialty Commercial, partially offset by increased earned premiums in Personal Lines.
• Earned premium decreased by $121, or 5%, driven primarily by decreases in commercial auto, workers’ compensation and general liability. Earned premium decreases were driven primarily by a decline in earned pricing in 2008 and the effect of non-renewals outpacing new business in commercial auto and general liability over the last nine months of 2007 and first nine months of 2008, partially offset by the effect of new business outpacing non-renewals in workers’ compensation since the fourth quarter of 2007.
• Earned premium grew by $129, or 3%, primarily due to an increase in AARP and Agency earned premiums. AARP earned premium grew primarily due to an increase in the size of the AARP target market, the effect of direct marketing programs and the effect of cross selling homeowners insurance to insureds who have auto policies. Agency earned premium grew as a result of an increase in the number of agency appointments and further refinement of the Dimensions class plans. Partially offsetting this growth was the effect of the sale of the Omni non-standard auto business in the fourth quarter of 2006 which accounted for $127 of earned premium in 2006. Excluding Omni, Personal Lines’ earned premiums grew $251, or 7%, for the year ended December 31, 2007.
• Earned premium increased $84, or 3%, primarily due to new business premiums outpacing non-renewals for workers’ compensation business over the last six months of 2006 and the first six months of 2007.
• Earned premium decreased by $47, or 3%, primarily driven by a decrease in casualty and property and a decrease in earned premiums assumed under inter-segment arrangements, partially offset by an increase in professional liability, fidelity and surety.
• Other, net realized capital losses in 2008 were primarily related to net losses on credit derivatives as a result of credit spread widening on credit derivatives that assume credit exposure. Also included were derivative related losses of $7 for the year ended December 31, 2008 due to counterparty default related to the bankruptcy of Lehman Brothers Holdings Inc.
• Investment income decreased $434, or 26%, due to a change from net income to net losses on limited partnerships and other alternative investments in 2008 and decreased fixed maturity income. The net losses on limited partnerships and other alternative investments were largely due to negative returns on hedge funds and real estate partnerships as a result of the lack of liquidity in the financial markets and credit spreads widening. The decrease in income from fixed maturities was attributable to lower income on variable rate securities due to declines in short term interest rates as well as an increased allocation to lower yielding U.S. Treasuries and short-term investments.
• The $21 decrease in net servicing income was primarily driven by a decrease in servicing income from the AARP Health program, Specialty Risk Services and the Write Your Own flood program and the write-off of software used in administering policies for third parties.
• Income taxes changed from income tax expense of $570 in 2007 to an income tax benefit of $95 in 2008. Despite near break-even pre-tax income in 2008, there was a net income tax benefit in 2008 because the income tax benefit on realized capital losses was greater than the income tax expense on all other components of pre-tax income. A portion of the Company’s net investment income was generated from tax-exempt securities.
• Current accident year catastrophe losses decreased by $22. The largest catastrophe losses in 2007 were from wildfires in California, spring windstorms in the Southeast and Northeast, tornadoes and thunderstorms in the Midwest and a December ice storm in the Midwest. Catastrophes in 2006 included tornadoes and hail storms in the Midwest and windstorms in Texas and on the East coast.
• Impairments in 2007 primarily consisted of impairments of asset-backed securities backed by sub-prime residential mortgage loans and impairments of corporate securities in the financial services and homebuilders sectors. (See the Other-than-Temporary Impairments discussion within Investment Results for more information on the impairments recorded in 2007.)
• Primarily driving the $201 increase in net investment income was a higher average invested asset base and income earned from a higher portfolio yield. The increase in the average invested asset base contributing to the increase in investment income was primarily due to positive operating cash flows, partially offset by the return of capital to Corporate. Contributing to the increase in net investment income was an increase in income from limited partnerships and other alternative investments, driven by a higher yield on these investments and shifting a greater allocation of investments to these asset classes.
• Income taxes increased by $19, reflecting the increase in pre-tax income from 2006 to 2007, partially offset by a $20 benefit in 2007 from a tax true-up.
• Earned premium decreased by 4% in 2008 compared to a decrease of 3% in 2007. A larger earned premium decrease in property and a change from earned premium growth in professional liability, fidelity and surety in 2007 to no growth in 2008, was partially offset by an improvement in the rate of earned premium decline in casualty. Property earned premium decreased more significantly in 2008 than in 2007 due, in part, to a decision to stop writing specialty property business with large, national accounts. Also contributing to the larger decrease in property earned premium in 2008 were the effects of a change to decreasing earned pricing and a change to decreasing new business in 2008 on core excess and surplus lines business. The change to no growth in professional liability, fidelity and surety earned premium in 2008 was largely due to larger earned pricing decreases in 2008 than in 2007 and a change to declining new business in professional liability since the third quarter of 2007.
For 2008, the Ongoing Operations’ combined ratio was relatively flat at 90.7 as a 1.7 point increase in net favorable non-catastrophe prior accident year reserve development and a 1.6 point reduction in the current accident year combined ratio before catastrophes and prior year development was almost entirely offset by a 3.2 point increase in catastrophes, driven by higher current accident year catastrophes.
• The combined ratio before catastrophes and prior accident year development decreased by 1.6 points, to 88.9, as the effects of a lower loss and loss adjustment expense ratio for Small Commercial and Middle Market workers’ compensation claims, lower claim frequency on Personal Lines auto claims and lower non-catastrophe losses on Small Commercial package business were partially offset by earned pricing decreases across the commercial lines businesses and higher non-catastrophe losses on Middle Market property and Personal Lines homeowners’ business.
In 2008, the after-tax investment yield decreased due to a change from net income to net losses from limited partnerships and other alternative investments in 2008 and, to a lesser extent, a lower investment yield for fixed maturities.
Average annual invested assets at cost increased modestly due to positive operating cash flows, partially offset by the effects of impairments of securities and dividends paid to Corporate.
• The decrease in the earned premium growth rate from 2006 to 2007 was due to the Company’s exit from the Omni non-standard auto business. Omni, which was sold in the fourth quarter of 2006, accounted for $127 of earned premium in 2006. Excluding Omni, the Personal Lines earned premium growth rate was 7% in both 2006 and 2007. In 2007, an increase in the growth rate of AARP earned premium was offset by the effect of a decrease in the growth rate of Agency earned premium.
• The decrease in the earned premium growth rate was primarily attributable to a decrease in new business written premium and premium renewal retention over the last six months of 2006 and the first six months of 2007. Also contributing to the lower growth rate was a decrease in earned pricing.
• The rate of decline in Specialty Commercial earned premium slowed in 2007, primarily due to a lower earned premium decrease in casualty and property, partially offset by a lower earned premium increase in professional liability, fidelity and surety. Casualty earned premium experienced a larger decrease in 2006, primarily because of a decrease in 2006 earned premium from a single captive insured program that expired in 2005. Earned premium decreases in property were larger in 2006 than in 2007 as a result of a strategic decision in 2006 not to renew certain accounts with properties in catastrophe-prone areas. The growth rate in professional liability, fidelity and surety earned premium slowed in 2007 due to a decrease in earned pricing and a decline in new business growth and premium renewal retention.
• The increase in the combined ratio before catastrophes and prior accident year development, from 88.0 to 90.5, was primarily due to a 1.4 point increase in the current accident year loss and loss adjustment expense ratio before catastrophes and, to a lesser extent, an increase in the expense ratio. The increase in the loss and loss adjustment expense ratio before catastrophes and prior accident year development was primarily due to increased severity on Personal Lines auto liability claims, increased frequency on Personal Lines auto property damage claims and, to a lesser extent, increased severity on Personal Lines homeowners claims and a higher loss and loss adjustment expense ratio for both Small Commercial package business and Middle Market workers’ compensation claims. Contributing to the increase in the expense ratio was the effect of a $41 reduction of estimated Florida Citizens’ assessments in 2006 related to the 2005 Florida hurricanes.
• Net non-catastrophe prior accident year reserve development was slightly unfavorable in 2006, but favorable in 2007. Favorable reserve development in 2007 was largely attributable to the release of reserves for workers’ compensation claims, primarily related to accident years 2002 to 2006. See the “Reserves” section for a discussion of prior accident year reserve development for Ongoing Operations in 2007.
Other Operations reported net income of $30 in 2007 compared to a net loss of $35 in 2006. The improvement in results was primarily due to a decrease in unfavorable prior accident year reserve development, partially offset by a change from net realized gains in 2006 to net realized losses in 2007 and a decrease in net investment income. See the Other Operations segment MD&A for further discussion.
Policies in force represent the number of policies with coverage in effect as of the end of the period. The number of policies in force is a growth measure used for Personal Lines, Small Commercial and Middle Market and is affected by both new business growth and premium renewal retention.
The current accident year catastrophe ratio represents the ratio of catastrophe losses (net of reinsurance) to earned premiums for catastrophe claims incurred during the current accident year. A catastrophe is an event that causes $25 or more in industry insured property losses and affects a significant number of property and casualty policyholders and insurers. The catastrophe ratio includes the effect of catastrophe losses, but does not include the effect of reinstatement premiums.
The investment yield, or return, on the Company’s invested assets primarily includes interest income on fixed maturity investments. Based upon the fair value of Property & Casualty’s investments as of December 31, 2008 and 2007, approximately 82% and 89%, respectively, of invested assets were held in fixed maturities. A number of factors affect the yield on fixed maturity investments, including fluctuations in interest rates and the level of prepayments. The Company also invests in equity securities, mortgage loans, limited partnership arrangements and other alternative investments.
The Hartford attributes capital to each line of business or segment using an internally-developed, risk-based capital attribution methodology that incorporates management’s assessment of the relative risks within each line of business or segment, as well as the capital requirements of external parties, such as regulators and rating agencies. Net investment income earned on the Hartford Fire invested asset portfolio is allocated between Ongoing Operations and Other Operations based on the allocation of invested assets to each segment and the expected investment yields earned by each segment. Net investment income earned on the separate portfolios within Other Operations is recorded entirely within Other Operations. Based on the Company’s method of allocating net investment income for the Hartford Fire Insurance Pool and the net investment income earned by Other Operations on its separate investment portfolios, in 2008, the after-tax investment yield for Ongoing Operations was 3.2% and the after-tax investment yield for Other Operations was 3.6%.
The Company has also seen favorable emergence during 2008 on Personal Lines auto liability claims. The severity of reported claims for the 2005 through 2007 accident years and the frequency of reported claims for the 2008 accident year have been lower than expected and reserves were released in the third and fourth quarter of 2008 as a result. If these favorable trends continue, future releases are possible.
A rollforward of liabilities for unpaid losses and loss adjustment expenses by segment for Property & Casualty for the year ended December 31, 2008 follows:
The Company’s estimate of ultimate loss and loss expenses arising from hurricanes and other catastrophes is based on covered losses under the terms of the policies. The Company does not provide residential flood insurance on its Personal Lines homeowners policies so the Company’s estimate of hurricane losses on Personal Lines homeowners business does not include any provision for damages arising from flood waters. The Company acts as an administrator for the Write Your Own flood program on behalf of the National Flood Insurance Program under FEMA, for which it earns a fee for collecting premiums and processing claims. Under the program, the Company services both personal lines and commercial lines flood insurance policies and does not assume any underwriting risk. As a result, catastrophe losses in the above table do not include any losses related to the Write Your Own flood program.
Included within prior accident year development for the year ended December 31, 2008 were the following reserve strengthenings (releases).
Released reserves for Personal Lines auto liability claims by $46, principally related to AARP business for the 2005 through 2007 accident years. Beginning in the first quarter of 2008, management observed an improvement in emerged claim severity for the 2005 through 2007 accident years attributed, in part, to changes made in claim handling procedures in 2007. In the third and fourth quarter of 2008, the Company recognized that favorable development in reported severity was a sustained trend and, accordingly, management reduced its reserve estimate. The $46 reserve release represented 3% of the Company’s net reserves for Personal Lines auto liability claims as of December 31, 2007.
Among other net reserve re-estimates for Other Operations in 2008, the Company recognized favorable prior year development of $30 on its HartRe assumed reinsurance liabilities as the result of lower than expected reported losses and $25 of adverse development for assumed reinsurance obligations of the Company’s Bermuda operations.
The “loss and loss expense paid ratio” represents the ratio of paid loss and loss adjustment expenses to earned premiums.
Released Small Commercial workers’ compensation reserves by $151, primarily related to accident years 2002 to 2006. This reserve release is a continuation of favorable developments first recognized in 2005 and 2006. The workers’ compensation reserve releases in 2007 resulted from a determination that workers’ compensation losses continue to develop even more favorably from prior expectations due to the California and Florida legal reforms and underwriting actions as well as cost reduction initiatives first instituted in 2003. In particular, the state legal reforms and underwriting actions have resulted in lower than expected medical claim severity. In addition, the Company determined that paid losses related to workers’ compensation policies sold through payroll service providers were emerging favorably, leading to a release of reserves for the 2003 to 2006 accident years. The $151 reserve release represented 9% of the Company’s net reserves for Small Commercial workers’ compensation claims as of December 31, 2006.
Released Middle Market commercial auto liability reserves by $18 for accident years 2003 and 2004. Since the first quarter of 2007, reported losses for commercial auto liability claims in these accident years have emerged favorably although management did not determine that this was a verifiable trend until the third quarter of 2007 when it released the reserves. The $18 reserve release represented 6% of the Company’s net reserves for Middle Market auto liability claims as of December 31, 2006.
Released reserves for errors and omissions claims for accident year 2005 by $15. During the fourth quarter of 2007, the Company updated its analysis of certain professional liability claims and the new analysis showed that claims under errors and omissions policies were emerging favorable to initial expectations, resulting in this reserve release. The $15 reserve release represented 3% of the Company’s net reserves for professional liability claims as of December 31, 2006.
Strengthened Middle Market workers’ compensation reserves by $40 for accident years 1973 and prior, primarily driven by a reduction in reinsurance recoverables from the commutation of certain reinsurance treaties. Due to the commutations, within the past two years, net paid losses on these claims have begun to emerge unfavorably to initial expectations and, during 2007, the Company determined that this trend in higher paid losses would ultimately result in unpaid losses settling for more than management’s previous estimates. The $40 reserve strengthening represented 2% of net reserves for Middle Market workers’ compensation claims as of December 31, 2006.
Released allocated loss adjustment expense reserves by $58 for accident years 2003 to 2005, primarily for workers’ compensation business and package business, as a result of cost reduction initiatives implemented by the Company to reduce allocated loss adjustment expenses for both legal and non-legal expenses. The Company began implementing cost reduction initiatives in late 2003. It was initially uncertain what effect those efforts would have on controlling allocated loss adjustment expenses. During 2004, favorable trends started to emerge, particularly on shorter-tailed auto liability claims, but it was not clear if these trends would be sustained. In early 2005, favorable trends continued and the Company analyzed claims involving legal expenses separate from claims that do not involve legal expenses. This analysis included a review of the trends in the number of claims involving legal expenses, the average expenses incurred and trends in legal expenses. During the second quarter of 2005, the Company released allocated loss adjustment expense reserves on shorter-tailed auto liability claims as the favorable trends on shorter-tailed business emerged more quickly and were determined to be reliable. During both the second and fourth quarter of 2006, the Company determined that the favorable development on package business and workers’ compensation business had become a verifiable trend and, accordingly, reserves were reduced. The $58 release represented 1% of total net reserves for workers’ compensation and package business as of December 31, 2005.
Over the past ten years, reserve re-estimates for total Property & Casualty ranged from (1.3)% to 21.5%. Excluding the reserve strengthening for asbestos and environmental reserves, over the past ten years reserve re-estimates for total Property & Casualty ranged from (3.0)% to 1.6%.
The potential variability of the Company’s Property & Casualty reserves would normally be expected to vary by segment and the types of loss exposures insured by those segments. Illustrative factors influencing the potential reserve variability for each of the segments are discussed under Critical Accounting Estimates.
In managing risk, The Hartford’s management processes involve establishing underwriting guidelines for both individual risks, including individual policy limits, and in aggregate, including aggregate exposure limits by geographic zone and peril. The Company establishes risk limits and actively monitors the risk exposures as a percent of Property & Casualty statutory surplus. For natural catastrophe perils, the Company generally limits its estimated loss to natural catastrophes from a single 250-year event prior to reinsurance to less than 30% of statutory surplus of the Property & Casualty operations and its estimated loss to natural catastrophes from a single 250-year event after reinsurance to less than 15% of statutory surplus of the Property & Casualty operations. From time to time, the estimated loss to natural catastrophes from a single 250-year event prior to reinsurance may fluctuate above or below 30% of statutory surplus due to changes in modeled loss estimates, exposures, or statutory surplus. Currently, the Company’s estimated pre-tax loss to a single 250-year natural catastrophe event prior to reinsurance is 31% of statutory surplus of the Property & Casualty operations and the Company’s estimated pre-tax loss net of reinsurance is less than 15% of statutory surplus of the Property & Casualty operations. For terrorism, the Company monitors its exposure in major metropolitan areas to a single-site conventional terrorism attack scenario, and manages its potential estimated loss, including exposures resulting from the Company’s Group Life operations, to less than $1.3 billion, which is approximately 10% of the combined statutory surplus of the Life and Property & Casualty operations as of December 31, 2008. Among the 251 locations specifically monitored by the Company, the largest estimated modeled loss arising from a single event is approximately $1.2 billion. The Company monitors exposures monthly and employs both internally developed and vendor-licensed loss modeling tools as part of its risk management discipline.
In addition to the reinsurance protection provided by The Hartford’s reinsurance program described above, the Company has fully collateralized reinsurance coverages from Foundation Re and Foundation Re II for losses sustained from qualifying hurricane and earthquake loss events and other qualifying catastrophe losses. Foundation Re and Foundation Re II are Cayman Islands reinsurance companies which financed the provision of the reinsurance through the issuance of catastrophe bonds. Under the terms of the treaties with Foundation Re and Foundation Re II, the Company is reimbursed for losses from natural disaster events using a customized industry index contract designed to replicate The Hartford’s own catastrophe losses, with a provision that the actual losses incurred by the Company for covered events, net of reinsurance recoveries, cannot be less than zero.
As of December 31, 2008, there have been no events that are expected to trigger a recovery under any of the reinsurance programs with Foundation Re or Foundation Re II and, accordingly, the Company has not recorded any recoveries from the associated reinsurance treaties.
The Company uses third party models to estimate the potential loss resulting from various catastrophe events and the potential financial impact those events would have on the Company’s financial position and results of operations. The following table shows modeled loss estimates before expected reinsurance recoveries and after expected reinsurance recoveries. The loss estimates represent total property losses for hurricane events and property and workers’ compensation losses for earthquake events resulting from a single event. The estimates provided are based on 250-year return period loss estimates, which have a 0.4% likelihood of being exceeded in any single year. The net loss estimates assume that the Company would be able to recover all losses ceded to reinsurers under its reinsurance programs. There are various methodologies used in the industry to estimate the potential property and workers’ compensation losses that would arise from various catastrophe events and companies may use different models and assumptions in their estimates. Therefore, the Company’s estimates of gross and net losses arising from a 250-year hurricane or earthquake event may not be comparable to estimates provided by other companies. Furthermore, the Company’s estimates are subject to significant uncertainty and could vary materially from the actual losses that would arise from these events.
The Company’s modeled loss estimates are derived by averaging 21 modeled loss events representing a 250-year return period loss. For the peril of earthquake, the 21 events averaged to determine the modeled loss estimate include events occurring in California as well as the Northwestern, Northeastern, Southeastern and Midwestern regions of the United States with associated magnitudes ranging from 6.9 to 7.9 on the Richter scale. For the peril of hurricane, the 21 events averaged to determine the modeled loss estimate include category 3, 4 and 5 events in Florida as well as other Southeastern, Northeastern and Gulf region landfalls.
Among other items, TRIPRA required that the President’s Working Group on Financial Markets (“PWG”) continue to perform an analysis regarding the long-term availability and affordability of insurance for terrorism risk. Among the findings detailed in the PWG’s initial report, released October 2, 2006, were that the high level of uncertainty associated with predicting the frequency of terrorist attacks, coupled with the unwillingness of some insurance policyholders to purchase insurance coverage, makes predicting long term development of the terrorism risk market difficult, and that there is likely little potential for future market development for nuclear, biological, chemical and radiological (“NBCR”) coverage. A December 2008 study by the U.S. Government Accountability Office (GAO) found that property and casualty insurers still generally seek to exclude NBCR coverage from their commercial policies when permitted. However, while nuclear, pollution and contamination exclusions are contained in many property and liability insurance policies, the GAO report concluded that such exclusions may be subject to challenges in court because they were not specifically drafted to address terrorist attacks. Furthermore, workers’ compensation policies generally have no exclusions or limitations. The GAO found that commercial property and casualty policyholders, including companies that own high-value properties in large cities, generally reported that they could not obtain NBCR coverage. Commercial property and casualty insurers generally remain unwilling to offer NBCR coverage because of uncertainties about the risk and the potential for catastrophic losses.
The Texas Windstorm Insurance Association (“TWIA”) provides hail and windstorm coverage to Texas residents of 14 counties along the Texas Gulf coast who are unable to obtain insurance from other carriers. Insurance carriers who write property insurance in the state of Texas, including The Hartford, are required to be members of TWIA and are obligated to pay assessments in the event that TWIA losses exceed funds on hand, the available funds in the Texas Catastrophe Reserve Trust Fund (“CRTF”) and any available reinsurance. Assessments are allocated to carriers based on their share of premium writings in the state of Texas, as defined.
Through premium tax credits, member companies may recoup a portion of Ike-related assessments made to cover the first $2.1 billion of TWIA losses and may recoup all of the Ike-related assessments made to fund losses in excess of that amount. None of the assessments for hurricane Dolly may be recouped. Under generally accepted accounting principles, the Company is required to accrue the assessments in the period the assessments become probable and estimable and the obligating event has occurred. However, premium tax credits may not be recorded as an asset until the related premium is earned and TWIA requires that premium tax credits be spread over a period of at least five years. The Company estimates that of the $27 of accrued assessments for Ike, it will ultimately be able to recoup $20 through premium tax credits.
Unless otherwise specified, the following discussion speaks to changes for the year ended December 31, 2008 compared to the year ended December 31, 2007 and the year ended December 31, 2007 compared to the year ended December 31, 2006.
Net income decreased by $1,415, from net income of $1,507 in 2007 to net income of $92 in 2008. The decrease in net income was due to a $1,288 decrease in Ongoing Operations’ net income and a decrease in Other Operations’ results, from net income of $30 in 2007 to a net loss of $97 in 2008. See the Ongoing Operations and Other Operations segment MD&A discussions for an analysis of the underwriting results and investment performance driving the decrease in net income.
Net income decreased by $12, or 1%, as a result of a $77 decrease in Ongoing Operations’ net income, partially offset by an improvement in Other Operations’ results, from a net loss of $35 in 2006 to net income of $30 in 2007. See the Ongoing Operations and Other Operations segment MD&A discussions for an analysis of the underwriting results and investment performance driving the change in net income.
Net income for Ongoing Operations includes underwriting results for each of its segments, income from servicing businesses, net investment income, other expenses and net realized capital gains (losses), net of related income taxes.
Current accident year losses and loss adjustment expenses before catastrophes decreased by $302
• The current accident year loss and loss adjustment expense ratio before catastrophes in Personal Lines decreased by 1.4 points, primarily due to favorable expected frequency on auto liability claims and the effect of earned pricing increases for both auto and homeowners, partially offset by increased frequency and severity of non-catastrophe losses on homeowners’ business.
Current accident year catastrophe losses of $543, or 5.3 points, in 2008 were higher than current accident year catastrophe losses of $177, or 1.7 points, in 2007, primarily due to losses from hurricane Ike and tornadoes and thunderstorms in the South and Midwest.
An increase in net favorable prior accident year reserve development of $210
The decrease in net servicing income was primarily driven by a decrease in servicing income from the AARP Health program, Specialty Risk Services and the Write Your Own flood program and the write-off of software used in administering policies for third parties.
Income taxes changed from income tax expense of $575 in 2007 to an income tax benefit of $33 in 2008. Despite pre-tax income in 2008, there was a net income tax benefit in 2008 because the income tax benefit on realized capital losses was greater than the income tax expense on all other components of pre-tax income. A portion of the Company’s net investment income was generated from tax-exempt securities.
Ongoing Operations’ earned premium increased by $63, or 1%, to $10,491, driven by a 3% increase in both Personal Lines and Small Commercial, partially offset by a 4% decrease in Middle Market and a 3% decrease in Specialty Commercial. Excluding Omni, earned premium increased by $185, or 2%. Refer to the earned premium discussion in the Executive Overview section of the Property & Casualty MD&A for further discussion of the increase in earned premium.
Ongoing Operations’ current accident year loss and loss adjustment expenses before catastrophes increased by $185 in 2007, to $6,692, due largely to an increase in the current accident year loss and loss adjustment expense ratio and an increase in earned premium, partially offset by a decrease due to the sale of Omni. Excluding Omni, the current accident year loss and loss adjustment expense ratio before catastrophes increased by 1.7 points, to 63.8, due to an increase in the current accident year loss and loss adjustment expense ratio before catastrophes of 3.3 points in Personal Lines, 1.4 points in Small Commercial and 1.9 points in Middle Market, partially offset by a decrease in the current accident year loss and loss adjustment expense ratio before catastrophes of 1.8 points in Specialty Commercial.
• Excluding the effect of Omni, the 3.3 point increase in the current accident year loss and loss adjustment expense ratio before catastrophes in Personal Lines was primarily due to increased severity on auto liability claims, increased frequency on auto property damage claims and, to a lesser extent, increased severity on homeowners claims, partially offset by the effect of earned pricing increases in homeowners.
• The 1.9 point increase in the current accident year loss and loss adjustment expense ratio before catastrophes in Middle Market was primarily due to a higher loss and loss adjustment expense ratio for workers’ compensation, general liability and commercial auto claims driven, in part, by earned pricing decreases. For commercial auto, loss costs increased for both liability and property damage claims.
The $64 of net favorable prior accident year development in 2006 included several changes in reserves, including an $83 net release of prior accident year hurricane reserves. Refer to the “Reserves” section of the MD&A for further discussion of the prior accident year reserve development in 2006.
Net realized capital losses increased from $17 in 2006 to $160 in 2007, primarily due to an increase in impairments and decreases in the fair value of non-qualifying derivatives attributable to changes in value associated with credit derivatives due to credit spread widening. Impairments in 2007 primarily consisted of impairments of asset-backed securities backed by sub-prime residential mortgage loans and impairments of corporate securities in the financial services and homebuilders sectors. (See the Other-Than-Temporary Impairments discussion within Investment Results for more information on the impairments recorded in 2007).
Other expenses increased by $26, primarily due to $49 of interest charged by Corporate on the amount of capital held by the Property & Casualty operation in excess of the amount needed to support the capital requirements of the Property & Casualty operation, partially offset by a reduction in the estimated cost of legal settlements in 2007.
Personal Lines sells automobile, homeowners and home-based business coverages directly to the consumer and through a network of independent agents. Most of the Company’s personal lines business sold directly to the consumer is to the members of AARP through a direct marketing operation. Up until the sale of the business on November 30, 2006, the Company also sold non-standard auto insurance through the Company’s Omni Insurance Group, Inc. (“Omni”) subsidiary. Personal Lines also operates a member contact center for health insurance products offered through the AARP Health program. The Hartford’s exclusive licensing arrangement with AARP continues until January 1, 2020 for automobile, homeowners and home-based business. The AARP Health program agreement continues through 2009.
• Auto earned pricing increases of 1% represent the portion of the 2% increase in written pricing for 2008 that is reflected in earned premium. While auto written pricing was flat in 2007, in 2008 the Company has increased auto insurance rates in certain states for certain classes to maintain profitability in the face of rising loss costs. Although moderating, written pricing increases in 2008 included the effect of policyholders purchasing newer vehicle models in place of older models. Homeowners’ earned pricing increases of 3% primarily reflect the earning of a blend of mid-single digit written pricing increases recognized over the last nine months of 2007 and 2% written pricing increases recognized in the first nine months of 2008. Written pricing increases in homeowners were largely driven by increases in coverage limits due to rising replacement costs.
AARP earned premium grew $215, or 9%, reflecting growth in the size of the AARP target market, the effect of direct marketing programs and the effect of cross selling homeowners insurance to insureds who have auto policies.
The earned premium growth in AARP and Agency was primarily due to auto and homeowners new business written premium outpacing non-renewals over the last six months of 2006 and the first six months of 2007.
Auto earned premium grew slightly, by $30, or 1%, for the year ended December 31, 2007, primarily due to new business outpacing non-renewals in AARP and Agency over the last six months of 2006 and the first six months of 2007, partially offset by the effect of the sale of Omni. Before considering the effect of the sale of Omni, auto earned premium grew $152, or 6%, for the year ended December 31, 2007. Homeowners’ earned premium grew $99, or 10%, primarily due to earned pricing increases and due to new business outpacing non-renewals in AARP business over the last six months of 2006 and the first six months of 2007 and new business outpacing non-renewals in Agency over the last three months of 2006 and the first six months of 2007.
• Omni accounted for $25 of new business written premium during the 2006 calendar year. Excluding Omni business, auto new business written premium decreased by $20, or 5%, to $424, for the year ended December 31, 2007. The decrease in auto new business premium was due to a decrease in AARP and Agency auto new business as a result of increased competition. Homeowners’ new business written premium decreased by $21, or 13%, primarily due to a decrease in Agency new business, partially offset by an increase in AARP new business.
• The trend in earned pricing during 2007 was primarily a reflection of the written pricing changes in the last six months of 2006 and the first six months of 2007. Written pricing remained flat in auto primarily due to an extended period of favorable results factoring into the rate setting process. Homeowners’ written pricing continued to increase due largely to increases in insurance to value and an increase in the value of insured properties. Insurance to value is the ratio of the amount of insurance purchased to the value of the insured property.
Earned premiums increased $37, or 1%, primarily due to earned premium growth in AARP, partially offset by a decrease in Agency and Other earned premium. Refer to the earned premium section above for further discussion.
Current accident year losses and loss adjustment expenses before catastrophes decreased by $34
Amortization of deferred policy acquisition costs increased by $16, driven primarily by the increase in earned premium and the amortization of a higher amount of acquisition costs for AARP business. Insurance operating costs and expenses increased by $11, primarily due to an estimated $10 of assessments owed to TWIA in 2008. The expense ratio increased 0.4 points, to 22.8, due to the increase in insurance operating costs and expenses and the amortization of a higher amount of acquisition costs on AARP business.
Personal Lines current accident year loss and loss adjustment expenses before catastrophes increased by $180 in 2007, to $2,576, due to an increase in earned premium and an increase in the current accident year loss and loss adjustment expense ratio before catastrophes, partially offset by a decrease due to the sale of Omni. Excluding the effect of Omni, the current accident year loss and loss adjustment expense ratio before catastrophes increased by 3.3 points, to 66.2. The increase was primarily due to a higher loss and loss adjustment expense ratio for auto liability claims, increased frequency on auto property damage claims and, to a lesser extent, increased severity on homeowners claims, partially offset by the effect of earned pricing increases in homeowners. The higher loss and loss adjustment expense ratio for auto liability claims was primarily driven by increased bodily injury severity.
Net favorable prior accident year reserve development decreased from $38, or 1.0 point, in 2006 to $4, or 0.1 points, in 2007. Net favorable reserve development of $4 in 2007 included a $16 release of reserves for loss and allocated loss and loss adjustment expenses on Personal Lines auto liability claims for accident years 2002 to 2006.
• Premium renewal retention decreased from 84% to 82% due largely to the effect of a decrease in retention of workers’ compensation business, including the effect of larger written pricing decreases.
• Earned pricing decreased for workers’ compensation and commercial auto and was flat for package business. As written premium is earned over the 12-month term of the policies, the earned pricing changes during 2008 were primarily a reflection of written pricing decreases of 2% over the last nine months of 2007 and 2% over the first nine months of 2008.
• While earned premium was slightly down for 2008, the number of policies in-force has increased 2%. The growth in policies in-force does not correspond directly with the change in earned premiums due to the effect of changes in earned pricing and changes in the average premium per policy.
• Consistent with the increase in earned premium, the number of policies in force has increased. The growth in policies in force does not correspond directly with the change in earned premiums due to the effect of changes in earned pricing, changes in the average premium per policy and because policy in force counts are as of a point in time rather than over a period of time.
Current accident year losses and loss adjustment expenses before catastrophes decreased by $147
Current accident year catastrophe losses of $122, or 4.5 points, in 2008 were higher than current accident year catastrophe losses of $28, or 1.0 point, in 2007, primarily due to hurricane Ike and tornadoes and thunderstorms in the South and Midwest.
Net favorable prior accident year development of $89 in 2008 included a $92 release of workers’ compensation reserves related to accident years 2000 to 2007. Net favorable reserve development of $209 in 2007 included a $151 release of workers’ compensation loss and loss adjustment expense reserves for accident years 2002 to 2006, a $33 release of workers’ compensation loss reserves accident years 1987 to 2000 and a $30 release of loss reserves for package business for accident years 2003 to 2006.
Current accident year loss and loss adjustment expenses before catastrophes increased by $85
• The decrease in new business written premium was primarily due to continued price competition and the effect of state-mandated rate reductions in workers’ compensation. New business written premium declined in all lines except workers’ compensation. As written premium is earned over the 12-month term of the policies, the earned pricing changes during 2007 were primarily a reflection of the written pricing changes over the last six months of 2006 and the first six months of 2007.
• The decrease in premium renewal retention was primarily due to continued price competition and the effect of state-mandated rate reductions in workers’ compensation. Premium renewal retention decreased in all lines of business, including property, commercial auto, general liability, workers’ compensation and marine.
Underwriting results increased by $12, from $157 in 2007 to $169 in 2008, with a corresponding 0.9 point decrease in the combined ratio, from 93.5 to 92.6, due to:
Current accident year losses and loss adjustment expenses before catastrophes decreased by $101
Middle Market current accident year losses and loss adjustment expenses before catastrophes decreased by $101 due largely to a decrease in earned premium. Before catastrophes, the current accident year loss and loss adjustment expense ratio decreased by 1.0 point, to 63.5, primarily due to a lower loss and loss adjustment expense ratio on workers’ compensation and general liability business, largely offset by higher non-catastrophe losses on property and marine business and the effect of earned pricing decreases. The higher non-catastrophe losses on property business were driven by increased severity, including a number of large individual claims, and the higher non-catastrophe losses on marine business were primarily driven by increased frequency.
Current accident year catastrophe losses of $116, or 5.1 points, in 2008 were higher than current accident year catastrophe losses of $15, or 0.6 points, in 2007, primarily due to losses from hurricane Ike and tornadoes and thunderstorms in the South and Midwest.
Net unfavorable reserve development of $16 in 2007 primarily included a $49 release of general liability loss and loss adjustment expense reserves for accident years 2003 to 2006 and an $18 release of commercial auto liability reserves for accident years 2003 and 2004, partially offset by a $40 strengthening of workers’ compensation reserves for accident years 1973 & prior and a $14 strengthening of general liability reserves for accident years more than 20 years old.
The $16 decrease in the amortization of deferred policy acquisition costs was largely due to the decrease in earned premium, partially offset by the amortization of higher underwriting costs. Insurance operating costs and expenses included policyholder dividends of $21 in 2008 and $14 in 2007 which increased primarily due to a $6 increase in the estimated amount of dividends payable to certain workers’ compensation policyholders due to underwriting profits. Apart from policyholder dividends, insurance operating costs and expenses decreased by $6 as the effect of lower compensation-related costs was partially offset by higher IT costs and an estimated $3 of TWIA assessments in 2008. The expense ratio increased by 0.5 points, to 29.0, due to the amortization of higher underwriting costs, the TWIA assessments in 2008 and the effect of lower earned premiums, partially offset by the effect of lower compensation-related costs.
Underwriting results decreased by $57, from $214 to $157, with a corresponding 2.0 point increase in the combined ratio, from 91.5 to 93.5, due to:
Middle Market current accident year loss and loss adjustment expenses before catastrophes decreased by $16 in 2007, to $1,561, due to a decrease in earned premium, largely offset by the effect of an increase in the current accident year loss and loss adjustment expense ratio before catastrophes. Before catastrophes, the current accident year loss and loss adjustment expense ratio increased by 1.9 points, to 64.5, primarily due to a higher loss and loss adjustment expense ratio for workers’ compensation, general liability and commercial auto claims driven, in part, by earned pricing decreases. For commercial auto, loss costs increased for both liability and property damage claims.
Net unfavorable reserve development of $13 in 2006 consisted primarily of a $20 increase in general liability loss and loss adjustment expense reserves related to accident years 1998 to 2005 and a $10 increase in marine loss reserves, partially offset by a $25 reduction in allocated loss adjustment expense reserves for workers’ compensation business related to accident years 2003 to 2005.
Specialty Commercial offers a variety of customized insurance products and risk management services. The segment provides standard commercial insurance products including workers’ compensation, automobile and liability coverages to large-sized companies. Specialty Commercial also provides professional liability, fidelity and surety and specialty casualty coverages, as well as core property and excess and surplus lines coverages not normally written by standard lines insurers. Specialty Commercial provides other insurance products and services primarily to captive insurance companies, pools and self-insurance groups. In addition, Specialty Commercial provides third-party administrator services for claims administration, integrated benefits and loss control through Specialty Risk Services.
Property earned premiums decreased by $46, or 35%, primarily due to the Company’s decision to stop writing specialty property business with large, national accounts and the effect of increased competition for core excess and surplus lines business. As a result of increased competition and capacity for core excess and surplus lines business, the Company has experienced a decrease in earned pricing, lower new business growth and lower premium renewal retention since the third quarter of 2007, particularly for catastrophe-exposed business.
Casualty earned premiums decreased by $17, or 3%, primarily because of lower earned premium from captive programs and a decline in new business premium on loss-sensitive business written with larger accounts over the last nine months of 2007 and first three months of 2008.
Professional liability, fidelity and surety earned premium was flat. Earned premium for professional liability was relatively flat as the effect of earned pricing decreases in 2008 and the effect of a decline in new business written premium over the last nine months of 2007 and the first six months of 2008 were largely offset by the effect of a decrease in the portion of risks ceded to outside reinsurers. Earned premium for fidelity and surety business was also relatively flat as a modest decrease in commercial surety was largely offset by a modest increase in contract surety.
Within the “Other” category, earned premium remained relatively flat from 2007 to 2008. The “Other” category of earned premiums includes premiums assumed under inter-segment arrangements.
Property earned premiums decreased by $11, or 8%, primarily due to lower premium renewal retention and the effect of an arrangement with Berkshire Hathaway to share premiums written under subscription policies. Under the arrangement with Berkshire Hathaway that commenced in the second quarter of 2007, a share of excess and surplus lines business that was previously written entirely by the Company is now being written in conjunction with Berkshire Hathaway under subscription policies, whereby both companies share, or participate, in the business written. The arrangement with Berkshire Hathaway enables the Company to offer its insureds larger policy limits and thereby enhance its competitive position in the marketplace. The decrease in earned premium was partially offset by the effect of earned pricing increases, new business growth, lower reinsurance costs and a decrease in reinstatement premium payable to reinsurers. Renewal retention has decreased in 2007, primarily due to increased competition on national account business as well as in the standard excess and surplus lines market. After experiencing significant rate increases throughout 2006 and smaller rate increases for the first six months of 2007, written pricing decreased in the last six months of the year. While new business decreased in the fourth quarter of 2007, new business increased for the full year, largely because the Company had significantly curtailed new business in 2006 in order to reduce catastrophe loss exposures in certain geographic areas.
Casualty earned premiums decreased by $36, or 6%, for the year ended December 31, 2007, primarily because of a decline in new business written premium and lower premium renewal retention on business written through industry trade groups. Also contributing to the decrease in earned premiums was an increase in the estimated return premium due to insureds under retrospectively-rated policies.
Within the “other” category, earned premium decreased by $35, or 29%. The “Other” category of earned premiums includes premiums assumed under inter-segment arrangements. Beginning in the third quarter of 2006, the Company reduced the premiums assumed by Specialty Commercial under inter-segment arrangements covering certain liability claims.
Underwriting results increased by $89, with a corresponding 6.5 point decrease in the combined ratio, from 101.3 to 94.8, due to:
Earned premiums for the Specialty Commercial segment decreased by $64, or 4%, primarily due to a decrease in property and, to a lesser extent, casualty earned premiums. Refer to the earned premium section above for further discussion.
Current accident year catastrophe losses increased $38, or 2.8 points, primarily due to losses from hurricane Ike.
Change to net favorable prior accident year reserve development by $165
Amortization of deferred policy acquisition costs decreased by $10 due to the decrease in earned premium, partially offset by the effect of an increase in net acquisition costs related to writing a greater mix of higher net commission small commercial and private directors’ and officers’ insurance. Insurance operating costs and expenses increased by $4, primarily due to an increase in IT costs. The expense ratio increased by 0.9 points, to 28.3, primarily due to the increase in insurance operating costs and expenses, the increase in net acquisition costs for directors’ and officers’ insurance and the effect of the decrease in earned premium.
Underwriting results decreased by $64, with a corresponding 4.3 point increase in the combined ratio, to 101.3, due to:
Specialty Commercial earned premium decreased by $47, or 3%, to $1,446. Refer to the earned premium discussion for a description of the decrease in earned premium.
Net unfavorable prior accident year reserve development of $36 in 2006 included a $35 strengthening of reserves for construction defects claims on casualty business for accident years 1997 and prior and a $20 strengthening of allocated loss adjustment expense reserves on workers’ compensation policies for claim payments expected to emerge after 20 years of development, partially offset by a $35 reduction in catastrophe reserves related to the 2005 hurricanes.
Other Operations reported a net loss of $97 in 2008 compared to net income of $30 in 2007, driven by the following:
A $51 decrease in net investment income, primarily as a result of net losses on limited partnerships and other alternative investments in 2008 and decreased fixed maturity income.
A change from $26 of net realized capital gains in 2006 to $12 of net realized capital losses in 2007, primarily due to an increase in impairments and decreases in the fair value of non-qualifying derivatives attributable to changes in value associated with credit derivatives due to credit spreads widening.
In the case of the reserves for asbestos exposures, factors contributing to the high degree of uncertainty include inadequate loss development patterns, plaintiffs’ expanding theories of liability, the risks inherent in major litigation, and inconsistent emerging legal doctrines. Furthermore, over time, insurers, including the Company, have experienced significant changes in the rate at which asbestos claims are brought, the claims experience of particular insureds, and the value of claims, making predictions of future exposure from past experience uncertain. Plaintiffs and insureds also have sought to use bankruptcy proceedings, including “pre-packaged” bankruptcies, to accelerate and increase loss payments by insurers. In addition, some policyholders have asserted new classes of claims for coverages to which an aggregate limit of liability may not apply. Further uncertainties include insolvencies of other carriers and unanticipated developments pertaining to the Company’s ability to recover reinsurance for asbestos and environmental claims. Management believes these issues are not likely to be resolved in the near future.
Reserves and reserve activity in the Other Operations segment are categorized and reported as asbestos, environmental, or “all other”. The “all other” category of reserves covers a wide range of insurance and assumed reinsurance coverages, including, but not limited to, potential liability for construction defects, lead paint, silica, pharmaceutical products, molestation and other long-tail liabilities. In addition, within the “all other” category of reserves, Other Operations records its allowance for future reinsurer insolvencies and disputes that might affect reinsurance collectability associated with asbestos, environmental, and other claims recoverable from reinsurers.
“All Other” includes unallocated loss adjustment expense reserves and the allowance for uncollectible reinsurance.
Excludes asbestos and environmental net liabilities reported in Ongoing Operations of $12 and $6, respectively, as of December 31, 2008, $9 and $6, respectively, as of December 31, 2007, and $9 and $6, respectively, as of December 31, 2006. Total net losses and loss adjustment expenses incurred in Ongoing Operations for the years ended December 31, 2008, 2007 and 2006 includes $16, $10 and $11, respectively, related to asbestos and environmental claims. Total net losses and loss adjustment expenses paid in Ongoing Operations for the years ended December 31, 2008, 2007 and 2006 includes $13, $10 and $12, respectively, related to asbestos and environmental claims.
Gross of reinsurance, asbestos and environmental reserves, including liabilities in Ongoing Operations, were $2,498 and $309, respectively, as of December 31, 2008, $2,707 and $290, respectively, as of December 31, 2007, and $3,242 and $362, respectively, as of December 31, 2006.
During the third quarters of 2008, 2007 and 2006, the Company completed its annual ground up environmental reserve evaluations. In each of these evaluations, the Company reviewed all of its open direct domestic insurance accounts exposed to environmental liability as well as assumed reinsurance accounts and its London Market exposures for both direct insurance and assumed reinsurance. In all three years, the Company found estimates for individual cases changed based upon the particular circumstances of each account. These changes were case specific and not as a result of any underlying change in the current environment. The Company also found that, during 2008, the decline in the reporting of new accounts and sites has been slower than anticipated in the previous review. The net effect of these changes resulted in $53, $25 and $43 increases in net environmental liabilities in 2008, 2007 and 2006, respectively. The Company currently expects to continue to perform an evaluation of its environmental liabilities annually.
The three year average gross paid amount for total environmental claims is $95, resulting in a three year gross survival ratio of 3.2.
Gross Asbestos Reserves based on the second quarter 2008 asbestos reserve study.
An account may move between categories from one evaluation to the next. Reclassifications were made as a result of the reserve evaluation completed in the second quarter of 2008.
Survival ratio is a commonly used industry ratio for comparing reserve levels between companies. While the method is commonly used, it is not a predictive technique. Survival ratios may vary over time for numerous reasons such as large payments due to the final resolution of certain asbestos liabilities, or reserve re-estimates. The survival ratio is computed by dividing the recorded reserves by the average of the past three years of payments. The ratio is the calculated number of years the recorded reserves would survive if future annual payments were equal to the average annual payments for the past three years. The 3-year gross survival ratio of 5.7 as of December 31, 2008 is computed based on total paid losses of $1.307 billion for the period from January 1, 2006 to December 31, 2008. As of December 31, 2008, the one year gross paid amount for total asbestos claims is $294 resulting in a one year gross survival ratio of 8.5.
The following table sets forth, for the years ended December 31, 2008, 2007 and 2006, paid and incurred loss activity by the three categories of claims for asbestos and environmental.
Excludes asbestos and environmental paid and incurred loss and LAE reported in Ongoing Operations. Total gross loss and LAE incurred in Ongoing Operations for the twelve months ended December 31, 2008, 2007, and 2006 includes $15, $9 and $10, respectively, related to asbestos and environmental claims. Total gross loss and LAE paid in Ongoing Operations for the twelve months ended December 31, 2008, 2007, and 2006 includes $12, $10 and $12, respectively, related to asbestos and environmental claims.
A number of factors affect the variability of estimates for asbestos and environmental reserves including assumptions with respect to the frequency of claims, the average severity of those claims settled with payment, the dismissal rate of claims with no payment and the expense to indemnity ratio. The uncertainty with respect to the underlying reserve assumptions for asbestos and environmental adds a greater degree of variability to these reserve estimates than reserve estimates for more traditional exposures. While this variability is reflected in part in the size of the range of reserves developed by the Company, that range may still not be indicative of the potential variance between the ultimate outcome and the recorded reserves. The recorded net reserves as of December 31, 2008 of $2.18 billion ($1.90 billion and $275 for asbestos and environmental, respectively) is within an estimated range, unadjusted for covariance, of $1.80 billion to $2.42 billion. The process of estimating asbestos and environmental reserves remains subject to a wide variety of uncertainties, which are detailed in the “Critical Accounting Estimates-Property & Casualty Reserves, Net of Reinsurance” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations. The Company believes that its current asbestos and environmental reserves are reasonable and appropriate. However, analyses of further developments could cause the Company to change its estimates and ranges of its asbestos and environmental reserves, and the effect of these changes could be material to the Company’s consolidated operating results, financial condition and liquidity. If there are significant developments that affect particular exposures, reinsurance arrangements or the financial condition of particular reinsurers, the Company will make adjustments to its reserves or to the amounts recoverable from its reinsurers.
During the second quarters of 2008, 2007 and 2006, the Company completed its annual evaluations of the collectability of the reinsurance recoverables and the adequacy of the allowance for uncollectible reinsurance associated with older, long-term casualty liabilities reported in the Other Operations segment. The evaluations in the second quarters of 2008 and 2007 resulted in no addition to the allowance for uncollectible reinsurance. In the second quarter of 2006, the Company entered into an agreement with Equitas and all Lloyd’s syndicates reinsured by Equitas (collectively, “Equitas”) that resolved, with minor exception, all of the Company’s ceded and assumed domestic reinsurance exposures with Equitas, including all of the Company’s reinsurance recoveries from Equitas under the Blanket Casualty Treaty (BCT). As a result of the settlement with Equitas and the 2006 reinsurance recoverable evaluation, the Company reduced its net reinsurance recoverable by $243.
In conducting these evaluations of reinsurance recoverables, the Company used its most recent detailed evaluations of ceded liabilities reported in the segment. The Company analyzed the overall credit quality of the Company’s reinsurers, recent trends in arbitration and litigation outcomes in disputes between cedants and reinsurers, and recent developments in commutation activity between reinsurers and cedants. The Company also considered the effect of the Equitas settlement on the collectability of amounts due from other upper-layer reinsurers under the BCT. The allowance for uncollectible reinsurance reflects management’s current estimate of reinsurance cessions that may be uncollectible in the future due to reinsurers’ unwillingness or inability to pay. As of December 31, 2008, the allowance for uncollectible reinsurance for Other Operations totals $254. The Company currently expects to perform its regular comprehensive review of Other Operations reinsurance recoverables annually. Uncertainties regarding the factors that affect the allowance for uncollectible reinsurance could cause the Company to change its estimates, and the effect of these changes could be material to the Company’s consolidated results of operations or cash flows.
Fluctuations in interest rates affect the Company’s return on, and the fair value of, fixed maturity investments, which comprised approximately 54% and 61% of the fair value of its invested assets as of December 31, 2008 and 2007, respectively. Other events beyond the Company’s control, including changes in credit spreads, a downgrade of an issuer’s credit rating or default of payment by an issuer, could also adversely impact the fair value of these investments.
The primary investment objective of Life’s general account is to maximize economic value within acceptable risk parameters, including the management of the interest rate sensitivity of invested assets, while generating sufficient after-tax income to support policyholder and corporate obligations, as discussed in the Capital Markets Risk Management section of the MD&A under “Market Risk - Life”.
The following table identifies the invested assets by type held in the general account.
These assets primarily support the International variable annuity business. Changes in these balances are also reflected in the respective liabilities.
The following table summarizes Life’s limited partnerships and other alternative investments.
Net investment income, excluding equity securities, held for trading, decreased $452, or 13%, for the year ended December 31, 2008, compared to the prior year period. The decrease in net investment income was primarily due to lower yield on variable rate securities due to declines in short term interest rates, increased allocation to lower yielding U.S. Treasuries and short-term investments, and a decrease in investment yield for limited partnership and other alternative investments. The decrease in limited partnerships and other alternative investments yield was largely due to negative returns on hedge funds and real estate partnerships as a result of the lack of liquidity in the financial markets and a wider credit spread environment. Based upon the current interest rate and credit environment, Life expects a slightly higher average portfolio yield for 2009 as compared to 2008.
The following table summarizes Life’s net realized capital gains and losses results.
Includes SFAS 157 implementation losses of $616, $10 and $24 related to the embedded derivatives within GMWB-US, GMWB-UK and GMAB liabilities, respectively.
• Gross gains and losses on sales for the year ended December 31, 2007 were primarily comprised of corporate securities. During the year ended December 31, 2007, securities sold at a loss were depressed, on average, approximately 1% at the respective period’s impairment review date and were deemed to be temporarily impaired.
• Gross gains on sales for the year ended December 31, 2006 were primarily within fixed maturities and were concentrated in U.S. government, corporate and foreign government securities. Gross losses on sale for the year ended December 31, 2006 were primarily within fixed maturities and were concentrated in the corporate and CMBS sectors.
• See Note 4 in the Notes to the Consolidated Financial Statements for a discussion of the SFAS 157 transition impact.
• Other, net losses for the year ended December 31, 2008 were primarily related to net losses of $291 related to transactional foreign currency losses predominately on the internal reinsurance of the Japan variable annuity business, which is entirely offset in AOCI, resulting from appreciation of the Yen and credit derivative losses of $222 due to significant credit spread widening. Also included were losses on HIMCO managed CLOs in the first quarter and derivative related losses of $39 in the third quarter due to counterparty default related to the bankruptcy of Lehman Brothers Holdings Inc. For more information regarding the CLO losses, refer to the Variable Interest Entities section below.
• Other, net losses for the year ended December 31, 2006 were primarily driven from the change in value of non-qualifying derivatives due to fluctuations in interest rates and foreign currency exchange rates. These losses were partially offset by a before-tax benefit of $25 received from the WorldCom security settlement.
Includes hedge fund investments outside of limited partnerships and a real estate joint venture.
Total investments decreased $6.5 billion since December 31, 2007 primarily as a result of increased unrealized losses. Unrealized losses increased as a result of market deterioration due to significant credit spread widening. In addition, P&C increased its investment in short-term securities to maintain higher than average liquidity while waiting for market and asset valuations to stabilize.
The following table summarizes Property & Casualty’s limited partnerships and other alternative investments.
Private equity and other funds primarily consist of investments in funds whose assets typically consist of a diversified pool of investments in small non-public businesses with high growth potential.
Before-tax net investment income decreased $434, or 26%, and after-tax net investment income decreased $325, or 26%, compared to the prior year period. The decrease in net investment income was primarily due to lower yield on variable rate securities due to declines in short term interest rates, increased allocation to lower yielding U.S. Treasuries and short-term investments, and a decrease in investment yield for limited partnership and other alternative investments. The decrease in limited partnerships and other alternative investments yield was largely due to negative returns on hedge funds and real estate partnerships as a result of the lack of liquidity in the financial markets and a wider credit spread environment. Based upon the current interest rate and credit environment, Property & Casualty expects a slightly higher average portfolio yield for 2009 as compared to 2008.
Before-tax net investment income increased $201, or 14%, and after-tax net investment income increased $139, or 13%, compared to the prior year period. The increase in net investment income was primarily due to a higher average invested asset base and a higher portfolio yield. The increase in the average invested asset base as compared to the prior year period, was primarily due to positive operating cash flows. Limited partnerships and other alternative investments contributed to the increase in income compared to the prior year period due to a higher portfolio yield and greater allocation of investments to this asset class.
Primarily consists of changes in fair value on non-qualifying derivatives, hedge ineffectiveness on qualifying derivative instruments, and other investment gains and losses.
• Gross gains on sales for the year ended December 31, 2006 were concentrated in the corporate, foreign government and municipal sectors. Gross losses on sales for the year ended December 31, 2006 were concentrated in the corporate and CMBS sectors.
The investment objective of Corporate is to raise capital through financing activities to support the Life and Property & Casualty operations of the Company and to maintain sufficient funds to support the cost of those financing activities including the payment of interest for The Hartford Financial Services Group, Inc. (“HFSG”) issued debt and dividends to shareholders of The Hartford’s common stock. As of December 31, 2008 and 2007, Corporate held $155 and $308, respectively, of fixed maturity investments, $1.5 billion and $160, respectively, of short-term investments and $73 and $103, respectively, of equity securities, available-for-sale. Short-term investments are intended to be used for general corporate purposes, which may include the capital and liquidity needs of our operations. For further information, see “Capital Resources and Liquidity” section under Liquidity Requirements. As of December 31, 2008 and 2007, a put option agreement for the Company’s contingent capital facility with a fair value of $43 was included in Other invested assets. Realized capital gains for the year ended December 31, 2008, included gains of $110 resulting from a decrease in the liability related to certain warrants associated with the Allianz transaction. For further discussion on Allianz, see the Capital Resources and Liquidity section.
The Company participates in securities lending programs to generate additional income, whereby certain domestic fixed income securities are loaned from the Company’s portfolio to qualifying third party borrowers, in return for collateral in the form of cash or U.S. government securities. Borrowers of these securities provide collateral of 102% of the market value of the loaned securities and can return the securities to the Company for cash at varying maturity dates. As of December 31, 2008, the Company loaned securities with a fair value of $2.9 billion and had received collateral against the loaned securities in the amount of $3.0 billion. The Company reduced its securities lending program by $1.4 billion since December 31, 2007 and plans to significantly reduce its term lending program in 2009 as securities mature.
The following table represents when the borrowers can return the loaned securities to the Company and, in turn, when the cash collateral would be returned to the borrower.
The Company has no implied or unfunded commitments to these VIEs.
The Company has a comprehensive security monitoring process overseen by a committee of investment and accounting professionals that, on a quarterly basis, identifies securities that could potentially be other-than-temporarily impaired. When a security is deemed to be other-than-temporarily impaired, its cost or amortized cost is written down to current fair value and a realized loss is recorded in the Company’s consolidated statements of operations. For fixed maturities, the Company accretes the new cost basis to par or to the estimated future value over the expected remaining life of the security by adjusting the security’s yield. For further discussion regarding the Company’s other-than-temporary impairment policy, see “Evaluation of Other-Than-Temporary Impairments on Available-for-Sale Securities” included in the Critical Accounting Estimates section of the MD&A, Note 1 of Notes to Consolidated Financial Statements and Item 1A, Risk Factors.
The following discussion provides an analysis of significant other-than-temporary impairments (“impairments”) recognized during 2008, 2007 and 2006 and the related circumstances giving rise to the impairments.
For the year ended December 31, 2007, impairments of $483 were concentrated in securitized assets and corporate fixed maturities. Impairments for securitized assets totaled $249 and were primarily on securities backed by sub-prime residential mortgage loans rated A and below in the 2006 and 2007 vintage years. Impairments on corporate fixed maturities of $165 were primarily within the financial services and home builders sectors. The majority of these securities experienced extensive credit spread widening and the Company could not reasonably assert that the security would recover in value in a reasonable period of time. For the majority of these securities, the Company expects to recover principal and interest substantially greater than what the market price indicates.
For the year ended December 31, 2006, impairments were primarily recorded on corporate fixed maturities and ABS. Other than a $16 impairment on a single issuer in the utilities sector, there were no other significant impairments (i.e., $15 or greater) recorded on any single security or issuer. The impairments on ABS primarily related to investments backed by aircraft lease receivables. Impairments resulted from higher than expected maintenance expenses.
Other than U.S. government and certain U.S. government agencies backed by the full faith and credit of the U.S. government, the Company’s only exposure to any credit concentration risk of a single issuer greater than 10% of the Company’s stockholders’ equity, is the Government of Japan, which represents $2.3 billion, or 25%, of stockholders’ equity. For further discussion of concentration of credit risk, see the “Concentration of Credit Risk” section in Note 5 of Notes to Consolidated Financial Statements.
The Company minimizes the credit risk of derivative instruments by entering into transactions with high quality counterparties rated A2/A or better, which are monitored and evaluated by the Company’s risk management team and reviewed by senior management. In addition, the internal compliance unit monitors counterparty credit exposure on a monthly basis to ensure compliance with Company policies and statutory limitations. The Company also maintains a policy of requiring that derivative contracts, other than exchange traded contracts, currency forward contracts, and certain embedded derivatives, be governed by an International Swaps and Derivatives Association Master Agreement which is structured by legal entity and by counterparty and permits right of offset.
For the year ended December 31, 2008, the Company has incurred losses of $46 on derivative instruments due to counterparty default related to the bankruptcy of Lehman Brothers Holdings Inc. These losses were a result of the contractual collateral threshold amounts and open collateral calls in excess of such amounts immediately prior to the bankruptcy filing, as well as interest rate and credit spread movements from the date of the last collateral call to the date of the bankruptcy filing.
The Company uses credit derivatives to assume credit risk from and reduce credit risk to a single entity, referenced index, or asset pool. The credit default swaps in which the Company assumes credit risk reference investment grade single corporate issuers, baskets of up to five corporate issuers and diversified portfolios of corporate issuers. The diversified portfolios of corporate issuers are established within sector concentration limits and are typically divided into tranches which possess different credit ratings ranging from AAA through the CCC rated first loss position. In addition to the credit default swaps that assume credit exposure, the Company also purchases credit protection through credit default swaps to economically hedge and manage credit risk of certain fixed maturity investments across multiple sectors of the investment portfolio.
The credit default swaps are carried on the balance sheet at fair value. The Company received upfront premium payments on certain credit default swaps, which reduces the Company’s overall credit exposure. The following table summarizes the credit default swaps used by the Company to manage credit risk within the portfolio, excluding credit default swaps in offsetting positions, which had a notional amount of $2.6 billion as of December 31, 2008.
Prior to the first quarter of 2008, the Company also assumed credit exposure through credit index swaps referencing AAA rated CMBS indices. During the first and second quarter of 2008, the Company realized a loss of $100 and $3, before-tax, respectively, as a result of these swaps maturing as well as the Company eliminating exposure to the remaining swaps by entering into offsetting positions. As of December 31, 2008, the Company does not have exposure to CMBS through credit derivatives.
The following table identifies fixed maturities by credit quality on a consolidated basis. The ratings referenced below are based on the ratings of a nationally recognized rating organization or, if not rated, assigned based on the Company’s internal analysis of such securities.
The Company’s investment ratings as a percentage of total fixed maturities experienced a downward shift from AAA since December 31, 2007 primarily due to rating agency downgrades of monoline insurers, as well as, downgrades of sub-prime, CMBS, and financial services sector securities. The movement in both government rated and BB & below securities is attributable to efforts to reallocate the portfolio to higher quality, risk adverse assets through purchases of U.S. Treasuries and sales of high yield securities.
Includes securities with an amortized cost and fair value of $214 and $135, respectively, as of December 31, 2008, and $270 as of December 31, 2007, which were backed by pools of loans issued to Alt-A borrowers.
Gross unrealized gains represent gains of $860, $526, and $1 for Life, Property & Casualty, and Corporate, respectively, as of December 31, 2008 and $1,339, $734, and $14, respectively, as of December 31, 2007. Gross unrealized losses represent losses of $10,766 $3,835, and $8 for Life, Property & Casualty, and Corporate, respectively, as of December 31, 2008 and $1,985, $781, and $6, respectively, as of December 31, 2007.
The following table presents the Company’s exposure to ABS supported by sub-prime mortgage loans by current credit quality and vintage year, including direct investments in CDOs that contain a sub-prime loan component, included in the RMBS and ABS other line in the Consolidated Available-for-Sale Securities by Type table above. A comparison of fair value to amortized cost is not indicative of the pricing of individual securities as rating downgrades and impairments have occurred. Credit protection represents the current weighted average percentage, excluding wrapped securities, of the outstanding capital structure subordinated to the Company’s investment holding that is available to absorb losses before the security incurs the first dollar loss of principal. The table below excludes the Company’s exposure to Alt-A residential mortgage loans, with an amortized cost and fair value of $305 and $197, respectively, as of December 31, 2008, and $366 and $357, respectively, as of December 31, 2007. These securities were primarily backed by 2007 vintage year collateral and rated A and above.
As of December 31, 2008, the weighted average life of the sub-prime residential mortgage portfolio was 3.8 years.
Approximately 84% of the portfolio is backed by adjustable rate mortgages.
As of December 31, 2008, approximately 36% of the underlying CMBS CRE CDO collateral are seasoned, below investment grade securities.
The following table presents commercial mortgage loans by region and property type.
The Company continues to see weakness in consumer credit fundamentals. Rising delinquency and loss rates have been driven by the recessionary economy and higher unemployment rates. Delinquencies and losses on consumer loans rose during 2008 and the Company expects this trend to continue in the upcoming year. However, the Company expects its ABS consumer loan holdings to face limited credit concerns, as the borrower collateral quality and structural credit enhancement of the securities are sufficient to absorb a significantly higher level of defaults than are currently anticipated. The following table presents the Company’s exposure to ABS consumer loans by credit quality.
Includes monoline insured securities with an amortized cost and fair value of $47 and $38, respectively, at December 31, 2008, and amortized cost and fair value of $49 at December 31, 2007. Additionally, approximately 13% of the auto consumer loan-backed securities were issued by lenders whose primary business is to sub-prime borrowers.
The following tables present the Company’s unrealized loss aging for available-for-sale securities by length of time the security was in a continuous greater than 20% unrealized loss position.
The majority of securitized assets depressed over 20%, as well as, over 50% for six consecutive months are primarily related to CMBS and sub-prime RMBS. Based upon the Company’s cash flow modeling in a severe negative economic outlook, which shows no loss of principal and interest, and the Company’s assertion of its ability and intent to retain the securities until recovery, it has been determined that these securities are temporarily impaired as of December 31, 2008.
As part of the Company’s ongoing security monitoring process by a committee of investment and accounting professionals, the Company has reviewed its investment portfolio and concluded that there were no additional other-than-temporary impairments as of December 31, 2008 and 2007. During this analysis, the Company asserts its intent and ability to retain until recovery those securities judged to be temporarily impaired. Once identified, these securities are systematically restricted from trading unless approved by the committee. The committee will only authorize the sale of these securities based on predefined criteria that relate to events that could not have been reasonably foreseen at the time the committee rendered its judgment on the Company’s intent and ability to retain such securities until recovery. Examples of the criteria include, but are not limited to, the deterioration in the issuer’s creditworthiness, a change in regulatory requirements or a major business combination or major disposition.
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 the specific classes of investments, while asset/liability management is the responsibility of a dedicated risk management unit supporting Life and Property & Casualty operations. Derivative instruments are utilized in compliance with established Company policy and regulatory requirements and are monitored internally and reviewed by senior management. During 2008, the continued deterioration in the U.S. housing market, tightened lending conditions, the market’s flight to quality securities, the U.S. recession, and the declining global economy contributed to substantial spread widening in the Company’s fixed maturity portfolio.
The Hartford is exposed to market risk, primarily relating to the market price and/or cash flow variability associated with changes in interest rates, credit spreads including issuer defaults, equity prices or market indices, and foreign currency exchange rates. The Hartford is also exposed to credit and counterparty repayment risk. The Company analyzes interest rate risk using various models including parametric models that forecast cash flows of the liabilities and the supporting investments, including derivative instruments, under various market scenarios.
As interest rates decline, certain securities such as MBS and CMOs, as well as, other mortgage loan backed securities are more susceptible to paydowns and prepayments. During such periods, the Company generally will not be able to reinvest the proceeds at comparable yields, however in 2008, in general, increases in credit spreads off-set lower interest rates. Lower interest rates will also likely result in lower net investment income, increased hedging cost associated with variable annuities and, if declines are sustained for a long period of time, it may subject the Company to reinvestment risks, higher pension costs expense and possibly reduced profit margins associated with guaranteed crediting rates on certain Life products. Conversely, the fair value of the investment portfolio will increase when interest rates decline and the Company’s interest expense will be lower on its variable rate debt obligations.
The derivative counterparty exposure policy establishes market-based credit limits, favors long-term financial stability and creditworthiness of the counterparty and typically requires credit enhancement/credit risk reducing agreements. The Company minimizes the credit risk in derivative instruments by entering into transactions with high quality counterparties rated A2/A or better, which are monitored and evaluated by the Company’s risk management team and reviewed by senior management. In addition, the internal compliance unit monitors counterparty credit exposure on a monthly basis to ensure compliance with Company policies and statutory limitations.
The Company has developed credit exposure thresholds which are based upon counterparty ratings. The maximum uncollateralized threshold for a derivative counterparty for a single legal entity is $10, excluding reinsurance derivatives. The Company currently transacts derivatives in five legal entities and therefore the maximum combined threshold for a single counterparty over all legal entities that use derivatives is $50. In addition, the Company may have exposure to multiple counterparties in a single corporate family due to a common credit support provider. As of December 31, 2008, the maximum combined threshold for all counterparties under a single credit support provider over all legal entities that use derivatives is $100. Based on the contractual terms of the collateral agreements, these thresholds may be immediately reduced due to a downgrade in a counterparty’s credit rating.
In addition to counterparty credit risk, the Company enters into credit derivative instruments, including credit default, index and total return swaps, in which the Company assumes credit risk from or reduces credit risk to a single entity, referenced index, or asset pool, in exchange for periodic payments. For further information on credit derivatives, see the “Investment Credit Risk” section.
The Company is also exposed to credit spread risk related to security market price and cash flows associated with changes in credit spreads. Credit spread widening will reduce the fair value of the investment portfolio and will increase net investment income on new purchases. This will also result in losses associated with credit based non-qualifying derivatives where the Company assumes credit exposure. If issuer credit spreads increase significantly or for an extended period of time, it may result in higher other-than-temporary impairments. Credit spread tightening will reduce net investment income associated with new purchases of fixed maturities and increase the fair value of the investment portfolio. During 2008, credit spread widening resulted in a significant increase in the Company’s unrealized losses and other-than-temporary impairments. For further discussion of sectors most significantly impacted, see the “Investment Credit Risk” section. Also, see “Capital Resources and Liquidity” for a discussion of the widening of credit spread impacts on the Company’s statutory financial results as it relates to the accounting and reporting for market value adjusted fixed annuities.
Life’s exposure to interest rate risk relates to the market price and/or cash flow variability associated with changes in market interest rates. As stated above, changes in interest rates can potentially impact Life’s profitability. In certain scenarios where interest rates are volatile, Life could be exposed to disintermediation risk and a reduction in net interest rate spread or profit margins. The investments and liabilities primarily associated with interest rate risk are included in the following discussion. Certain product liabilities, including those containing GMWB, GMIB, GMAB, or GMDB, expose the Company to interest rate risk but also have significant equity risk. These liabilities are discussed as part of the Equity Risk section below.
Life’s investment portfolios primarily consist of investment grade fixed maturity securities, including corporate bonds, ABS, CMBS, tax-exempt municipal securities and government bonds. The fair value of Life’s fixed maturities was $45.2 billion and $52.5 billion at December 31, 2008 and 2007, respectively. The fair value of Life’s fixed maturities and other invested assets fluctuates depending on the interest rate environment and other general economic conditions. The weighted average duration of the fixed maturity portfolio was approximately 5.3 and 4.6 years as of December 31, 2008 and 2007, respectively.
Life’s investment contracts and certain insurance product liabilities, other than non-guaranteed separate accounts, include asset accumulation vehicles such as fixed annuities, guaranteed investment contracts, other investment and universal life-type contracts and certain insurance products such as long-term disability.
The Company also manages the risk of certain insurance liabilities similar to how it manages the risk associated with investment type products due to the relative predictability of the aggregate cash flow payment streams. Products in this category may contain significant actuarial (including mortality and morbidity) pricing and cash flow risks. Product examples include structured settlement contracts, on-benefit annuities (i.e., the annuitant is currently receiving benefits thereon) and short-term and long-term disability contracts. The cash outflows associated with these policy liabilities are not interest rate sensitive but do vary based on the timing and amount of benefit payments. The primary risks associated with these products are that the benefits will exceed expected actuarial pricing and/or that the actual timing of the cash flows will differ from those anticipated, resulting in an investment return lower than that assumed in pricing. Average contract duration can range from less than one year to typically up to fifteen years.
Substantially all of the Company’s variable annuity contracts contain a GMDB and a portion of those contracts also contain one or more living benefits. The Company’s maximum exposure disclosed below for death and living benefits are calculated independently, however, these exposures are substantially overlapping.
Generally, declines in equity markets, such as those experienced in 2008, will and did in 2008:
reduce the value of equity securities, held for trading, for international variable annuities, the related policyholder funds and benefits payable, and the amount of fee income generated from those annuities;
increase the liability for GMWB and GMAB benefits resulting in realized capital losses;
increase the amount of required statutory capital necessary to maintain targeted risk based capital (RBC) ratios.
turn customer sentiment toward equity-linked products negative, causing a decline in sales;
For GMAB benefits, the only ways the contract holder can monetize the excess of the GRB over the account value of the contract is upon death or by waiting until the end of the contractual deferral period of 10 years. As the amount of the excess of the GRB over the account value can fluctuate with equity market returns on a daily basis, the ultimate amount to be paid by the Company, if any, is uncertain and could be significantly more or less than $15.
The Company’s total gross exposure (i.e., before reinsurance) to U.S. guaranteed death benefits as of December 31, 2008 is $36.3 billion. The Company will incur these guaranteed death benefit payments in the future only if the policyholder has an in-the-money guaranteed death benefit at their time of death. The Company currently reinsures 51% of these death benefit guarantees. Under certain of these reinsurance agreements, the reinsurers’ exposure is subject to an annual cap. The Company’s net exposure (i.e. after reinsurance) is $17.8 billion, as of December 31, 2008. This amount is often referred to as the retained net amount at risk.
As a result of these significant accounting differences, the liability for guarantees recorded under SOP 03-1 may be significantly different than if it was recorded under SFAS 133 and vice versa. In addition, the conditions in the capital markets in Japan versus those in the U.S. are sufficiently different that if the Company’s GMWB product currently offered in the U.S. were offered in Japan, the capital market conditions in Japan would have a significant impact on the valuation of the GMWB, irrespective of the accounting model. The same would hold true if the Company’s GMIB product currently offered in Japan were to be offered in the U.S. Capital market conditions in the U.S. would have a significant impact on the valuation of the GMIB.
In consideration of current market conditions, the Company’s risk management program for the variable annuity market will include redesigned product features which serve to lessen the financial risk of the product guarantees and increased rider fees charged for the product guarantees. Depending upon competitors’ reactions with respect to product suites and related rider charges, the Company’s strategies of reducing product risk and increasing fees may cause a decline in market share.
The Company uses reinsurance to manage the risk exposure for a portion of contracts issued with GMWB riders prior to the third quarter of 2003 and, in addition, in 2008, the Company entered into a reinsurance agreement to reinsure GMWB risks associated with a block of business sold between the third quarter of 2003 and the second quarter of 2006. The Company’s GMWB reinsurance is accounted for as a freestanding derivative and is reported at fair value under SFAS 157.
The Company is continually exploring new ways and new markets to manage or layoff the capital markets and policyholder behavior risks associated with its U.S. GMWB living benefits. During 2007 and 2008, the Company entered into customized derivative contracts to hedge certain capital market risk components for the remaining term of specific blocks of non-reinsured U.S. GMWB riders. These customized derivative contracts provide protection from capital markets risks based on policyholder behavior assumptions specified by the Company at the inception of the derivative transactions. The Company retains the risk for actual policyholder behavior that is different from assumptions within the customized derivatives.
In the fourth quarter of 2008, the global economy experienced severe weakening resulting from the dramatic decline in the equity markets, increasing equity index implied volatility, widening of credit spreads, significant declines in interest rates, and volatility in foreign currency exchanges rates. These significant and precipitous economic events increased, to varying degrees, the Company’s exposure to death and living benefit guarantees, the statutory product guarantee liabilities, and the level of statutory surplus required to maintain the Company’s RBC ratios.
In response to these severe economic drivers, the Company initiated a redesign of the variable annuity product suite strategy designed to lessen the financial risk of variable annuity product guarantees and increase the rider fees on new sales and on in-force, as contractually permitted. The Company will continue to hedge the risk of the product guarantees with a greater relative emphasis on protection of statutory surplus. This rebalancing of the hedging program affords an additional measure of protection to improve the Company’s capital efficiency in managing tail risk for statutory surplus during periods of declines in the equity markets. This shift in relative emphasis will likely result in greater U.S. GAAP earnings volatility.
In the fourth quarter of 2008, the rebalancing of variable annuity hedging programs resulted in the sale of certain derivative positions, a portion of which proceeds were used to purchase other derivatives for the protection of statutory surplus and the associated target RBC ratios. The Company entered into hedge positions on the S&P 500 index to economically hedge statutory reserves and to provide protection of statutory surplus arising primarily from GMDB and GMWB obligations. Refer to Note 5 of Notes to Consolidated Financial Statements for additional information on hedging derivatives.
The following table summarizes the Company‘s U.S. GMWB account value by type of risk management strategy as of December 31, 2008:
The Company enters into foreign currency forward and option contracts that convert euros to yen in order to economically hedge the foreign currency risk associated with certain Japanese variable annuity products. As of December 31, 2008, the derivatives used to hedge foreign currency risk associated with Japanese variable annuity products had a total notional amount of $259 and a total fair value of $35. As of December 31, 2007, there were no derivative positions held as part of this strategy.
The yen based fixed annuity product is written by Hartford Life Insurance K.K. (“HLIKK”), a wholly-owned Japanese subsidiary of Hartford Life, Inc. (“HLI”), and subsequently reinsured to Hartford Life Insurance Company, a U.S. dollar based wholly-owned indirect subsidiary of HLI. The underlying investment involves investing in U.S. securities markets, which offer favorable credit spreads. The yen denominated fixed annuity product (“yen fixed annuities”) is recorded in the consolidated balance sheets with invested assets denominated in dollars while policyholder liabilities are denominated in yen and converted to U.S. dollars based upon the December 31, yen to U.S. dollar spot rate. The difference between U.S. dollar denominated investments and yen denominated liabilities exposes the Company to currency risk. The Company manages this currency risk associated with the yen fixed annuities primarily with pay variable U.S. dollar and receive fixed yen currency swaps. As of December 31, 2008 and 2007, the notional value and fair value of the currency swaps were $2.3 billion and $1.8 billion, respectively, and $383 and $(115), respectively. Although economically an effective hedge, a divergence between the yen denominated fixed annuity product liability and the currency swaps exists primarily due to the difference in the basis of accounting between the liability and the derivative instruments (i.e. historical cost versus fair value). The yen denominated fixed annuity product liabilities are recorded on a historical cost basis and are only adjusted for changes in foreign spot rates and accrued income. The currency swaps are recorded at fair value, incorporating changes in value due to changes in forward foreign exchange rates, interest rates and accrued income. An after-tax net gain of $42 and $12 for the years ended December 31, 2008 and 2007, respectively, which includes the changes in value of the currency swaps, excluding net periodic coupon settlements, and the yen fixed annuity contract remeasurement, was recorded in net realized capital gains and losses.
Based on the fair values of Life’s non-U.S. dollar denominated investments and derivative instruments (including its yen based individual fixed annuity product) as of December 31, 2008 and 2007, management estimates that a 10% unfavorable change in exchange rates would decrease the fair values by an after-tax total of $111 and $1, respectively. The estimated impact was based upon a 10% change in December 31 spot rates. The selection of the 10% unfavorable change was made only for illustration of the potential hypothetical impact of such an event and should not be construed as a prediction of future market events. Actual results could differ materially from those illustrated above due to the nature of the estimates and assumptions used in the above analysis.
The primary exposure to interest rate risk in Property & Casualty relates to its fixed maturity securities, including corporate bonds, ABS, municipal bonds, CMBS and government bonds. The fair value of these investments was $19.8 billion and $27.2 billion at December 31, 2008 and 2007, respectively. The fair value of these and Property & Casualty’s other invested assets fluctuates depending on the interest rate environment and other general economic conditions. A variety of derivative instruments, primarily swaps, are used to manage interest rate risk and had a total notional amount as of December 31, 2008 and 2007 of $2.3 billion and $1.8 billion, respectively, and fair value of $23 and $(15), respectively.
The following table provides an analysis showing the estimated after-tax change in the fair value of Property & Casualty’s fixed maturity investments and related derivatives, assuming 100 basis point upward and downward parallel shifts in the yield curve as of December 31, 2008 and 2007. Certain financial instruments, such as limited partnerships, have been omitted from the analysis due to the fact that the investments are accounted for under the equity method and generally lack sensitivity to interest rate changes.
Based on the fair values of Property & Casualty’s non-U.S. dollar denominated securities and derivative instruments as of December 31, 2008 and 2007, management estimates that a 10% unfavorable change in exchange rates would decrease the fair values by an after-tax total of approximately $42 and $37, respectively. The estimated impact was based upon a 10% change in December 31 spot rates. The selection of the 10% unfavorable change was made only for illustration of the potential hypothetical impact of such an event and should not be construed as a prediction of future market events. Actual results could differ materially from those illustrated above due to the nature of the estimates and assumptions used in the above analysis.
The principal sources of operating funds are premiums and investment income, while investing cash flows originate from maturities and sales of invested assets. The primary uses of funds are to pay claims, policy benefits, operating expenses and commissions and to purchase new investments. In addition, The Hartford holds a significant short-term investment position to meet liquidity needs. As of December 31, 2008 and 2007, HFSG held total fixed maturity investments of $1.6 billion and $457, respectively, of which $1.5 billion and $154 were short-term investments, respectively. The funds are intended to be used for general corporate purposes, which may include the capital and liquidity needs of our operations. For a discussion of the Company’s investment objectives and strategies, see the Investments and Capital Markets Risk Management sections.
On November 14, 2008, the Company announced that it applied to participate in the U.S. Treasury Department’s Capital Purchase Program (“CPP”). In conjunction with this application, the Company also applied to the Office of Thrift Supervision (“OTS”) to become a savings and loan holding company and signed a merger agreement to acquire the parent company of Federal Trust Bank (“FTB”), a federally chartered, FDIC-insured savings bank. Federal Trust Bank is owned by Federal Trust Corporation, a unitary thrift holding company headquartered in Sanford, Florida. The completion of this acquisition will satisfy a key eligibility requirement for participation in the CPP. On January 9, 2009, the Office of Thrift Supervision approved the Company’s application to become a savings and loan holding company and on January 26, 2009, Federal Trust Corporation’s shareholders approved the acquisition. The Company’s purchase of Federal Trust Corporation remains contingent on the U.S. Treasury’s approval of the Company’s participation in the CPP. The Company estimates that, if approved for participation in the CPP, it would be eligible for a capital purchase of between $1.1 billion and $3.4 billion under existing Treasury guidelines. The final amount of capital requested will be determined following approval by Treasury. Because the Company’s application to participate in the CPP is subject to approval by the U.S. Treasury, there can be no assurance that the Company will participate in the CPP or that it will not need to pursue alternate sources of capital. In addition, if we consummate the acquisition of FTB, we have agreed with OTS to contribute approximately $100 to the capital of FTB and to serve as a source of strength to FTB, which could require the contribution of additional capital to FTB in the future.
The revolving credit facility provides for up to $1.9 billion of unsecured credit, which excludes a $100 commitment from an affiliate of Lehman Brothers. Of the total availability under the revolving credit facility, up to $100 is available to support letters of credit issued on behalf of The Hartford or other subsidiaries of The Hartford. Under the revolving credit facility, the Company must maintain a minimum level of consolidated net worth. In addition, the Company must not exceed a maximum ratio of debt to capitalization. Quarterly, the Company certifies compliance with the financial covenants for the syndicate of participating financial institutions. As of December 31, 2008, the Company was in compliance with all such covenants.
The Federal Reserve Board authorized the Commercial Paper Funding Facility (“CPFF”) on October 7, 2008 under Section 13(3) of the Federal Reserve Act to provide a liquidity backstop to U.S. issuers of commercial paper. The CPFF is intended to improve liquidity in short-term funding markets by increasing the availability of term commercial paper funding to issuers and by providing greater assurance to both issuers and investors that firms will be able to roll over their maturing commercial paper.
While The Hartford’s maximum borrowings available under its commercial paper program are $2.0 billion, which includes the $375 from the CPFF, the Company is dependent upon market conditions, including recent market conditions, to finance the remaining available commercial paper with investors.
The Company has unfunded commitments to purchase investments in limited partnerships, mortgage and construction loans of about $1.1 billion as disclosed in Note 12 of Notes to Consolidated Financial Statements.
The following table identifies the Company’s aggregate contractual obligations as of December 31, 2008:
The following points are significant to understanding the cash flows estimated for obligations under property and casualty contracts:
In estimating the timing of future payments by year, the Company has assumed that its historical payment patterns will continue. However, the actual timing of future payments could vary materially from these estimates due to, among other things, changes in claim reporting and payment patterns and large unanticipated settlements. In particular, there is significant uncertainty over the claim payment patterns of asbestos and environmental claims. Also, estimated payments in 2009 do not include payments that will be made on claims incurred in 2009 on policies that were in force as of December 31, 2008. In addition, the table does not include future cash flows related to the receipt of premiums that may be used, in part, to fund loss payments.
Includes future minimum lease payments on operating and capital lease agreements. See Notes 12 and 14 of Notes to Consolidated Financial Statements for additional discussion on lease commitments.
Also included in purchase obligations is $695 relating to contractual commitments to purchase various goods and services such as maintenance, human resources, information technology, and transportation in the normal course of business. Purchase obligations exclude contracts that are cancelable without penalty or contracts that do not specify minimum levels of goods or services to be purchased.
The capital structure of The Hartford as of December 31, 2008 and 2007 consisted of debt and equity, summarized as follows:
Decreased $6.7 billion primarily due to increases in unrealized losses on securities of $7.1 billion.
Decreased $3.3 billion primarily due to a net loss of $2.7 billion, dividends declared of $598 and treasury stock acquired of $1.0 billion in connection with the Company’s stock purchase program. These decreases were offset by $967 from the issuance of preferred shares and warrants to purchase preferred shares to Allianz.
In order to strengthen its capital and liquidity position, the Company on October 17, 2008 closed on a $2.5 billion investment by Allianz SE (“Allianz”). Allianz purchased $1.75 billion of the Company’s 10% Fixed-to-Floating Rate Junior Subordinated Debentures due 2068, and $750 of the Company’s Series D Non-Voting Contingent Convertible Preferred Stock (the “Convertible Preferred”) initially convertible into 24,193,548 shares of the Company’s common stock (the “Common Stock”), upon receipt of applicable approvals, at an issue price of $31.00 per share of Common Stock. Allianz additionally received warrants to purchase an aggregate of $1.75 billion of the Company’s Series B and Series C Convertible Preferred at an initial exercise price of $25.32 per share. Conversion of the Convertible Preferred referred to above into Common Stock is subject to receipt of certain governmental and regulatory approvals and, in the case of the Series C Convertible Preferred, to the approval of the Company’s stockholders in accordance with the rules of the New York Stock Exchange. For further detail about the Allianz investment in The Hartford, see Note 21 of Notes to the Consolidated Financial Statements.
On November 1, 2008, The Hartford repaid its $200, 6.375% senior notes at maturity.
On August 16, 2008, The Hartford repaid its $425, 5.55% senior notes at maturity.
On May 12, 2008, The Hartford issued $500 of 6.0% senior notes due January 15, 2019. The issuance was made pursuant to the Company’s shelf registration statement (Registration No. 333-142044).
HFSG used the majority of the proceeds from the total $1 billion in issuances of senior notes to repay its $425 5.55% notes at maturity on August 16, 2008, to repay its $200 6.375% notes at maturity on November 1, 2008 and $330 5.663% notes at maturity on November 16, 2008.
On June 6, 2008, the Company issued $500 aggregate principal amount of 8.125% fixed-to-floating rate junior subordinated debentures (the “debentures”) due June 15, 2068 for net proceeds of approximately $493, after deducting underwriting discounts and expenses from the offering. The debentures bear interest at an annual fixed rate of 8.125% from the date of issuance to, but excluding, June 15, 2018, payable semi-annually in arrears on June 15 and December 15. From and including June 15, 2018, the debentures will bear interest at an annual rate, reset quarterly, equal to three-month LIBOR plus 4.6025%, payable quarterly in arrears on March 15, June 15, September 15 and December 15 of each year. The Company has the right, on one or more occasions, to defer the payment of interest on the debentures. The Company may defer interest for up to ten consecutive years without giving rise to an event of default. Deferred interest will accumulate additional interest at an annual rate equal to the annual interest rate then applicable to the debentures. If the Company defers interest for five consecutive years or, if earlier, pays current interest during a deferral period, which may be paid from any source of funds, the Company will be required to pay deferred interest from proceeds from the sale of certain qualifying securities.
The debentures carry a scheduled maturity date of June 15, 2038 and a final maturity date of June 15, 2068. During the 180-day period ending on a notice date not more than fifteen and not less than ten business days prior to the scheduled maturity date, the Company is required to use commercially reasonable efforts to sell certain qualifying replacement securities sufficient to permit repayment of the debentures at the scheduled maturity date. If any debentures remain outstanding after the scheduled maturity date, the unpaid amount will remain outstanding until the Company has raised sufficient proceeds from the sale of qualifying replacement securities to permit the repayment in full of the debentures. If there are remaining debentures at the final maturity date, the Company is required to redeem the debentures using any source of funds.
For a discussion of the 10.0% junior subordinated debentures from the investment of Allianz SE in The Hartford, see Note 21.
Institutional began issuing consumer notes through its Retail Investor Notes Program in September 2006. A consumer note is an investment product distributed through broker-dealers directly to retail investors as medium-term, publicly traded fixed or floating rate, or a combination of fixed and floating rate, notes. Consumer notes are part of the Company’s spread-based business and proceeds are used to purchase investment products, primarily fixed rate bonds. Proceeds are not used for general operating purposes. Consumer notes maturities may extend up to 30 years and have contractual coupons based upon varying interest rates or indexes (e.g. consumer price index) and may include a call provision that allows the Company to extinguish the notes prior to its scheduled maturity date. Certain Consumer notes may be redeemed by the holder in the event of death. Redemptions are subject to certain limitations, including calendar year aggregate and individual limits. The aggregate limit is equal to the greater of $1 or 1% of the aggregate principal amount of the notes as of the end of the prior year. The individual limit is $250 thousand per individual. Derivative instruments are utilized to hedge the Company’s exposure to market risk in accordance with Company policy.
As of December 31, 2008 and 2007, $1,210 and $809, respectively, of consumer notes were outstanding. As of December 31, 2008, these consumer notes have interest rates ranging from 4.0% to 6.3% for fixed notes and, for variable notes, based on December 31, 2008 rates, notes indexed to the consumer price index plus 80 to 267 basis points, or indexed to the S&P 500, Dow Jones Industrials, foreign currency, or the Nikkei 225. The aggregate maturities of consumer notes are as follows: $11 in 2009, $30 in 2010, $131 in 2011, $291 in 2012 and $751 thereafter. For 2008 and 2007, interest credited to holders of consumer notes was $59 and $11, respectively. During 2008, the Company made the decision to discontinue future issuances of consumer notes, this decision does not impact consumer notes currently outstanding.
Treasury stock acquired - For the year ended December 31, 2008, The Hartford repurchased $1.0 billion of its common stock (14.7 million shares), of which $500 (7.3 million shares) were repurchased under an accelerated share repurchase transaction described below. For additional information regarding the share repurchase program, see the Liquidity Requirements section above.
Dividends - The Hartford declared $598 and paid $660 in dividends to shareholders in 2008 and declared $643 and paid $636 in dividends to shareholders in 2007.
On February 10, 2009, The Hartford’s Board of Directors declared a quarterly dividend of $0.05 per share payable on April 1, 2009 to shareholders of record as of March 2, 2009.