Critical Accounting Estimates 17 Consolidated Results of Operations: Operating Summary 23 Life 27 Investment Products 29 Individual Life 30 Group Benefits 31 Corporate Owned Life Insurance (COLI) 32 Property & Casualty 33 Business Insurance 36 Personal Lines 37 Specialty Commercial 38 Reinsurance 40 Other Operations (Including Asbestos and Environmental Claims) 41 Investments 46 Capital Markets Risk Management 50 Capital Resources and Liquidity 64 Effect of Inflation 71
The preparation of financial statements, in conformity with accounting principles generally accepted in the United States of America, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
The liability for policy benefits for universal life-type contracts and interest-sensitive whole life policies is equal to the balance that accrues to the benefit of policyholders, including credited interest, amounts that have been assessed to compensate the Company for services to be performed over future periods and any amounts previously assessed against policyholders that are refundable on termination of the contract.
For investment contracts, policyholder liabilities are equal to the accumulated policy account values, which consist of an accumulation of deposit payments plus credited interest, less withdrawals and amounts assessed through the end of the period. Certain investment contracts include provisions whereby a guaranteed minimum death benefit is provided in the event that the contractholder's account value at death is below the guaranteed value. Although the Company reinsures the majority of the death benefit guarantees associated with its in-force block of business, declines in the equity market may increase the Company's net exposure to death benefits under these contracts. In addition, these contracts contain various provisions for determining the amount of the death benefit guaranteed following the withdrawal of a portion of the account value by the policyholder. Partial withdrawals under certain of these contracts may not result in a reduction in the guaranteed minimum death benefit in proportion to the portion surrendered. The Company records the death benefit costs, net of reinsurance, when deaths occur.
the ultimate liabilities for these claims may change and that the required adjustment to recorded reserves could exceed the currently recorded reserves by an amount that could be material to The Hartford's results of operations, financial condition and liquidity.
The Hartford wrote several different categories of insurance coverage to which asbestos and environmental claims may apply. First, The Hartford wrote direct policies as a primary liability insurance carrier. Second, The Hartford wrote direct excess insurance policies providing additional coverage for insureds that exhaust their primary liability insurance coverage. Third, The Hartford acted as a reinsurer assuming a portion of risks previously assumed by other insurers writing primary, excess and reinsurance coverages. Fourth, The Hartford participated as a London Market company that wrote both direct insurance and assumed reinsurance business.
Once the gross ultimate exposure for indemnity and allocated claim adjustment expense is determined for each insured by each policy year, The Hartford calculates its ceded reinsurance projection based on any applicable facultative and treaty reinsurance and the Company's experience with reinsurance collections.
In the case of the reserves for asbestos exposures, factors contributing to the high degree of uncertainty include inadequate development patterns, plaintiffs' expanding theories of liability, the risks inherent in major litigation and inconsistent emerging legal doctrines. Courts have reached inconsistent conclusions as to when losses are deemed to have occurred and which policies provide coverage; what types of losses are covered; whether there is an insurer obligation to defend; how policy limits are determined; whether particular claims are product/completed operation claims subject to an aggregate limit and how policy exclusions and conditions are applied and interpreted. Furthermore, insurers in general, including The Hartford, have recently experienced an increase in the number of asbestos-related claims due to, among other things, more intensive advertising by lawyers seeking asbestos claimants, plaintiffs' increased focus on new and previously peripheral defendants and an increase in the number of insureds seeking bankruptcy protection as a result of asbestos-related liabilities. Plaintiffs and insureds have sought to use bankruptcy proceedings to accelerate and increase loss payments by insurers. In addition, some policyholders have begun to assert new classes of claims for so called "non-product" coverages to which an aggregate limit of liability may not apply. Recently, many insurers, including, in a limited number of instances, The Hartford, also have been sued directly by asbestos claimants asserting that insurers had a duty to protect the public from the dangers of asbestos. Management believes these issues are not likely to be resolved in the near future.
In the case of the reserves for environmental exposures, factors contributing to the high degree of uncertainty include court
decisions that have interpreted the insurance coverage to be broader than originally intended; inconsistent decisions, especially across jurisdictions and uncertainty as to the monetary amount being sought by the claimant from the insured.
One of the significant estimations inherent in the valuation of investments is the evaluation of other than temporary impairments. The evaluation for other than temporary impairments is a quantitative and qualitative process which is subject to risks and uncertainties in the determination of whether declines in the fair value of investments are other than temporary. The risks and uncertainties include changes in general economic conditions, the issuer's financial condition or near term recovery prospects and the effects of changes in interest rates. The Company's accounting policy requires that a decline in the value of a security below its amortized cost basis be assessed to determine if the decline is other than temporary. If so, the security is deemed to be impaired and, a charge is recorded in net realized capital losses equal to the difference between the fair value and amortized cost basis of the security. The fair value of the impaired investment becomes its new cost basis. The Company has a security monitoring process overseen by a committee of investment and accounting professionals that identifies securities that, due to certain characteristics, are subjected to an enhanced analysis on a quarterly basis. Such characteristics include, but are not limited to: a deterioration of the financial condition of the issuer, the magnitude and duration of unrealized losses, credit rating and industry category.
The primary factors considered in evaluating whether a decline in value for corporate issued securities is other than temporary include: (a) the length of time and the extent to which the fair value has been less than cost, (b) the financial condition and near-term 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 any anticipated recovery. Additionally, for certain securitized financial assets with contractual cash flows (including asset-backed securities), Emerging Issues Task Force ("EITF") Issue No. 99-20, "Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets", requires the Company to periodically update its best estimate of cash flows over the life of the security. If management estimates that the fair value of its securitized financial asset is less than its carrying amount and there has been a decrease in the present value of the estimated cash flows since the last revised estimate, considering both timing and amount, then an other than temporary impairment charge
Policy acquisition costs, which include commissions and certain other expenses that vary with and are primarily associated with acquiring business, are deferred and amortized over the estimated lives of the contracts, usually 20 years. The deferred costs are recorded as an asset commonly referred to as deferred policy acquisition costs ("DAC"). At December 31, 2002 and 2001, the carrying value of the Company's Life operations' DAC was $5.2 billion and $5.0 billion, respectively.
DAC related to traditional policies are amortized over the premium-paying period in proportion to the present value of annual expected premium income. Adjustments are made each year to recognize actual experience as compared to assumed experience for the current period.
The Company regularly evaluates its estimated gross profits to determine if actual experience or other evidence suggests that earlier estimates should be revised. Several assumptions considered to be significant in the development of EGPs include separate account fund performance, surrender and lapse rates, estimated interest spread and estimated mortality. The separate account fund performance assumption is critical to the development of the EGPs related to the Company's variable annuity and variable and interest-sensitive life insurance businesses. The average long-term rate of assumed separate account fund performance used in estimating gross profits for the variable annuity and variable life business was 9% at December 31, 2002 and 2001. For all other products including fixed annuities and other universal life-type contracts the average assumed investment yield ranged from 5% to 8.5% for the years ended December 31, 2002 and 2001.
Additionally, the Company has performed various sensitivity analyses with respect to separate account fund performance to provide an indication of future separate account fund performance levels, which could result in the need to revise future EGPs. The Company has estimated that a revision to the future EGPs is unlikely in 2003 in the event that the separate account fund performance meets or exceeds the Company's long-term assumption of 9% and that a revision is likely if the overall separate account fund performance is negative for the year. In the event that separate account fund performance falls between 0% and 9% during 2003, the Company will need to evaluate the actual gross profits versus the mean EGPs generated by the stochastic DAC analysis and determine whether or not to make a revision to the future EGPs. Factors that will influence this determination include the degree of volatility in separate account fund performance, when during the year performance becomes negative and shifts in asset allocation within the separate account made by policyholders. The overall return generated by the separate account is dependent on several factors, including the relative mix of the underlying sub-accounts among bond funds and equity funds as well as equity sector weightings. The Company's overall separate account fund performance has been reasonably correlated to the overall performance of the S&P 500 Index, although no assurance can be provided that this correlation will continue in the future.
The overall recoverability of the DAC asset is dependent on the future profitability of the business. The Company tests the aggregate recoverability of the DAC asset by comparing the amounts deferred to total EGPs. In addition, the Company routinely stress tests its DAC asset for recoverability against severe declines in its separate account assets, which could occur if the equity markets experienced another significant sell-off, as the majority of policyholders' money held in the separate accounts are invested in the equity market. As of December 31, 2002, separate account assets could fall 25% and the Company believes its DAC asset would still be recoverable.
To illustrate the impact of these assumptions on annual pension expense for 2003 and going forward, a 25 basis point change in the discount rate will increase/decrease pension expense by approximately $12, and a 25 basis point change in the long-term asset return assumption will increase/decrease pension expense by approximately $5.
The Hartford defines "operating income" as after-tax operational results excluding, as applicable, net realized capital gains and losses, restructuring charges, losses from early retirement of debt and the cumulative effect of accounting changes. Operating income is a performance measure used by the Company in the management of its operations. Management believes that this performance measure delineates the results of operations of the Company's ongoing businesses in a manner that allows for a better understanding of the underlying trends in the Company's current business. However, operating income should only be analyzed in conjunction with, and not in lieu of, net income and may not be comparable to other performance measures used by the Company's competitors.
2001 COMPARED TO 2000 -- Revenues increased $444, or 3%. Included in revenues in 2001 was a $91 reduction in Property & Casualty earned premiums, resulting from additional reinsurance cessions related to September 11. The increase in revenues was related to continued new business growth in the Group Benefits segment, increased fee income in Individual Life, primarily as a result of the April 2001 acquisition of the United States individual life insurance, annuity and mutual fund businesses of Fortis, Inc. (operating as "Fortis" or "Fortis Financial Group") and earned premium growth in most of the Property & Casualty segments. (For further discussion of the Fortis acquisition, see Note 18(a) of Notes to Consolidated Financial Statements.) Also contributing to the increase was higher net investment income, primarily due to income earned on fixed maturities. These increases were partially offset by a decrease in revenues in the Other Operations segment, reflecting the sales of Property & Casualty's international subsidiaries.
Operating income decreased $238, or 25%. This decrease was primarily the result of $440 of losses, after-tax and net of reinsurance, related to September 11. Also contributing to the decline were decreased underwriting results in the Personal Lines and Reinsurance segments. Partially offsetting the decrease were a $130 tax benefit at Hartford Life, Inc. ("HLI"), primarily the result of the favorable treatment of certain tax matters related to separate account investment activity during the 1996-2000 tax years and increased operating income in Life's four operating segments.
Net income decreased $467, or 48%. The decrease was due primarily to the decline in operating income described above. In addition, net realized capital losses were $236 in 2001, compared with net realized capital gains of $145 in 2000. The change in net realized capital losses resulted from other than temporary impairments on fixed maturities in 2001.
The effective tax rate for 2002, 2001 and 2000 was 6%, (59)% and 28%, respectively. Excluding the impacts of September 11, net realized capital losses and the HLI federal tax benefits of $76, $130 and $24 in 2002, 2001 and 2000, respectively, the effective tax rate for 2002 was 20% compared with 19% and 22%, respectively, for 2001 and 2000. Tax-exempt interest earned on invested assets and the separate account dividends received deduction were the principal causes of effective rates being lower than the 35% United States statutory rate in all years. Income taxes paid (received) in 2002, 2001 and 2000 were $(102), $(52) and $95, respectively. (For additional information, see Note 15 of Notes to Consolidated Financial Statements.)
In December 2002, the Financial Accounting Standards Board ("FASB") issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure and Amendment to SFAS No. 123", which provides three optional transition methods for entities that decide to voluntarily adopt the fair value recognition principles of SFAS No. 123, "Accounting for Stock Issued to Employees", and modifies the disclosure requirements of that Statement. Under the prospective method, stock-based compensation expense is recognized for awards granted after the beginning of the fiscal year in which the change is made. The modified prospective method recognizes stock-based compensation expense related to new and unvested awards in the year of change equal to that which would have been recognized had SFAS No. 123 been adopted as of its effective date, fiscal years beginning after December 15, 1994. The retrospective restatement method recognizes stock compensation costs for the year of change and restates financial statements for all prior periods presented as though the fair value recognition provisions of SFAS No. 123 had been adopted as of its effective date.
SFAS No. 123 permits companies either to use the fair-value method and recognize compensation expense upon the issuance of stock options, thereby lowering earnings, or, alternatively, to disclose the pro-forma impact of the issuance.
The fair value of each option grant is estimated on the date of the grant using the Black-Scholes options-pricing model with the following weighted average assumptions used for grants in 2002, 2001 and 2000: dividend yield of 1.6% for 2002, 1.6% for 2001 and 1.5% for 2000; expected price variability of 40.8% for 2002, 29.1% for 2001 and 35.7% for 2000; risk-free interest rates of 4.27% for 2002 grants, 4.98% for 2001 grants and 6.41% for 2000 grants; and expected lives of six years for 2002, six years for 2001 and four years for 2000.
The use of the fair value recognition method results in compensation expense being recognized in the financial statements in different amounts and in different periods than the related income tax deduction. Generally, the compensation expense recognized under SFAS No. 123 will result in a deferred tax asset since the stock compensation expense is not deductible for tax until the option is exercised. Deferred tax assets arising under SFAS No. 123 will be evaluated as to future realizability to determine whether a valuation allowance is necessary.
The Hartford is organized into two major operations: Life and Property & Casualty. Within these operations, The Hartford conducts business principally in nine operating segments. Additionally, the capital raising and purchase accounting adjustment activities related to The HLI Repurchase, capital raised in 2002 that was not contributed to the Company's insurance subsidiaries and the minority interest in HLI for pre-acquisition periods are included in Corporate.
Life is organized into four reportable operating segments: Investment Products, Individual Life, Group Benefits and Corporate Owned Life Insurance ("COLI"). Life also includes in an Other category its international operations, which are primarily located in Japan and Latin America; realized capital gains and losses; as well as corporate items not directly allocated to any of its reportable operating segments, principally interest expense; and intersegment eliminations.
In January 2002, Property & Casualty integrated its Affinity Personal Lines and Personal Insurance segments, now reported as Personal Lines. As a result, Property & Casualty is now organized into five reportable operating segments: the North American underwriting segments of Business Insurance, Personal Lines, Specialty Commercial and Reinsurance; and the Other Operations segment, which includes substantially all of the Company's asbestos and environmental exposures. "North American" includes the combined underwriting results of Business Insurance, Personal Lines, Specialty Commercial and Reinsurance underwriting segments along with income and expense items not directly allocated to these segments, such as net investment income, net realized capital gains and losses, other expenses including interest, and income taxes.
The measure of profit or loss used by The Hartford's management in evaluating performance is operating income, except for its North American underwriting segments, which are evaluated by The Hartford's management primarily based upon underwriting results. While not considered segments, the Company also reports and evaluates operating income results for Life, Property & Casualty and North American. Property & Casualty includes operating income for North American and the Other Operations segment.
Life provides investment and retirement products such as variable and fixed annuities; mutual funds and retirement plan services; individual and corporate owned life insurance; and group benefit products, such as group life and group disability insurance.
Life derives its revenues principally from: (a) fee income, including asset management fees on separate account and mutual fund assets and mortality and expense fees, as well as cost of insurance charges; (b) fully insured premiums; (c) certain other fees; and (d) net investment income on general account assets. Asset management fees and mortality and expense fees are primarily generated from separate account assets, which are deposited with the Company through the sale of variable annuity, variable life products and mutual funds. Cost of insurance charges are assessed on the net amount at risk for investment-oriented life insurance products. Premium revenues are derived primarily from the sale of group life and group disability insurance products.
Life's expenses essentially consist of interest credited to policyholders on general account liabilities, insurance benefits provided, dividends to policyholders, costs of selling and servicing the various products offered by the Company and other general business expenses.
As discussed above, Life consists of the following reportable operating segments: Investment Products, Individual Life, Group Benefits and COLI. In addition, Life includes in an Other category its international operations, which are primarily located in Japan and Latin America, and corporate items not directly allocated to any of its reportable operating segments.
On April 2, 2001, The Hartford acquired the United States individual life insurance, annuity and mutual fund businesses of Fortis. (For further discussion, see "Acquisitions" in the Capital Resources and Liquidity section and Note 18(a) of Notes to Consolidated Financial Statements.) This transaction was accounted for as a purchase and, as such, the revenues and
Net income decreased $31, or 7%, driven by the continued lower equity markets resulting in the decline in revenues in the individual annuity operation and increases in the death benefit costs incurred by the individual annuity operation. The decrease in individual annuity revenues was significantly offset by growth in revenues related to other investment products, particularly the institutional investment product business. (For discussion of the potential future financial statement impact of continued declines in the equity market on the Investment Products segment, see the Capital Markets Risk Management section under "Market Risk".)
Benefits, claims and expenses increased $121, or 7%, driven by higher interest credited and insurance operating expenses related to other investment products consistent with the revenue growth described above. Interest credited related to other investment products increased $83, or 18%, while insurance operating expenses increased $44, or 17%. Also, individual annuity benefits and claims expenses increased $35, or 14%, principally due to the business acquired from Fortis and higher death benefits resulting from the lower equity markets in 2001. Individual annuity's insurance operating costs increased $13, or 4%, due to the business acquired from Fortis. Excluding Fortis, individual annuity's operating expenses decreased $39, or 4%, from prior year, driven by management's continued focus on maintaining operating expense levels. Partially offsetting the
increase in benefits, claims and insurance operating costs was a decrease in amortization of deferred policy acquisition costs resulting from the lower gross profits associated with the individual annuity business. In addition, income tax expense for the twelve months ended December 31, 2001, was $118, a $45, or 28%, decrease due to lower pretax operating income and the ongoing tax impact related to separate account investment activity.
The individual annuity segment continues to be impacted by the lower equity markets in terms of lower assets under management. However, the Company experienced strong sales of annuities which were $11.6 billion in 2002 as compared to $10.0 billion in 2001. Partially contributing to the growth in sales is The Hartford's introduction of Principal First, a guaranteed withdrawal benefit rider, which was developed in response to the customers' needs. Based on VARDS, the Company had 9.4% market share as of December 31, 2002 as compared to 8.7% at December 31, 2001. (For discussion of the potential future financial statement impact of continued declines in the equity market on the Investment Products segment, see the Capital Markets Risk Management section under "Equity Risk".)
2002 COMPARED TO 2001 -- Revenues in the Individual Life segment increased $68, or 8%, primarily driven by business growth, including the impact of the Fortis transaction. However, the Company sold $173 of new business in 2002, as compared to $228 in 2001.
Expenses increased $56, or 7%, principally driven by the growth in the business resulting from the Fortis acquisition. In addition, mortality experience (expressed as death claims as a percentage of net amount at risk) for 2002 increased as compared to the prior year, but was in line with management's expectations.
Net income increased $12, or 10%. Individual Life incurred an after-tax charge of $3 related to September 11 in the third quarter of 2001. Excluding this charge, Individual Life's earnings increased $9, or 7%, for the year ended December 31,
2002, due to the contribution to earnings from the Fortis transaction.
Individual Life sales continue to be impacted by the lower equity markets, uncertainty surrounding estate tax legislation and aggressive competition from universal life providers. However, The Hartford's acquisition of the United States individual life insurance business of Fortis has increased its scale while broadening its distribution capabilities as described above. Additionally, The Hartford continues to introduce new and enhanced products, which are expected to increase universal life sales.
2002 COMPARED TO 2001 -- Revenues in the Group Benefits segment increased $75, or 3%, and excluding buyouts, increased $159, or 7%, driven primarily by growth in premiums, which increased $66, or 3%. The growth in premiums was due to an increase of $281, or 14%, in fully insured ongoing premiums, as a result of steady persistency and pricing actions on the in-force block of business and strong sales to new customers. Offsetting this increase was a decrease in military Medicare supplement premiums of $131 resulting from federal legislation effective in the fourth quarter of 2001. This legislation provides retired military officers age 65 and older with full medical insurance paid for by the government, eliminating the need for Medicare supplement insurance. Additionally, premium revenues for 2002 were offset by an $84 decrease in total buyouts. Buyouts involve the acquisition of claim liabilities from another carrier for a purchase price calculated to cover the run off of those liabilities plus administration expenses and profit. Due to the nature of the buyout market place, the predictability of buyout premiums is uncertain. Fully insured ongoing sales were $597, an increase of $66, or 12%.
Expenses increased $53, or 2%, and excluding buyouts, increased $137, or 6%. The increase in expenses is consistent with the growth in revenues previously described. Benefits and claims expenses, excluding buyouts, increased $88, or 5%. The segment's loss ratio (defined as benefits, claims and claim adjustment expenses as a percentage of premiums and other considerations, excluding buyouts) was 81% down slightly from 82% in 2001. Insurance operating costs and other expenses increased $43, or 9%, due to the fully insured ongoing premium growth previously described and continued investments in technology and service. The segment's expense ratio of insurance operating costs and other expenses to premiums and other considerations was approximately 23%, consistent with prior year.
Net income increased $22, or 21%. Group Benefits incurred an after-tax charge of $2 related to September 11 in the third quarter of 2001. Excluding this charge, earnings increased $20, or 19%, for the year ended December 31, 2002 compared to a year ago. The increase in earnings is due to the increase in premium revenues and favorable loss costs, which was partially offset by increased insurance operating costs and other expenses as previously described.
2001 COMPARED TO 2000 -- Revenues in the Group Benefits segment increased $300, or 14%, driven primarily by growth in
Total benefits, claims and expenses increased $279, or 13%, driven primarily by higher benefits and claims, which increased $231, or 14%. These increases are consistent with the growth in the business described above as the loss ratio has remained relatively consistent compared to the 2000 loss ratio. In addition, expenses other than benefits and claims increased $48, or 11%, for the year ended December 31, 2001, also consistent with the overall growth in the segment.
Employees continue to look to the workplace for a broader and ever expanding array of insurance products. As employers design benefit strategies to attract and retain employees while attempting to control their benefit costs, management believes that the need the Group Benefits segment's products will continue to expand. This, combined with the significant number of employees who currently do not have coverage or adequate levels of coverage, creates unique opportunities for the Group Benefits segment's products and services. Current market conditions, including low interest rates, rising medical costs and cost containment pressure on employers, create a challenging business environment. However, the Company's strength in claim and risk management, service and distribution will enable the Group Benefits segment to continue to capitalize on market opportunities despite the challenging business environment.
2002 COMPARED TO 2001 -- COLI revenues decreased $127, or 18%, primarily related to lower net investment and fee income due to the declining block of leveraged COLI, where related account values declined by $994, or 23%. Net investment income decreased $76, or 22%, while fee income decreased $50, or 14%.
Expenses decreased $122, or 18%, which is relatively consistent with the decrease in revenues described above. However, the decrease was partially offset by $11, after-tax, in accrued litigation expenses related to the Bancorp dispute. (For a discussion of the Bancorp litigation, see Note 16(a) of Notes to Consolidated Financial Statements.)
2001 COMPARED TO 2000 -- COLI revenues decreased $48, or 6%, mostly due to lower fee income and net investment income. Fee income and other decreased $34, or 8%, due to a decline in variable COLI sales and deposits which were approximately $1.5 billion in 2001 as compared to $2.9 billion in 2000. In addition, net investment income decreased $14, or 4%, due primarily to lower interest rates and the decline in leveraged COLI account values.
Net income increased $3, or 9%, primarily due to the overall growth in variable COLI business and earnings associated with the leveraged COLI business recaptured in 1998. COLI incurred an after-tax charge of $2 related to September 11; excluding this charge, net income increased $5, or 15%.
2002 COMPARED TO 2001 -- Net income increased $584 primarily due to after-tax losses related to September 11 of $420 in 2001, an increase in operating income as discussed below and a decrease in net realized capital losses.
2001 COMPARED TO 2000 -- Net income decreased $609 primarily due to after-tax losses related to September 11 of $420, an increase in net realized capital losses, and a decrease in operating income as discussed below.
The previous table and the following segment discussions for the years ended December 31, 2002, 2001 and 2000 include various operating ratios. Management believes that these ratios are useful in understanding the underlying trends in The Hartford's current business. However, these measures should only be used in conjunction with, and not in lieu of, underwriting income and may not be comparable to other performance measures used by the Company's competitors. The "loss ratio" is the ratio of claims expense (exclusive of claim adjustment expenses) to earned premiums. The "loss adjustment expense ratio" represents the ratio of claim adjustment expenses to earned premiums. The "expense ratio" is the ratio of statutory underwriting expenses (commissions; taxes, licenses and fees; as well as other underwriting expenses) to written premiums. The "policyholder dividend ratio" is the ratio of policyholder dividends to earned premiums. The "combined ratio" is the sum of the loss ratio, the loss adjustment expense ratio, the expense ratio and the policyholder dividend ratio. These ratios are relative measurements that describe for every $100 of net premiums earned or written, the cost of losses and statutory expenses, respectively. The combined ratio presents the total cost per $100 of premium production. A combined ratio below 100 demonstrates underwriting profit; a combined ratio above 100 demonstrates underwriting losses. GAAP combined ratios differ from statutory combined ratios primarily due to the deferral and amortization of certain expenses for GAAP reporting purposes and the use of earned premium in the expense ratio rather than written premium.
Underwriting results are discussed in each of the Business Insurance, Personal Lines, Specialty Commercial and Reinsurance segment sections. Net investment income and net realized capital gains and losses are discussed in the Investments section. (For a further discussion of September 11, see Note 2 of Notes to Consolidated Financial Statements.)
2002 COMPARED TO 2001 -- Operating income, excluding the after-tax $420 impact of September 11, increased $117, or 29%, primarily due to improved underwriting results across each of the North American underwriting segments, particularly in Specialty Commercial and Reinsurance. Partially offsetting the improvement was an increase in other expenses primarily as a result of an increase in e-business research and development expenses and certain employee benefits costs, as well as expenses incurred related to the transfer of the Company's New Jersey personal lines agency auto business to Palisades Safety and Insurance Association and Palisades Insurance Co.
2001 COMPARED TO 2000 -- Operating income, excluding the after-tax $420 impact of September 11, decreased $23, or 5%. Earned premium growth in Business Insurance due to price increases, strong new business growth and improved premium renewal retention, as well as an increase in North American investment income, was offset by increased losses in the personal automobile lines of business and in Reinsurance. A decrease in underwriting results of $16, after-tax, related to Enron Corporation and lower income resulting from the sales of international subsidiaries also contributed to the decrease.
Business Insurance provides standard commercial insurance coverage to small and middle market commercial businesses primarily throughout the United States. This segment offers workers' compensation, property, automobile, liability, umbrella and marine coverages. The Business Insurance segment also provides commercial risk management products and services.
2001 COMPARED TO 2000 -- Written premiums increased $466 (including $15 of reinsurance cessions related to September 11), or 19%, driven by strong growth in small commercial and middle market. Small commercial increased $278, or 24%, as a result of written pricing increases, strong premium renewal retention and the success of product, marketing, technology and service growth initiatives. The increase in middle market of $203, or 16%, was attributable primarily to double-digit pricing increases and improved premium renewal retention as well as strong new business growth.
Earned premiums increased $332 (including $15 of reinsurance cessions related to September 11), or 14%, due primarily to strong earned premium growth in both small commercial and middle market. Small commercial increased $252, or 23%, as a result of mid-single digit earned pricing increases, while middle market achieved double-digit earned pricing increases, driving $95, or 8% growth.
Personal Lines provides automobile, homeowners' and home-based business coverages to the members of AARP through a direct marketing operation; to individuals who prefer local agent involvement through a network of independent agents in the standard personal lines market ("Standard") and in the non-standard automobile market through the Company's Omni Insurance Group, Inc. ("Omni") subsidiary. Personal Lines also operates a member contact center for health insurance products offered through AARP's Health Care Options. The Hartford's exclusive licensing arrangement with AARP, which was renewed during the fourth quarter of 2001, continues through January 1, 2010 for automobile, homeowners and home-based business. The Health Care Options agreement continues through 2007.
Underwriting results improved $41 (including $9 of underwriting loss related to September 11), with a corresponding 2.3 point decrease (including a 0.3 point impact related to September 11) in the combined ratio. While automobile results improved due to favorable frequency loss costs, the line of business was negatively impacted by the increasing severity of automobile claims as a result of medical inflation and higher repair costs. The underwriting experience relating to homeowners has remained favorable due to improved frequency of claims, despite an increase in the severity of individual homeowners' claims. An improvement in the underwriting expense ratio, primarily due to written pricing increases and prudent expense management, resulted in a 1.0 point decrease in the expense ratio over the prior year.
Earned premiums declined $12 (including $7 of reinsurance cessions related to September 11), or 1%, primarily due to a decrease in earned premiums from the sold or exited business lines referred to above. Partially offsetting the decrease was an increase in earned premiums due to The Hartford's purchase of the financial products and excess and surplus lines businesses of Reliance mentioned above, which resulted in $74 of additional earned premiums as compared with 2000.
Underwriting results improved $316 (including $226 of underwriting loss related to September 11), with a corresponding 36.8 point decrease (including a 27.8 point impact related to September 11) in the combined ratio. The improvement in underwriting results and combined ratio, excluding September 11, was primarily due to underwriting initiatives including a shift to excess of loss policies and increased property business mix, as well as the exit from nearly all international lines, an intense focus on returns and lower catastrophes. Underwriting results and the combined ratio were negatively impacted by adverse loss development on prior underwriting years.
2001 COMPARED TO 2000 -- Written premiums increased $23 (including $69 of reinsurance cessions related to September 11), or 3%, and earned premiums increased $42 (including $69 related to September 11), or 5%, primarily due to growth in the ART line of business. ART written and earned premiums increased $91, or 100%, and $98, or 111%, respectively, driven primarily by a significant first quarter ART transaction. The achievement of double-digit pricing increases in traditional reinsurance was offset by the termination of business that failed to meet profitability targets.
The Other Operations segment includes operations that are under a single management structure, Heritage Holdings, that was finalized in late 2001 to be responsible for two related activities. The first activity is the management of certain subsidiaries and operations of The Hartford that have discontinued writing new business. The second is the management of claims (and the associated reserves) related to asbestos and environmental exposures.
The companies in this segment which are not writing new business include First State Insurance Company and two affiliated subsidiaries, located in Boston, Massachusetts; Heritage Reinsurance Company, Ltd. ("Heritage Re"), headquartered in Bermuda; and Excess Insurance Company, Ltd., located in the United Kingdom. Each of these companies is primarily focused on managing claims, resolving disputes and collecting reinsurance proceeds, related largely to business underwritten and reinsured in 1985 and prior years. While the business that was written in these units on either a direct or reinsurance basis spanned a wide variety of insurance and reinsurance policies and coverages, a significant and increasing proportion of current and future claims activity arising from these businesses relates to environmental and, to a greater extent, asbestos exposures. Other Operations also includes the results of The Hartford's international property-casualty businesses (substantially all of which were disposed of in a series of transactions concluding in 2001) and the international businesses of the Reinsurance segment, exited in the fourth quarter of 2001. (For further discussion of the restructuring, see Note 18(c) of Notes to Consolidated Financial Statements.)
In 2001, The Hartford consolidated management and claims handling of all of its asbestos and environmental exposures under the Other Operations' management structure. This action was taken to maximize The Hartford's management expertise in this area. As part of this organizational change, the Company consolidated substantially all of its asbestos and environmental loss reserves into one legal entity, Heritage Re, within Other Operations through intercompany reinsurance agreements. These reinsurance agreements ceded $602 of the then carried reserves (net of reinsurance), primarily related to asbestos and environmental exposures from 1985 and prior, from the Specialty Commercial segment to Other Operations.
In September 2001, The Hartford entered into an agreement to sell its Singapore-based Hartford Insurance Company (Singapore), Ltd. The Company recorded a net realized capital loss of $9 after-tax related to the sale, which was recorded in the 2001 investment results of North American. The sale was completed in January 2002.
On December 22, 2000, The Hartford completed the sale of its Netherlands-based Zwolsche Algemeene N.V. ("Zwolsche") subsidiary located in the Netherlands, Belgium and Luxembourg. The Hartford received $547, before costs of sale and recorded a $69 after-tax net realized capital gain that was reported in the 2000 investment results of North American.
2002 COMPARED TO 2001 -- Revenues for the year increased $21 due to earned premium, offset by net realized capital losses. The increase in earned premium was primarily due to runoff premium from the exited international business of the Reinsurance segment, which was transferred to Other Operations in January 2002.
Operating income was relatively flat compared to the prior year period.
There are a wide variety of claims that drive the reserves associated with asbestos, environmental and all other categories the Company has defined in Other Operations. Asbestos claims relate primarily to bodily injuries asserted by those who came in contact with asbestos or products containing asbestos. Environmental claims relate primarily to pollution and related clean-up costs. The all other category of reserves covers a wide range of insurance coverages, including liability for breast implants, blood products, construction defects and lead paint.
Approximately $390 of the $600 reclassification resulted from changes in the estimates of the proportions of certain of the Company's broad-based liability and assumed reinsurance reserves that would more appropriately be categorized as asbestos or environmental reserves. The change in allocation did not involve a change in The Hartford's estimated net liability with respect to the policies in question. Instead, the Company's estimate of what type of claims the insured would present against these liabilities changed. To give an example: when the Company writes a broad reinsurance contract for another insurer, it gives the insurer the right to submit a variety of different types of claims, up to a limit, against that policy. The Company establishes a reserve for that policy that considers the exposure for total incurred claims under that policy. Over time, the Company changes its view as to what type of claims may be presented, but its aggregate liability and appropriate reserve are less likely to change, particularly if the reserves are already at the limit payable under the policy.
The foregoing $390 reduction of the all other reserves was related to the Company's assessment of trends that suggested noteworthy changes in the claims made against these reserves. These trends indicated that the categories of claims presented were becoming better defined. In response to these noted trends, management decided to study whether sufficient information existed to change estimates of what portions of certain reserves were likely to be used for asbestos and environmental claims. This study was completed in the second quarter of 2002. On a net basis, it resulted in approximately $60 of reserves being categorized as likely to be associated with an environmental claim and approximately $330 as likely to be associated with an asbestos claim. This resulted in a reclassification of $390 of reserves previously categorized in the all other category to the asbestos and environmental reserves categories, respectively.
management decided to increase the Company's reserves for asbestos liability by approximately $210.
The following table presents reserve activity, inclusive of estimates for both reported and incurred but not reported claims, net of reinsurance, for Other Operations, categorized by asbestos, environmental and all other claims, for the years ended December 31, 2002, 2001 and 2000. Also included are the remaining asbestos and environmental exposures of North American.
layers of the Company's policies and into later years of coverage than had been expected.
Over the last three years, The Hartford has been experiencing lower than previously expected claim activity with respect to claims classified as environmental. During the last two years, The Hartford has been experiencing higher than previously expected claim activity with respect to claims classified as asbestos. The increase in both the number of claims being submitted and the number of customer bankruptcies, being driven by asbestos related issues, have accelerated over the last year. The following table sets forth, for the three years ended December 31, 2002, paid and incurred loss activity by the three categories of claims for asbestos and environmental. The table shows that in this timeframe asbestos payments and incurred losses have been increasing, while environmental activity generally has been improving.
The Company also invests in unaffiliated limited partnership arrangements in order to further diversify its investment portfolio. These limited partnerships represent approximately 2% and 3% of the fair value of its invested assets as of December 31, 2002 and 2001, respectively. Limited partnerships are typically less liquid than direct investments in fixed income or equity investments. Market volatility and other factors beyond the Company's control can adversely affect the value of these investments. Because the Company is a limited partner, its ability to control the timing or the realization of the related investment income is restricted.
A decrease in the fair value of any investment that is deemed other than temporary would result in the Company's recognition of a realized loss in its financial results prior to the actual sale of the investment. (For a further discussion, see the Company's discussion of evaluation of other than temporary impairment in Critical Accounting Estimates under "Valuation of Investments and Derivative Instruments".)
As of December 31, 2002 and 2001, 18% and 21%, respectively, of Life's fixed maturities were invested in private placement securities (including 11% and 12% of Rule 144A offerings as of December 31, 2002 and 2001, respectively). Private placement securities are generally less liquid than public securities. However, private placements generally have covenants designed to compensate for liquidity risk. Most of the private placement securities in the Life operation's portfolio are rated by nationally recognized rating agencies. (For further discussion of the Company's investment credit policies, see the Capital Markets Risk Management section under "Credit Risk".)
2002 COMPARED TO 2001 -- Net investment income, excluding policy loan income, increased $132, or 9%. The increase was primarily due to income earned on the previously discussed higher invested asset base partially offset by $36 lower income on limited partnerships and the impact of lower interest rates on new investment purchases. Yields on average invested assets decreased as a result of lower rates on new investment purchases, decreased policy loan income and decreased income on limited partnerships.
During 2002, fixed maturity investments increased 16% due to the investment of increased operating cash flows and an increase in fair value due to a lower interest rate environment. Total equity securities decreased 50% primarily due to the sale of foreign and domestic equity holdings and declines in domestic equity market values. Limited partnerships decreased $199, or 35%, due to redemptions. Other investments increased due to the purchase of a corporate owned life insurance contract and increased investment in mortgage loans.
The following table identifies, by type, the fixed maturity securities held as of December 31, 2002 and 2001.
2002 COMPARED TO 2001 -- Both before- and after-tax net investment income increased 2% compared to the prior year as increased operating cash flow resulted in higher investment income on the higher invested asset base. Yields on average invested assets declined due to the lower interest rate environment.
Net realized capital losses were $103 compared to net realized capital gains of $234 for the prior year. The 2001 net realized capital losses included write-downs for other than temporary impairments on primarily corporate and asset-backed fixed maturities of $61. Write-downs on corporate securities totaled $39 and included impairments in the communications sector of $17 and the utilities sector of $16. Write-downs on corporate fixed maturities in the utilities sector were all on securities issued by Enron Corporation. Write-downs on asset-backed securities totaled $22 and included impairments of securities backed by corporate debt of $9 and on various other asset-backed securities totaling $13. The 2001 net realized capital losses also included write-downs for other than temporary impairments of $30 on equities and other invested assets. An additional $7 of losses were sustained on sales of Enron Corporation common stock. Also included in 2001 net realized capital losses were losses generated from the sales of international subsidiaries of $54, in addition to losses associated with the credit deterioration of certain investments in which the Company has an indirect economic interest. These losses were partially offset by gains from the sale of fixed maturities.
The Hartford has a disciplined approach to managing risks associated with its capital markets and asset/liability management activities. Investment portfolio management is organized to focus investment management expertise on specific classes of investments, while asset/liability management is the responsibility of dedicated risk management units supporting Life, including guaranteed separate accounts, 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.
Credit default swaps involve a transfer of credit risk from one party to another in exchange for periodic payments. One party to the contract will make a payment based on an agreed upon rate and a notional amount. The second party, who assumes credit exposures, will only make a payment when there is a credit event, and such payment will be equal to the notional value of the swap contract, and in return, the second party will receive the debt obligation of the first party. A credit event is generally defined as default on contractually obligated interest or principal payment or restructure.
The following tables identify fixed maturity securities for Life, including guaranteed separate accounts, and Property & Casualty by credit quality. The ratings referenced in the tables 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. In addition, an aging of the gross unrealized loss position is presented for fixed maturity and equity securities.
The BIG and equity securities that were in an unrealized loss position for longer than six months as of December 31, 2002 primarily consisted of corporate securities in the technology and communications and utilities sectors as well as asset-backed securities backed by corporate debt, equipment loans and credit card receivables. The technology and communications and utilities sectors along with diversified equity mutual funds and asset-backed securities comprised 26%, 22%, 18% and 15%, respectively, of the BIG and equity securities that were in an unrealized loss position for greater than six months at December 31, 2002. The total unrealized loss position of BIG and equity securities of $(192) consisted of $(157) in general account losses and $(35) in guaranteed separate account losses.
As part of the Company's ongoing monitoring process by a committee of investment and accounting professionals, the Company has reviewed these securities and concluded that there were no additional other than temporary impairments as of December 31, 2002 and 2001. Due to the issuers' continued satisfaction of the securities' obligations in accordance with their contractual terms and their continued expectation to do so, as well as the evaluation of the fundamentals of the issuers' financial condition, the Company believes that the prices of the securities in the sectors identified above, were temporarily depressed primarily as a result of a market dislocation and generally poor cyclical economic conditions and sentiment. (See the Critical Accounting Estimates section in the MD&A for the factors considered in evaluating other than temporary impairments.)
As of December 31, 2002 and 2001, over 94% of the fixed maturity portfolio was invested in securities rated investment grade. During 2002, the percentage of BB and below rated fixed maturity investments increased due to increased downgrades of corporate and asset-backed securities.
The total securities that were in an unrealized loss position for longer than six months as of December 31, 2002 primarily consisted of corporate and asset-backed securities. The significant corporate security industry sectors of technology and communications, banking and financial services, utilities and airlines comprised 22%, 8%, 12% and 6%, respectively, of the greater than six months unrealized loss amount. Asset-backed securities comprised 17% of the greater than six month unrealized loss amount and include securities backed by corporate debt, aircraft lease receivables, home equity loans and credit card receivables. At December 31, 2002, the Company held no securities of a single issuer that were at an unrealized loss in excess of 6% of total unrealized losses.
The total securities that were in an unrealized loss position for longer than six months as of December 31, 2001 primarily consisted of corporate and asset-backed securities. The significant corporate security industry sectors of communications and technology, utilities and banking and financial services comprised 31%, 16% and 8%, respectively, of the greater than six months unrealized loss amount. Asset-backed securities comprised 14% of the greater than six month unrealized loss amount and included securities backed by corporate debt and manufactured housing receivables. The Company held no securities of a single issuer that were at an unrealized loss in excess of 3% of total unrealized losses at December 31, 2002.
Downward movement in market interest rates during 2002 resulted in a significant increase in the unrealized appreciation of the fixed maturity security portfolio from 2001. However, The Hartford's asset allocation and its exposure to market risk as of December 31, 2002 have not changed materially from its position at December 31, 2001.
The Company is subject to the risk of a change in financial condition due to the effect of interest rate and equity market fluctuations on the calculation of the Company's minimum pension liabilities. As discussed in the Capital Resources and Liquidity section, in the fourth quarter 2002, the Company recorded a minimum pension liability charge directly to stockholders' equity of $364, after-tax.
The Hartford utilizes a variety of derivative instruments, including swaps, caps, floors, forwards and exchange traded futures and options, in compliance with Company policy and regulatory requirements in order to achieve one of four Company approved objectives: to hedge risk arising from interest rate, price or currency exchange rate volatility; to manage liquidity; to control transaction costs; or to enter into income enhancement and replication transactions.
Financial futures are standardized commitments to either purchase or sell designated financial instruments, at a future date, for a specified price and may be settled in cash or through delivery of the underlying instrument. Futures contracts trade on organized exchanges. Margin requirements for futures are met by pledging securities, and changes in the futures' contract values are settled daily in cash.
Derivative activities are monitored by an internal compliance unit, reviewed frequently by senior management and reported to the Finance Committee of the Board of Directors. The notional amounts of derivative contracts represent the basis upon which pay or receive amounts are calculated and are not reflective of credit risk. Notional amounts pertaining to derivative instruments used in the management of market risk for both general and guaranteed separate accounts at December 31, 2002 and 2001 totaled $13.2 billion and $10.5 billion, respectively.
As described above, Life holds a significant fixed maturity portfolio that includes both fixed and variable rate securities. The following table reflects the principal amounts of Life's general and guaranteed separate accounts fixed and variable rate fixed maturity portfolios, along with the respective weighted average coupons by estimated maturity year at December 31, 2002. Comparative totals are included as of December 31, 2001. Expected maturities differ from contractual maturities due to call or prepayment provisions. The weighted average coupon ("WAC") on variable rate securities is based on spot rates as of December 31, 2002 and 2001, and is primarily based on London Interbank Offered Rate ("LIBOR"). Callable bonds and notes are distributed to either call dates or maturity, depending on which date produces the most conservative yield. Asset-backed securities, collateralized mortgage obligations and mortgage-backed securities are distributed based on estimates of the rate of future prepayments of principal over the remaining life of the securities. These estimates are developed using prepayment speeds provided in broker consensus data. Such estimates are derived from prepayment speeds previously experienced at the interest rate levels projected for the underlying collateral. Actual prepayment experience may vary from these estimates. Financial instruments with certain leverage features have been included in each of the fixed maturity categories. These instruments have not been separately displayed because they were immaterial to the Life investment portfolio.
Anticipatory Hedging -- For certain liabilities, the Company commits to the price of the product prior to receipt of the associated premium or deposit. Anticipatory hedges are executed to offset the impact of changes in asset prices arising from interest rate changes pending the receipt of premium or deposit and the subsequent purchase of an asset. These hedges involve taking a long position (purchase) in interest rate futures or entering into an interest rate swap with duration
Asset Hedging -- To meet the various policyholder obligations and to provide cost-effective, prudent investment risk diversification, the Company may combine two or more financial instruments to achieve the investment characteristics of a fixed maturity security or that match an associated liability. The use of derivative instruments in this regard effectively transfers unwanted investment risks or attributes to others. The selection of the appropriate derivative instruments depends on the investment risk, the liquidity and efficiency of the market and the asset and liability characteristics. The notional amounts of asset hedges as of December 31, 2002 and 2001 were $7.2 billion and $6.2 billion, respectively.
Portfolio Hedging -- The Company periodically compares the duration and convexity of its portfolios of assets to its corresponding liabilities and enters into portfolio hedges to reduce any difference to desired levels. Portfolio hedges reduce the duration and convexity mismatch between assets and liabilities and offset the potential impact to cash flows caused by changes in interest rates. The notional amounts of portfolio hedges as of December 31, 2002 and 2001 were $910 and $1.1 billion, respectively.
Life's product liabilities, other than non-guaranteed separate accounts, include accumulation vehicles such as fixed and variable annuities, other investment and universal life-type contracts and other insurance products such as long-term disability and term life insurance.
For liabilities whose cash flows are not substantially affected by changes in interest rates ("fixed liabilities") and where investment experience is substantially absorbed by Life, the sensitivity of the net economic value (discounted present value of asset cash flows less the discounted present value of liability cash flows) of those portfolios to 100 basis point shifts in interest rates is shown in the following table.
Change in Net Economic Value 2002 2001 ------------------------------------------ Basis point shift - 100 + 100 - 100 + 100 - ----------------------------------------------------------------- Amount $ 17 $ (51) $ 6 $ (31) Percent of liability value 0.08% (0.23)% 0.03% (0.16)% =================================================================
The Company's Life operations are significantly influenced by changes in the equity markets. Life's profitability depends largely on the amount of assets under management, which is primarily driven by the level of sales, equity market appreciation and depreciation and the persistency of the in-force block of business. A prolonged and precipitous decline in the equity markets, as has been experienced of late, can have a significant impact on the Company's operations, as sales of variable products may decline and surrender activity may increase, as customer sentiment towards the equity market turns negative. The lower assets under management will have a negative impact on the Company's financial results, primarily due to lower fee income related to the Investment Products and Individual Life segments, where a heavy concentration of equity linked products are administered and sold. Furthermore, the Company may experience a reduction in profit margins if a significant portion of the assets held in the variable annuity separate accounts move to the general account and the Company is unable to earn an acceptable investment spread, particularly in light of the low interest rate environment and the presence of contractually guaranteed minimum interest credited rates, which for the most part are at a 3% rate.
death benefit costs to be incurred in the future fell within a range of $86 to $349. This range was calculated utilizing a 95% confidence interval. The median of the 250 stochastically generated scenarios was $159.
The primary exposure to interest rate risk in Property & Casualty relates to its fixed maturity investments. Changes in market interest rates directly impact the market value of the fixed maturity securities. In addition, but to a lesser extent, interest rate risk exists on debt and trust preferred securities issued. Derivative instruments are used to manage interest rate risk and had a total notional amount as of December 31, 2002 and 2001 of $1.1 billion and $797, respectively.
The following table provides information as of December 31, 2002 on interest rate swaps used to manage interest rate risk on fixed maturities and trust preferred securities and presents notional amounts with weighted average pay and receive rates by maturity year. Comparative totals are included as of December 31, 2001. The weighted average rates are based on spot rates as of December 31, 2002 and 2001.
Currency exchange risk exists with respect to investments in non-US dollar denominated securities. The fair value of these fixed maturity securities at December 31, 2002 and 2001 was $1 billion and $649, respectively. In the fourth quarter of 2002, the Company entered into a costless collar strategy to temporarily mitigate a portion of its currency risk in certain foreign denominated securities. Accordingly, the Company purchased foreign put options and wrote foreign call options expiring in January 2003. At December 31, 2002, the foreign put and call options had a notional value of $793 and fair value of $(4). Forward foreign contracts with a notional amount of $7 were used to manage currency exchange risk at December 31, 2001.
The table below provides information as of December 31, 2002 on Corporate's debt obligations and reflects principal cash flows and related weighted average interest rates by maturity year.
The following table identifies the Company's contractual obligations by payment due period.
In addition, as was the case after September 11, the Company may use the capital markets to replace capital upon completion of its asbestos review.
On May 15, 2001, HLI filed with the SEC a shelf registration statement for the potential offering and sale of up to $1.0 billion in debt and preferred securities. The registration statement was declared effective on May 29, 2001. As of December 31, 2002, HLI had $1.0 billion remaining on its shelf.
On November 9, 2000, The Hartford filed with the SEC a shelf registration statement and a prospectus, as amended on May 21, 2002, for the potential offering and sale of up to an additional $2.6 billion in debt and equity securities. Specifically, the registration statement allows for the following types of securities to be offered: debt securities, preferred stock, common stock, depositary shares, warrants, stock purchase contracts, stock purchase units and junior subordinated deferrable interest debentures of the Company, preferred securities of any of one or more capital trusts organized by The Hartford ("The Hartford Trusts") and guarantees by the Company with respect to the preferred securities of any of The Hartford Trusts. As of December 31, 2002, The Hartford had $1.3 billion remaining on the shelf.
The Hartford has a commercial paper program which allows the Company to borrow up to a maximum amount of $2.0 billion in short-term commercial paper notes. As of December 31, 2002, the Company had $315 of outstanding borrowings under the program.
On September 13, 2002, The Hartford issued 6.6 million 6% equity units at a price of $50.00 per unit and received net proceeds of $319. The Hartford contributed $150 of the net proceeds to its property and casualty insurance subsidiaries and $75 of the net proceeds to its life insurance subsidiaries. The remaining balance of the net proceeds is for general corporate purposes, which may include additional capital contributions to subsidiaries.
Each equity unit offered initially consists of a corporate unit with a stated amount of $50.00. Each corporate unit consists of one purchase contract for the sale of a certain number of shares of the Company's stock and $50.00 principal amount of senior notes due November 16, 2008.
The corporate unit may be converted by the holder into a treasury unit consisting of the purchase contract and a 5% undivided beneficial interest in a zero-coupon U.S. Treasury
security with a principal amount of one-thousand dollars that matures on November 15, 2006. The holder of an equity unit owns the underlying senior notes or treasury portfolio but has pledged the senior notes or treasury portfolio to the Company to secure the holder's obligations under the purchase contract.
The purchase contract obligates the holder to purchase, and obligates The Hartford to sell, on November 16, 2006, for $50.00, a variable number of newly issued common shares of The Hartford. The number of The Hartford's shares to be issued will be determined at the time the purchase contracts are settled based upon the then current price of The Hartford's common stock. If the price of The Hartford's common stock is equal to or less than $47.25, then the Company will deliver 1.0582 shares to the holder of the equity unit. If the price of The Hartford's common stock is greater than $47.25 but less than $57.645, then the Company will deliver a fraction of shares equal to $50.00 divided by the then current price of The Hartford's common stock. Finally, if the price of The Hartford's common stock is equal to or greater than $57.645, then the Company will deliver 0.8674 shares to the holder. Accordingly, upon settlement of the purchase contracts on November 16, 2006, The Hartford will receive proceeds of approximately $330 and will deliver between 5.7 million and 7.0 million common shares in the aggregate. The proceeds will be credited to stockholders' equity and allocated between the common stock and additional paid-in-capital accounts. The Hartford will make quarterly contract adjustment payments to the equity unit holders at a rate of 1.90% of the stated amount per year until the purchase contract is settled.
The total distributions payable on the equity units are at an annual rate of 6.0%, consisting of interest (4.10%) and contract adjustment payments (1.90%). The corporate units are listed on the New York Stock Exchange under the symbol "HIG PrA".
In March 2002, the Company borrowed $16 of short-term commercial notes for general corporate purposes.
On December 1, 2001, The Hartford's 8.3% medium term notes became due. The Company borrowed $200 under its commercial paper program to retire the debt.
On October 26, 2001, Hartford Capital III, a Delaware statutory business trust formed by The Hartford, issued 20,000,000 7.45% Trust Originated Preferred Securities, Series C and received proceeds before underwriting expenses of $500.
For a further discussion of Company Obligated Mandatorily Redeemable Preferred Securities of Subsidiary Trusts Holding Solely Junior Subordinated Debentures, see Note 8(d) of Notes to Consolidated Financial Statements.
As a result of September 11, on October 22, 2001, The Hartford issued 7.0 million shares of common stock pursuant to an underwritten offering for net proceeds of $400.
Issuance of common stock-Fortis Financial Group acquisition - On February 16, 2001, The Hartford issued 10 million shares of common stock pursuant to an underwritten offering for net proceeds of $615 to partially fund the Fortis Financial Group acquisition.
Dividends - The Hartford declared $262 and paid $257 in dividends to shareholders in 2002, declared $242 and paid $235 in 2001 and declared $214 and paid $210 in 2000.
The Company made a voluntary contribution of $90 in cash to the Plan in 2001 and made no contributions in 2002 or 2000. Pension expense reflected in the Company's operating earnings was $67, $57 and $48 in 2002, 2001 and 2000, respectively. The Company estimates its 2003 pension expense will be approximately $135, based on current assumptions provided below. The assumptions that primarily impact the amount of the Company's pension obligations and periodic pension expense are the weighted-average discount rate and the asset portfolio's long-term rate of return.
The Company determines the long-term rate of return assumption for the Plan's asset portfolio based on analysis of the portfolio's historical compound rates of return since 1979 (the earliest date for which comparable portfolio data is available) over rolling 5 year, 10 year and 20 year periods, balanced along with future long-term return expectations. 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. While the historical return of the Plan's portfolio has been 10.7% since 1979, management lowered its long-term rate of return assumption from 9.75% to 9.00% as of December 31, 2002 based on its long-term outlook with respect to the markets, which has been influenced by the poor equity market performance in recent years coupled with the recent decline in fixed income security yields during 2002.
The Plan's asset portfolio is generally structured over time to include approximately 60% equity securities (substantially securities issued by United States-based companies) and 40% fixed income securities (substantially investment grade and above). At December 31, 2002, the portfolio composition varied from the targeted mix and was approximately 55% equity securities and 45% fixed income securities due in part to declines in the equity markets and declining interest rates.
2002 2001 2000 - ---------------------------------------------------------------- Net cash provided by operating activities $ 2,649 $ 2,303 $ 2,435 Net cash used for investing activities $ (6,624) $ (5,536) $ (2,164) Net cash provided by (used for) financing activities $ 3,989 $ 3,365 $ (208) Cash - end of year $ 377 $ 353 $ 227 ================================================================
2002 COMPARED TO 2001 -- The increase in cash provided by operating activities was primarily the result of higher net income reported for the year ended December 31, 2002 than for the prior year as well as an increase in income tax refunds received in 2002 compared with the prior year. The increase in cash provided by financing activities was primarily the result of increased proceeds from investment and universal life-type contracts, partially offset by lower proceeds received from issuances of common stock and no issuances of trust preferred securities in 2002. The increase in cash from financing activities accounted for the majority of the change in cash for investing activities.
2002 2001 - ------------------------------------------------------------------ Life Operations $ 3,019 $ 2,991 Property & Casualty Operations 5,131 4,159 - ------------------------------------------------------------------ TOTAL $ 8,150 $ 7,150 ==================================================================
On January 28, 2003, following The Hartford's announcement that it is commencing a comprehensive review of its asbestos loss reserves, A.M. Best Co. placed under review with negative implications the commercial paper and debt ratings of The Hartford Financial Services Group, Inc. ("HFSG") and Hartford Life, Inc. Concurrently, the financial strength ratings of The Hartford's various life and property and casualty subsidiaries remain unaffected. On December 16, 2002, all of The
Hartford's financial strength and debt ratings were affirmed. The under review status is expected to be completed in conjunction with the Company's completion of its asbestos reserve study prior to the end of second quarter 2003.
On January 28, 2003, Moody's confirmed the ratings of HFSG and its subsidiaries, including the ratings of Hartford Life, Inc. following the Company's announcement that it is commencing a comprehensive review of its asbestos loss reserves. The review is expected to be completed during the second quarter 2003. In the same action, Moody's changed the outlook on the debt ratings for both the parent company and HLI to negative from stable and also placed a negative outlook on the insurance financial strength ratings of members of The Hartford's property and casualty intercompany pool. The negative outlook reflects the significant uncertainty surrounding the Company's asbestos liabilities. The outlook for the insurance financial strength ratings (Aa3) for the life insurance companies remains stable.
On September 4, 2002, Moody's revised its outlook on The Hartford's debt ratings to Stable from Negative citing The Hartford's commitment to maintaining its capital strength in the event of a significant unforeseen loss or adverse development that would weaken its capital position.
On November 26, 2002, Standard & Poor's removed from CreditWatch its counterparty credit rating on The Hartford Financial Services Group, Inc. and related entities and lowered it to `A-' from `A' reflecting concerns about trends in the retirement and savings sector, the consolidated capitalization of the Company's insurance operations and the increasingly competitive environment for spread-based and equity-linked retirement and savings products. At the same time, Standard & Poor's lowered to AA- from AA the insurance financial strength ratings of Hartford Fire Intercompany Pool and the life insurance subsidiaries of HLI.
On April 2, 2001, The Hartford acquired Fortis Financial Group for $1.12 billion in cash. The Company effected the acquisition through several reinsurance agreements with subsidiaries of Fortis, Inc. and the purchase of 100% of the stock of Fortis Advisers, Inc. and Fortis Investors, Inc., wholly-owned subsidiaries of Fortis, Inc. The acquisition was recorded as a purchase transaction.
For a further discussion of the Fortis acquisition, see Note 18(a) of Notes to Consolidated Financial Statements.
The liquidity requirements of The Hartford have been and will continue to be met by funds from operations as well as the issuance of commercial paper, common stock, debt securities and borrowings from its credit facilities. The principal sources of operating funds are premiums and investment income as well as maturities and sales of invested assets. The Hartford Financial Services Group, Inc. is a holding company which receives operating cash flow in the form of dividends from its subsidiaries, enabling it to service debt, pay dividends on its common stock and pay certain business expenses.
As of December 31, 2002, the maximum amount of statutory dividends which may be paid to The Hartford Financial Services Group, Inc. from its insurance subsidiaries in 2003, without prior regulatory approval, is $1.8 billion.
The Act created a program under which the federal government will pay 90% of covered losses after an insurer's losses exceed a deductible determined by a statutorily prescribed formula, up to a combined annual aggregate limit for the federal government and all insurers of $100 billion. If an act of terrorism or acts of terrorism result in covered losses exceeding the $100 billion annual limit, insurers with losses exceeding their deductibles will not be responsible for additional losses.
The statutory formula for determining a company's deductible for each year is based on the company's direct commercial earned premiums for the prior calendar year multiplied by a specified percentage. The specified percentages are 7% for 2003, 10% for 2004 and 15% for 2005. For example, based on The Hartford's 2002 direct commercial earned premiums of $5 billion, The Hartford's 2003 deductible would be $350.
The Act requires all property and casualty insurers, including The Hartford, to make terrorism insurance coverage available in all of their covered commercial property and casualty insurance policies (as defined in the Act). The Hartford will evaluate risks with terrorism exposures by applying its internally developed underwriting guidelines and control plans. The Hartford does not anticipate significant increases in premiums due to the Act.
Dependence on Certain Third Party Relationships - The Company distributes its annuity, life and certain property and casualty insurance products through a variety of distribution channels, including broker-dealers, banks, wholesalers, its own internal sales force and other third party organizations. The Company periodically negotiates provisions and renewals of these relationships and there can be no assurance that such terms
will remain acceptable to the Company or such third parties. An interruption in the Company's continuing relationship with certain of these third parties could materially affect the Company's ability to market its products.
Federal measures which have been previously considered or enacted by Congress and which, if revisited, could affect the insurance business include tax law changes pertaining to the tax treatment of insurance companies and life insurance and annuity products, as well as changes in individual income tax rates and the estate tax. These changes could have an impact on the relative desirability of various personal investment vehicles. Legislation to restructure the Social Security system, expand private pension plans, and create new retirement savings incentives also may be considered.
The Bush Administration's fiscal year 2004 budget contains several proposals that could materially affect the Company's business. In particular, there are proposals that would more fully integrate corporate and individual taxes by permitting the distribution of nontaxable dividends to shareholders under certain circumstances. These proposals, if enacted, could have a material effect on sales of the Company's variable annuities and other retirement savings products, as well as implications for the Company's shareholders, both with respect to the amount of taxable dividends received, as well as the price of and tax basis in their holdings of the Company's common stock. The dividend exclusion proposal, if enacted, also would reduce the federal tax benefits currently received by the Company stemming from the dividends received deduction.
There also are proposals in the federal 2004 budget submitted by President Bush that would create new investment vehicles with larger annual contribution limits for individuals to use for savings purposes. Some of these proposed vehicles would have significant tax advantages, and could have material effects on the Company's product portfolio. There have also been proposals regarding certain deferred compensation arrangements that could have negative effects on the Company's product sales. Prospects for enactment of this legislation in 2003 are uncertain. Therefore, any potential effect on the Company's financial condition or results of operations cannot be reasonably estimated at this time.
The NAIC adopted the Codification of Statutory Accounting Principles ("Codification") in March 1998. The effective date for the statutory accounting guidance was January 1, 2001. Each of The Hartford's domiciliary states has adopted Codification, and the Company has made the necessary changes in its statutory reporting required for implementation. The impact of applying the new guidance resulted in a benefit of approximately $400 in statutory surplus.
For further information on other contingencies, see Note 16 of Notes to Consolidated Financial Statements.