2004 includes a $23 after-tax charge related to the cumulative effect of accounting change for the Company’s adoption of Statement of Position 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts”. 2001 includes a $34 after-tax charge related to the cumulative effect of accounting changes for the Company’s adoption of SFAS No 133, “Accounting for Derivative Instruments and Hedging Activities” and EITF Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets.”
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 Item 1A, Risk Factors. These factors include: 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; changes in the stock markets, interest rates or other financial markets, including the potential effect on the Company’s statutory capital levels; 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 Company’s potential exposure arising out of regulatory proceedings or private claims relating to incentive compensation or payments made to brokers or other producers and alleged anti-competitive conduct; the uncertain effect on the Company of regulatory and market-driven changes in practices relating to the payment of incentive compensation to brokers and other producers, including changes that have been announced and those which may occur in the future; 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 possibility of general economic and business conditions that are less favorable than anticipated; the Company’s ability to distribute its products through distribution channels, both current and future; the uncertain effects of emerging claim and coverage issues; a downgrade in the Company’s financial strength or credit ratings; the ability of the Company’s subsidiaries to pay dividends to the Company; and other factors described in such forward-looking statements.
The Hartford is a diversified insurance and financial services company with operations dating back to 1810. The Company is headquartered in Connecticut and is organized into two major operations: Life and Property & Casualty, each containing reporting segments. In the quarter ended December 31, 2005, and as more fully described below, the Company changed its reporting segments to reflect the current manner by which its chief operating decision maker views and manages the business. All segment data for prior reporting periods have been adjusted to reflect the current segment reporting. Within the Life and Property & Casualty operations, The Hartford conducts business principally in ten operating segments. Additionally, Corporate primarily includes all of the Company’s debt financing and related interest expense, as well as certain capital raising activities and purchase accounting adjustments.
Life has realigned its reportable operating segments during 2005 to include six reportable operating segments: Retail Products Group (“Retail”), Retirement Plans, Institutional Solutions Group (“Institutional”), Individual Life, Group Benefits and International. Through Life the Company provides investment and retirement products such as variable and fixed annuities, mutual funds and retirement plan services; other institutional investment products; structured settlements; private placement life insurance; individual life insurance
Property & Casualty is organized into four reportable operating segments: the underwriting segments of Business Insurance, Personal Lines and Specialty Commercial (collectively “Ongoing Operations”), and the Other Operations segment. Through Property & Casualty the Company 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, bond, professional liability and director’s and officer’s 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.
Many of the principal factors that drive the profitability of The Hartford’s Life and Property & Casualty operations are separate and distinct. Management considers this diversification to be a strength of The Hartford that distinguishes the Company from many of its peers. To present its operations in a more meaningful and organized way, management has included separate overviews within the Life and Property & Casualty sections of MD&A. For further overview of Life’s profitability and analysis, see page 43. For further overview of Property & Casualty’s profitability and analysis, see page 58.
In June 2004, the Company received a subpoena from the New York Attorney General’s Office in connection with its inquiry into compensation arrangements between brokers and carriers. In mid-September 2004 and subsequently, the Company has received additional subpoenas from the New York Attorney General’s Office, which relate more specifically to possible anti-competitive activity among brokers and insurers. Since the beginning of October 2004, the Company has received subpoenas or other information requests from Attorneys General and regulatory agencies in more than a dozen jurisdictions regarding broker compensation and possible anti-competitive activity. The Company may receive additional subpoenas and other information requests from Attorneys General or other regulatory agencies regarding similar issues. In addition, the Company has received a request for information from the New York Attorney General’s Office concerning the Company’s compensation arrangements in connection with the administration of workers compensation plans. The Company intends to continue cooperating fully with these investigations, and is conducting an internal review, with the assistance of outside counsel, regarding broker compensation issues in its Property & Casualty and Group Benefits operations.
On October 14, 2004, the New York Attorney General’s Office filed a civil complaint against Marsh & McLennan Companies, Inc., and Marsh, Inc. (collectively, “Marsh”). The complaint alleges, among other things, that certain insurance companies, including the Company, participated with Marsh in arrangements to submit inflated bids for business insurance and paid contingent commissions to ensure that Marsh would direct business to them. The Company was not joined as a defendant in the action, which has since settled. Although no regulatory action has been initiated against the Company in connection with the allegations described in the civil complaint, it is possible that the New York Attorney General’s Office or one or more other regulatory agencies may pursue action against the Company or one or more of its employees in the future. The potential timing of any such action is difficult to predict. If such an action is brought, it could have a material adverse effect on the Company.
There continues to be significant federal and state regulatory activity relating to financial services companies, particularly mutual funds companies. These regulatory inquiries have focused on a number of mutual fund issues, including market timing and late trading, revenue sharing and directed brokerage, fees, transfer agents and other fund service providers, and other mutual-fund related issues. The Company has received requests for information and subpoenas from the SEC, subpoenas from the New York Attorney General’s Office, a subpoena from the Connecticut Attorney General’s Office, requests for information from the Connecticut Securities and Investments Division of the Department of Banking, and requests for information from the New York Department of Insurance, in each case requesting documentation and other information regarding various mutual fund regulatory issues. The Company continues to cooperate fully with these regulators in these matters.
indemnified the affected mutual funds for material harm deemed to have been caused to the funds by frequent trading by these owners for the period from January 2, 2004 through December 31, 2005. The Company does not expect to incur additional costs pursuant to this agreement in principle in light of the exchange or surrender of these variable annuity contracts.
The SEC’s Division of Enforcement also is investigating aspects of the Company’s variable annuity and mutual fund operations related to directed brokerage and revenue sharing. The Company discontinued the use of directed brokerage in recognition of mutual fund sales in late 2003. The Company continues to cooperate fully with the SEC in these matters.
On June 23, 2005, the Company received a subpoena from the New York Attorney General’s Office requesting information relating to purchases of the Company’s variable annuity products, or exchanges of other products for the Company’s variable annuity products, by New York residents who were 65 or older at the time of the purchase or exchange. On August 25, 2005, the Company received an additional subpoena from the New York Attorney General’s Office requesting information relating to purchases of or exchanges into the Company’s variable annuity products by New York residents during the past five years where the purchase or exchange was funded using funds from a tax-qualified plan or where the variable annuity purchased or exchanged for was a sub-account of a tax-qualified plan or was subsequently put into a tax-qualified plan. The Company is cooperating fully with the New York Attorney General’s Office in these matters.
On July 14, 2005, the Company received an additional subpoena from the Connecticut Attorney General’s Office concerning the Company’s structured settlement business. This subpoena requests information about the Company’s sale of annuity products for structured settlements, and about the ways in which brokers are compensated in connection with the sale of these products. The Company is cooperating fully with the New York Attorney General’s Office and the Connecticut Attorney General’s Office in these matters.
The Company has received a request for information from the New York Attorney General’s Office about issues relating to the reporting of workers’ compensation premium. The Company is cooperating fully with the New York Attorney General’s Office in this matter.
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 for unpaid claims and claim adjustment expenses, net of reinsurance; Life deferred policy acquisition costs and present value of future profits associated with variable annuity and other universal life-type contracts; the evaluation of other-than-temporary impairments on investments in available-for-sale securities; the valuation of guaranteed minimum withdrawal benefit derivatives; pension and other postretirement benefit obligations; and contingencies relating to corporate litigation and regulatory matters. 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 Company provides an allowance for uncollectible reinsurance, reflecting management’s current estimate of reinsurance cessions that may be uncollectible in the future due to reinsurers’ unwillingness or inability to pay and contemplates recoveries under ceded reinsurance contracts and settlements of disputes that could be different than the ceded liabilities. The Company analyzes recent developments in commutation activity between reinsurers and cedants, recent trends in arbitration and litigation outcomes in disputes between reinsurers and cedants and the overall credit quality of the Company’s reinsurers. Where its contracts permit, the Company secures future claim obligations with various forms of collateral, including irrevocable letters of credit, secured trusts, funds held accounts and group-wide offsets. The allowance for uncollectible reinsurance was $413 as of December 31, 2005, including $335 related to Other Operations and $78 related to Ongoing Operations.
Due to the inherent uncertainties as to collection and the length of time before reinsurance recoverables become due, it is possible that future adjustments to the Company’s reinsurance recoverables, net of the allowance, could be required, which could have a material adverse effect on the Company’s consolidated results of operations or cash flows in a particular quarter or annual period.
Reserves are set by line of business within the various operating segments. As indicated in the above table, a single line of business may be written in one or more of the segments. Case reserves are established by a claims handler on each individual claim and are adjusted as new information becomes known during the course of handling the claim. Lines of business for which loss data (e.g. paid losses and case reserves) emerge (i.e. is reported) over a long period of time are referred to as long-tail lines of business. Lines of business for which loss data emerge more quickly are referred to as short-tail lines of business. Within the Company’s Ongoing Operations the shortest-tail lines of business are property and auto physical damage. The longest tail lines of business within Ongoing Operations include workers’ compensation, general liability, and professional liability. Assumed reinsurance, which is within Other Operations, is also long-tail business.
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 quarterly reserve reviews incorporate a variety of actuarial methods and judgments and involve rigorous analysis. For most lines of business, a variety of actuarial methods are reviewed and the actuaries select methods and specific assumptions appropriate for each line of business based on the current circumstances affecting that line of business. These selections incorporate input, as judged by the reserving actuaries to be appropriate, from claims personnel, pricing actuaries and operating management on reported loss cost trends and other factors that could affect the reserve estimates. The output of the quarterly reserve reviews are reserve estimates that are referred to herein as the “actuarial indication.”
For long-tail lines of business, emergence of paid losses and case reserves is less credible in the early periods and, accordingly may not be indicative of ultimate losses. For these lines, methods which rely on actual paid losses and case reserves and incorporate a development pattern assumption are given less weight in calculating IBNR reserves for the early stages of loss emergence because such
During 2005, there were numerous changes to reserve estimates. Among other loss developments in 2005, these changes included strengthening of workers’ compensation reserves for claim payments expected to emerge after 20 years of development, a release of 2003 and 2004 accident year workers’ compensation reserves, strengthening of assumed casualty reinsurance reserves and a release of reserves for allocated loss adjustment expenses, predominately in Personal Lines. See “Reserves” within the Property and Casualty MD&A for further discussion of reserve developments.
The Hartford is a multi-line company in the property and casualty business. The Hartford is therefore subject to reserve uncertainty stemming from a number of conditions, including but not limited to those noted above, any of which could be material at any point in time for any segment. Certain issues may become more or less important over time as conditions change. As various market conditions develop, management must assess whether those conditions constitute a long-term trend that should result in a reserving action (i.e. increasing or decreasing the reserve). Below is a discussion of certain market conditions that Company management has observed during 2005.
In Business Insurance, workers’ compensation is the Company’s single biggest line of business and the line of business with the longest pattern of loss emergence. Reserve estimates for workers’ compensation are particularly sensitive to assumptions about medical inflation, which has been increasing steadily over the past few years. In addition, changes in state legislative and regulatory environments impact the Company’s estimates. These changes increase the uncertainty in the application of development patterns.
Within Ongoing Operations, the Company has reserves for natural catastrophes that have occurred. The Company’s estimates of loss and loss expenses arising from catastrophe losses are based on information from reported claims, information from catastrophe loss models and estimates of reinsurance recoverables on ceded losses. For catastrophe losses that occur shortly before the end of the reporting period, the loss and loss expense reserves rely heavily on estimates derived from catastrophe loss models and previous experience and, therefore, are subject to significant uncertainty. For large catastrophes, such as with hurricane Katrina in 2005, there may be a long time lag between the date the catastrophe occurs and the date that residents and business owners are able to return to their properties to report a claim. In addition, it is sometimes difficult for claim adjusters to access the most significantly impacted areas. Estimating reserves for catastrophes is further complicated by the need to estimate the effect of anticipated “demand surge” which is the tendency for the cost of building materials and contractors to rise based on an increase in demand in the affected areas.
As stated above, the Company’s practice is to estimate reserves using a variety of methods, assumptions and data elements. Within its reserve estimation process for reserves other than asbestos and environmental, the Company does not derive statistical loss distributions or confidence levels around its reserve estimate and, as a result, does not have reserve range estimates to disclose.
Recorded reserves for auto liability, net of reinsurance, are $2.2 billion across all lines, $1.5 billion of which is in Personal Lines. Personal auto liability reserves are shorter-tailed than other lines of business (such as workers’ compensation) and, therefore, less volatile. However, the size of the reserve base means that future changes in estimate could be material to the Company’s results of operations in any given period. The key assumption for Personal Lines auto liability is the annual loss cost trend, particularly the severity trend component of loss costs. A review of Insurance Services Office (“ISO”) data suggests that annual growth in industry severity since 1999 has varied from +1% to +6%. A 2.5 point change in assumed annual severity is within historical variation for the industry and for the Company. A 2.5 point change in assumed annual severity for the two most recent accident years would change the estimated net reserve need by $70, in either direction. Assumed annual severity for accident years prior to the two most recent accident years is likely to have minimal variability.
The Company continues to receive asbestos and environmental claims. Asbestos claims relate primarily to bodily injuries asserted by people who came in contact with asbestos or products containing asbestos. Environmental claims relate primarily to pollution and related clean-up costs.
In establishing reserves for asbestos claims, the Company evaluates its insureds’ estimated liabilities for such claims using a ground-up approach. The Company considers a variety of factors, including the jurisdictions where underlying claims have been brought, past, pending and anticipated future claim activity, disease mix, past settlement values of similar claims, dismissal rates, allocated claim adjustment expense, and potential bankruptcy impact.
The Company amortizes DAC related to traditional policies (term, whole life and group insurance) over the premium-paying period in proportion to the present value of annual expected premium income. The Company amortizes DAC related to investment contracts and universal life-type contracts (including individual variable annuities) using the retrospective deposit method. Under the retrospective deposit method, acquisition costs are amortized in proportion to the present value of estimated gross profits (“EGPs”). The Company uses other measures for amortizing DAC, such as gross costs, as a replacement for EGPs when EGPs are expected to be negative for multiple years of the contract’s life. The Company also adjusts the DAC balance, through other comprehensive income, by an amount that represents the amortization of DAC that would have been required as a charge or credit to operations had unrealized gains and losses on investments been realized. 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, 2005, 2004 and 2003, was an increase to amortization of $18, $16 and $38, respectively.
As of December 31, 2005, the present value of the EGPs used in the DAC amortization models, for variable annuities and variable universal life business, fell within the statistical range of reasonable EGPs. Therefore, the Company did not revise the separate account return assumption, the account values or any other assumptions, in those DAC amortization models, for 2004 and prior cohorts.
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 rolling 5 year, 10 year and 20 year periods, balanced along with future long-term return expectations that generally anticipate an investment mix of 60% equity securities and 40% fixed income securities. 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 11.03% since 1979, based upon management’s outlook with respect to market returns, as well as the planned asset mix, management lowered its long-term rate of return assumption to 8.00% as of December 31, 2005 from 8.50% as of December 31, 2004.
To illustrate the impact of these assumptions on annual pension and other postretirement expense for 2006 and going forward, a 25 basis point change in the discount rate will increase/decrease pension and other postretirement expense by approximately $15 and a 25 basis point change in the long-term asset return assumption will increase/decrease pension and other postretirement expense by approximately $8.
Amounts reported in 2003 are prior to the adoption of Statement of Position 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts” (“SOP 03-1”),
2005 Compared to 2004 - Net income increased $159 for the year ended December 31, 2005 compared with the prior year. The increase was primarily due to the following:
An increase in net income for International of $57, principally driven by higher fee income and investment spread in Japan derived from a 78% increase in the assets under management.
An after-tax expense of $46 recorded in Life during 2005, related to the termination of a provision of an agreement with a mutual fund distribution partner of the Company’s retail mutual funds.
An increase in Property & Casualty net income of $1.7 billion driven primarily by a $1.7 billion after-tax charge to strengthen net asbestos reserves based on a ground up study in 2003.
Increased Property & Casualty catastrophe losses, primarily related to hurricanes Charley, Frances, Ivan and Jeanne.
Total revenues increased $4.0 billion for the year ended December 31, 2004 compared with the prior year. The increase was primarily due to the following:
Net investment income increased due primarily to the adoption of SOP 03-1, which resulted in $1.6 billion of net investment income.
The effective tax rate for 2005, 2004 and 2003 was 24%, 15% and 83%, respectively. The principal causes of the difference between the effective rate and the U.S. statutory rate of 35% for 2005 were tax-exempt interest earned on invested assets and the separate account dividends received deduction (“DRD”). For 2004, the principal causes were tax exempt interest earned on invested assets, the separate account DRD and the tax benefit associated with the settlement of the 1998-2001 IRS audit. Income taxes paid (received) in 2005, 2004 and 2003 were $447, $32 and ($107), respectively. For additional information, see Note 13 of Notes to Consolidated Financial Statements.
The future profitability of the Retirement Plans segment will depend on the Company’s ability to increase assets under management across all businesses and maintain its investment spread earnings on the products sold largely in the Government business. 401(k) sales are expected to remain strong throughout 2006 primarily due to the continuing growth in the market for retirement products. The Government market is highly competitive from a pricing perspective, and a small number of cases often account for a significant portion of sales, therefore the Company may not be able to sustain the level of sales growth attained in 2005.
In Group Benefits, management anticipates the increased scale of the group life and disability operations and the expanded distribution network for its products and services will generate strong sales growth. Sales, however, may be negatively affected by the competitive
pricing environment in the marketplace. Management is committed to selling competitively priced products that meet the Company’s internal rate of return guidelines.
Management expects written pricing trends in 2006 to be affected by increased competition in Business Insurance and Personal Lines. Price competition is most significant for Select Xpand and middle market business within Business Insurance. Competition is also intensifying in Personal Lines, especially in auto. Rather than competing on rate, many companies are advertising heavily to drive new business and retain profitable customers. In 2006, management believes that pricing declines in Business Insurance will lessen somewhat as higher reinsurance costs are reflected in the market. Within Personal Lines, the Company expects written pricing to be flat to slightly negative for auto and written pricing increases in the mid-single digits for homeowners. In the wake of the third and fourth quarter hurricanes of 2005, specialty property written pricing has been increasing in catastrophe prone areas and management expects rates to continue to increase in 2006.
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) net investment income on general account assets; (c) fully insured premiums; and (d) certain other fees. Asset management fees and mortality and expense fees are primarily generated from separate account assets, which are deposited with Life through the sale of variable annuity and variable universal life products and from 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 and individual term insurance products.
Life’s profitability 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 profitability 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. Thus, a prolonged downturn in the financial markets could reduce revenues and potentially raise the possibility of a charge against deferred policy acquisition costs.
The profitability of Life’s fixed annuities and other “spread-based” products depends largely on its ability to earn target spreads between earned investment rates on its general account assets and interest credited to policyholders. Profitability is also influenced by operating expense management including the benefits of economies of scale in the administration of its United States variable annuity businesses in particular. In addition, the size and persistency of gross profits from these businesses is an important driver of earnings as it affects the rate of amortization of the deferred policy acquisition costs.
Changes in market value are based on market conditions and investment management performance.
Certain investment type contracts such as fixed annuities and other spread-based contracts generate deposits that the Company collects and invests to earn investment income. These investment type contracts use this investment income to credit the contract holder an amount of interest specified in the respective contract; therefore, management evaluates performance of these products based on the spread between net investment income and interest credited. Net investment income and interest credited can be volatile period over period, which can have a significant positive or negative effect on the operating results of each segment. The volatile nature of net investment income is driven primarily by prepayments on securities and earnings on partnership investments. In addition, insurance type contracts such as those sold by Group Benefits (discussed below) collect and invest premiums for protection from losses specified in the particular insurance contract and those sold by Institutional, collect and invest premiums for certain life contingent benefits.
Net investment income and interest credited in Other increased for the year ended December 31, 2005 due to $3,847 increase in the mark-to-market effects of trading account securities supporting the Japanese variable annuity business.
As discussed above, traditional insurance type products, such as those sold by Group Benefits, collect premiums from policyholders in exchange for financial protection of the policy holder from a specified insurable loss, such as death or disability. These premiums together with net investment income earned from the overall investment strategy are used to pay the contractual obligations under these insurance contracts. Two major factors, new sales and persistency, impact premium growth. Sales can increase or decrease in a given year based on a number of factors, including but not limited to, customer demand for the Company’s product offerings, pricing competition, distribution channels and the Company’s reputation and ratings. A majority of sales correspond with the open enrollment periods of employers’ benefits, typically January 1 or July 1. Persistency is the percentage of insurance policies remaining in force from year to year as measured by premiums.
The persistency rate represents the employer market group life and disability business, which accounts for, on average, 75% of inforce premiums.
Earned premiums and other considerations include $27, $4 and $40 in buyout premiums for the years ended December 31, 2005, 2004 and 2003, respectively. The increase in premiums and other considerations for Group Benefits in 2005 compared to 2004 was driven by sales and favorable persistency.
There are three major categories for expenses. The first major category of expenses is benefits and claims. These include the costs of mortality and morbidity, particularly in the group benefits business, and mortality in the individual life businesses, as well as other contractholder benefits to policyholders. In addition, traditional insurance type products generally use a loss ratio which is expressed as the amount of benefits incurred during a particular period divided by total premiums and other considerations, as a key indicator of underwriting performance. Since Group Benefits occasionally buys a block of claims for a stated premium amount, the Company excludes this buyout from the loss ratio used for evaluating the underwriting results of the business as buyouts may distort the loss ratio.
The Group Benefits expense ratio, excluding buyouts, increased slightly for the year ended December 31, 2005 primarily due to higher operating expenses related to business growth.
Management evaluates the rates of return various businesses can provide as a way of determining where additional capital should be invested to increase net income and shareholder returns. Specifically, because of the importance of its individual annuity products, the Company uses the return on assets for the individual annuity business for evaluating profitability. In Group Benefits, after tax margin is a key indicator of overall profitability.
Individual annuity’s ROA increased for the year ended December 31, 2005, compared to the prior year. In particular, variable annuity fees and fixed annuity general account spreads each increased for the year ended December 31, 2005 compared to the prior year. The increase in the ROA can be attributed to the increase in account values and resulting increased fees including GMWB rider fees without a corresponding increase in expenses, while the increase in fixed annuity general account spread resulted from fixed annuity contracts that were repriced upon the contract reaching maturity. Also, contributing to a higher ROA in 2005 is an increase in the separate account dividends received deduction (“DRD”) tax benefit compared to 2004.
The improvement in the Group Benefits after-tax margin for the year ended December 31, 2005 was primarily due to favorable loss ratios and higher net investment income as compared to 2004.
Includes dividend income and mark-to-market effects of trading securities supporting the international variable annuity business, which are classified in net investment income with corresponding amounts credited to policyholders within benefits, claims and claim adjustment expenses.
Life realigned its reportable operating segments in 2005 from Retail, Institutional, Individual Life and Group Benefits to Retail, Retirement Plans, Institutional, Individual Life, Group Benefits and International.
Life recorded an after-tax charge of $102 for the year ended December 31, 2005 to establish reserves for regulatory matters for investigations related to market timing by the SEC and New York Attorney General’s Office, directed brokerage by the SEC,
and single premium group annuities by the New York Attorney General’s Office and the Connecticut Attorney General’s Office.
Life recorded an after-tax expense of $46 for the year ended December 31, 2005, which related to the termination of a provision of an agreement with a mutual fund distribution partner.
Institutional contributed higher earnings during 2005, driven by higher assets under management.
Net income in Group Benefits increased during 2005, primarily due to a non-recurring tax benefit of $9 related to the acquisition of the group life and accident, and short-term and long-term disability business of CNA Financial Corporation (“the CNA Acquisition”) and higher earned premiums and net investment income as well as a favorable loss ratio as compared to the prior year period.
Net investment income increased for all Life segments during 2005, driven by a higher asset base and increased partnership income, as compared to the prior year.
The effective tax rate was 21% for Life operations for the current year as compared to an effective tax rate of 13% for Life operations for the respective prior year period. The 2005 higher effective tax rate was attributed to the absence of the 2004 tax benefit of $190 (as mentioned above) offset by an increase in the DRD tax benefit of $50.
Net income in Retail increased, principally driven by growth in the variable annuity and mutual fund businesses as a result of increased assets under management.
Net income in Group Benefits increased due primarily to increased earned premiums and net investment income growth, primarily resulting from the CNA Acquisition. In addition, Group Benefits was impacted by favorable persistency in most businesses and a lower loss ratio.
The effective tax rate for 2005, 2004 and 2003 was 21%, 13% and 21%, respectively. The principal causes of the difference between the effective rates and the U.S. statutory rate of 35% for 2005 were tax-exempt interest earned on invested assets and the separate account dividends received deduction (“DRD”). For 2004, the principal causes were tax exempt interest earned on invested assets, the separate account dividends received deduction and the tax benefit associated with the settlement of the 1998-2001 IRS audit. For additional information, see Note 13 of Notes to Consolidated Financial Statements.
Retail focuses on the savings and retirement needs of the growing number of individuals who are preparing for retirement, or have already retired, through the sale of individual variable and fixed annuities, mutual funds and other investment products. Life is both a leading writer of individual variable annuities and a top seller of individual variable annuities through banks in the United States.
The increase in fee income in the variable annuity business for the year ended December 31, 2005 was mainly a result of growth in average account values. The year-over-year increase in average account values of 10% can be attributed to market appreciation of $6.3 billion during 2005. Variable annuities had net outflows of $881 for the year ended December 31, 2005 compared to net inflows of $5.5 billion for the year ended December 31, 2004. The net outflows in 2005 were due to increased surrender activity and increased sales competition, particularly as it relates to guaranteed living benefits riders were offered with variable annuity products.
Retail mutual fund fee income increased as a result of an increase in assets under management of 24% year over year principally due to net sales and market appreciation of $2.5 billion each during 2004.
2005 Compared to 2004 - Net income in Retirement Plans increased for the year ended December 31, 2005 compared to the prior year primarily due to higher earnings in the 401(k) business. Net income for the Government business was relatively stable as positive market appreciation was largely offset by negative net flows, resulting in modest growth in assets under management:
The DAC amortization rate decreased in 2005 compared to 2004 as a result of higher profits.
2004 Compared to 2003 - Net income for the year ended December 31, 2004 increased primarily due to higher fee income related to the 401(k) business compared to the prior year. A more expanded discussion of earnings growth can be found below.
increase in 401(k) assets under management of 42% to $6.5 billion. Total deposits and net flows increased substantially by 45% and 42%, respectively, over the prior year primarily due to the expansion of wholesaling capabilities and new product offerings.
The effective tax rate decreased for the year ended December 31, 2004 due to an increase in the DRD benefit as a percentage of pre-tax income.
Total revenues increased in Institutional driven by positive net flows of $2.4 billion during the past four quarters, which resulted in higher assets under management. Net flows for Institutional increased for the year ended December 31, 2005 compared to the prior year, primarily as a result of the Company’s funding agreement backed Investor Notes program, which was launched in the third quarter of 2004. Investor Note sales for the years ended December 31, 2005 and 2004 were $2.0 billion and $643, respectively.
General account spread is one of the main drivers of net income for the Institutional line of business. An increase in spread income in 2005 was driven by higher assets under management noted above, combined with improved partnership income and mortality gains related to terminal funding and structured settlement contracts that include life contingencies. For the year ended December 31, 2005 and 2004, gains related to mortality, investments or other activity were $10 and $3 after-tax, respectively. During 2005,
the Company invested in more variable rate assets to back the increasing block of variable rate liabilities sold under the stable value product line. This asset/liability matching strategy has decreased portfolio yields, as variable rate assets have lower initial coupon yields then fixed rate assets. At the same time the stable value variable rate liabilities have lower crediting rates in the current period than stable value fixed rate liabilities, which has allowed the Company to maintain-to-slightly-increase its general account spread on a yield basis.
2004 Compared to 2003 - Net income for the year ended December 31, 2004 increased primarily due to PPLI businesses compared to the prior year:
Lower income from the IIP and PPLI businesses, excluding the aforementioned settlement of a certain litigation matter.
The decrease in net income in IIP was due primarily to lower spread income and slightly higher insurance operating costs for the year ended December 31, 2004 as compared to 2003. In addition, IIP reported lower earnings for 2004 compared to the prior year due to favorable mortality experience in 2003.
Earned Premiums decreased for the year ended December 31, 2004 compared to 2003 due to lower sales on limited payment contracts for the Structured Settlement and Terminal Funding products, consistent with a corresponding decrease in Benefits, Claims and Claim Adjustment Expenses.
The future net income of this segment will depend on Life’s ability to increase assets under management across all businesses and maintain its investment spread earnings on the products sold largely in the IIP business. The IIP markets are highly competitive from a pricing perspective, and a small number of cases often account for a significant portion of sales, therefore the Company may not be able to sustain the level of assets under management growth attained in 2005. In 2004, IIP introduced the Hartford Income Notes, a new funding agreement backed product that provides the Company with opportunity for future growth. This product provides access to both a multi-billion dollar retail market, and a nearly trillion dollar institutional market. These markets are very competitive and the Company’s success depends in part on the level of credited interest rates and the Company’s credit rating.
As the “baby boom” generation approaches retirement, management believes these individuals will seek investment and insurance vehicles that will give them steady streams of income throughout retirement. IIP will launch new products in 2006 to provide solutions that deal specifically with longevity risk. Longevity risk is defined as the likelihood of an individual outliving their assets. IIP is also designing innovative solutions to corporation’s defined benefit liabilities. The focus of the PPLI business is variable PPLI products to fund non-qualified benefits or other post employment benefit liabilities. The market served by PPLI is subject to extensive legal and regulatory review that could have an adverse effect on its business.
2005 Compared to 2004 - Net income increased $11 or 7% for the year ended December 31, 2005 as compared to the prior year, primarily due to increases in both life insurance inforce and account values. The following factors contributed to the earnings increase:
Fee income increased $35 for the year ended December 31, 2005 as compared to the prior year. Cost of insurance charges, a component of total fee income, increased $22 in 2005, driven by business growth and aging of the prior year block of variable universal, universal, and interest-sensitive whole life insurance inforce. Other fee income, another component of total fee income, increased $7 in 2005 primarily due to growth and improved product performance primarily in interest-sensitive whole life and variable universal life insurance products. Variable fee income grew $6 in 2005, as equity market performance and premiums in excess of withdrawals added to the variable universal life account value.
Amortization of DAC increased for the year ended December 31, 2005 compared to the prior year primarily as a result of product mix and higher gross margins within variable universal and interest-sensitive whole life insurance products.
Insurance operating costs and other expenses increased $3 for the year ended December 31, 2005 compared to the prior year as a result of business growth.
2004 Compared to 2003 - Net income increased $10 or 7% for the year ended December 31, 2004 as compared to the prior year, primarily driven by increases in both life insurance inforce and account values, resulting from business growth and improved investment spreads. The following factors contributed to the earnings increase:
variable annuities at the end of 2000, has grown significantly to become the largest distributor of variable annuities in Japan and the largest component of International.
The Japan MVA fixed annuity business contributed $13 of higher investment spread income, including net periodic coupon settlements included in realized losses, in 2005 compared to 2004. This increase in investment spread was driven by higher assets under management. As of December 31, 2005, Japan’s MVA assets under management increased to $1.5 billion compared to $502 in the prior year. The increase in fixed annuity assets under management can be attributed to sales of $1.2 billion for the year ending December 31, 2005 as compared to $521 for the prior year.
The increase in fee income was primarily attributed to higher variable annuity assets under management in our Japan operations. As of December 31, 2004, Japan’s variable annuity assets under management were $14.1 billion, a 127% increase from the previous year.
Net investment income includes the mark-to-market adjustment for equity securities held for trading which increased primarily due to increased assets and market performance in International. This increase net investment income is offset by an increase in benefit, claims and claim adjustment expenses which reflects the interest credited on the Japan account balance liability.
Property & Casualty derives its revenues principally from premiums earned for insurance coverages provided to insureds, investment income, and, to a lesser extent, from fees earned for services provided to third parties and net realized capital gains and losses. Premiums charged for insurance coverages are earned principally on a pro rata basis over the terms of the related policies in force.
Service fees principally include revenues from third party claims administration services provided by Specialty Risk Services and revenues from member contact center services provided through AARP’s Health Care Options program.
Net income is the measure of profit or loss used in evaluating the performance of Ongoing Operations and the Other Operations segment. Within Ongoing Operations, the underwriting segments of Business Insurance, Personal Lines and Specialty Commercial are evaluated by The Hartford’s management primarily based upon underwriting results. Underwriting results is a before-tax measure that represents earned premiums less incurred claims, claim adjustment expenses and underwriting expenses. Underwriting results within Ongoing Operations are influenced significantly by earned premium growth and the adequacy of the Company’s pricing. Underwriting profitability over time is also greatly influenced by the Company’s underwriting discipline, which seeks to manage exposure to loss through favorable risk selection and diversification, its management of claims, its use of reinsurance and its ability to manage its expense ratio which it accomplishes through economies of scale and its management of acquisition costs and other underwriting expenses. The Hartford believes that underwriting results provides investors with a valuable measure of before-tax profitability derived from underwriting activities, which are managed separately from the Company’s investing activities. Underwriting results is also
Through its Other Operations segment, Property & Casualty is responsible for managing operations of The Hartford that have discontinued writing new or renewal business as well as managing the claims related to asbestos and environmental exposures.
The Company considers several measures and ratios to be the key performance indicators for the property and casualty underwriting businesses. The following tables and the segment discussions for the years ended December 31, 2005, 2004 and 2003 include various premium measures and underwriting ratios. Management believes that these measures and ratios are useful in understanding the underlying trends in The Hartford’s property and casualty insurance underwriting business. However, these key performance indicators should only be used in conjunction with, and not in lieu of, underwriting income for the individual Property & Casualty segments and net income for the Property & Casualty business as a whole and may not be comparable to other performance measures used by the Company’s competitors.
Policies in force represent the number of policies with coverage in effect as of the end of the period. In both automobile and homeowners, the policy in force count in 2005 has increased as a result of the new Dimensions class plan rolled out in 2004 and 2005. The increase is also attributable to continued growth in AARP business, reflecting an increase in the penetration of the AARP
Included in both the prior year loss and loss adjustment expense ratio and the catastrophe ratio is prior accident year development on catastrophe losses, including, in 2004, the net reserve release of (3.1) points related to September 11.
pricing increases have moderated in Personal Lines as written pricing increases over the prior 6 to 12 months have declined. Earned pricing in Business Insurance was flat in 2005 as written pricing turned slightly negative during 2005 after having been favorable in 2004.
The current year loss and loss adjustment expense ratio is a measure of the cost of claims incurred in the current accident year divided by earned premiums. The prior year loss and loss adjustment expense ratio represents the increase (decrease) in the estimated cost of settling claims incurred in prior accident years as recorded in the current calendar year divided by earned premiums. Among other factors, the loss and loss adjustment expense ratio needed for the Company to achieve its targeted return on equity fluctuates from year to year based on changes in the expected investment yield over the claim settlement period, the timing of expected claim settlements and the targeted returns set by management based on the competitive environment. The current accident year loss and loss adjustment expense ratio decreased by 3.1 points from 2004 to 2005 due largely to a 2.0 point decrease in current accident year catastrophe losses. Also contributing to the improvement in the current accident year loss and loss adjustment expense ratio is improved current accident year performance for auto bodily injury and workers’ compensation claims, partially offset by the effect of an increase in non-catastrophe loss costs for property coverages.
The expense ratio is the ratio of underwriting expenses, excluding bad debt expense, to earned premiums. Underwriting expenses include the amortization of deferred policy acquisition costs and insurance operating costs and expenses. Deferred policy acquisition costs include commissions, taxes, licenses and fees and other underwriting expenses and are amortized over the policy term. While changes in the expense ratio vary by segment, the overall expense ratio for Ongoing Operations’ segments has increased from 2004 to 2005, primarily due to $64 of hurricane related assessments incurred in 2005 related to the 2004 and 2005 hurricanes.
The catastrophe ratio (a component of the loss and loss adjustment expense ratio) represents the ratio of catastrophe losses (net of reinsurance) to earned premiums. 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. By their nature, catastrophe losses vary dramatically from year to year. Based on the mix and geographic dispersion of premium written and estimates derived from various catastrophe loss models, the Company’s expected catastrophe ratio over the long-term is 3.0 points. Reinstatement premium represents additional ceded premium paid for the reinstatement of the amount of reinsurance coverage that was reduced as a result of a reinsurance loss payment. See “Risk Management Strategy” below for a discussion of the Company’s property catastrophe risk management program that serves to mitigate the Company’s net exposure to catastrophe losses. The catastrophe ratio includes the effect of catastrophe losses, but does not include the effect of reinstatement premiums. Current accident year catastrophe loss and loss adjustment expenses and reinstatement premiums were as follows in each period:
The combined ratio before catastrophes and prior accident year development represents the combined ratio for the current accident year, excluding the impact of catastrophes. The Company believes this ratio is an important measure of the trend in profitability since it removes the impact of volatile and unpredictable catastrophe losses and prior accident year reserve development. Before considering catastrophes, the combined ratio related to current accident year business has improved from 2004 to 2005 principally due to improved current accident year performance for auto bodily injury and workers’ compensation claims, partially offset by the effect of an increase in non-catastrophe loss costs for property coverages and an increase in the expense ratio, which was largely due to the hurricane-related assessments of $64 in 2005.
Due to the emphasis on preservation of capital and the need to maintain sufficient liquidity to satisfy claim obligations, the vast majority of Property & Casualty’s invested assets have been held in fixed maturities, including, among other asset classes, corporate bonds, municipal bonds, government debt, short-term debt, mortgage-backed securities and asset-backed securities. Based upon the fair value of Property & Casualty’s investments as of December 31, 2005 and 2004, approximately 94% and 96%, respectively, of invested assets were held in fixed maturities.
When fixed maturity or equity investments are sold, any gain or loss is reported in net realized capital gains (losses). Individual securities may be sold for a variety of reasons, including a decision to change the Company’s asset allocation in response to market conditions and the need to liquidate funds to meet large claim settlements Accordingly, net realized capital gains (losses) for any particular period are not predictable and can vary significantly. Refer to the Investment section of MD&A for further discussion of net investment income and net realized capital gains (losses).
Allocation of Invested Assets and Investment Income to Ongoing Operations and Other Operations
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.
Includes 2005 catastrophes of $365 and 2004 catastrophes of $507, before the net reserve release of $395 related to September 11.
Includes a $26 tax benefit related to tax years prior to 2004.
Includes net realized capital gains (losses), after tax, of $29, $87, and $165 for the years ended December 31, 2005, 2004 and 2003, respectively.
Net income increased $326, or 36%, as a result of a $535, or 45%, increase in income before income taxes. The increase in income before income taxes was driven primarily by the following:
A $172 reduction in current accident year catastrophe losses. Current accident year catastrophe losses of $351 in 2005 included losses from hurricanes Katrina, Rita and Wilma. Current accident year catastrophe losses of $523 in 2004 included losses from hurricanes Charley, Frances, Ivan and Jeanne.
A $117 increase in net investment income, primarily as a result of a larger investment base due to increased cash flows from underwriting, higher investment yields on fixed maturity investments and an increase in income from limited partnership investments,
An improvement in current accident year non-catastrophe loss and loss adjustment expenses for auto liability and workers’ compensation claims.
An $89 decrease in net realized capital gains due to lower net realized gains on the sale of fixed maturity investments and net losses on non-qualifying derivatives during 2005 compared to net gains during 2004.
An $88 increase in insurance operating costs, principally related to hurricane-related assessments. Hurricane-related assessments in 2005 were $64, primarily for assessments payable to the Florida Citizens Property Insurance Corporation (Citizens) as a result of losses incurred by Citizens from the 2004 and 2005 Florida hurricanes.
An increase in property non-catastrophe current accident year loss and loss adjustment expenses as a percentage of earned premium.
A $2.6 billion increase in asbestos and environmental reserves recorded in 2003,
An increase in underwriting profit derived from a $779 increase in earned premium, before considering the $90 reduction in earned premium on retrospectively-rated policies in 2004. The $779 increase in earned premium reflected growth in Business Insurance, Personal Lines and Specialty Commercial, partially offset by a $346 decline in Other Operations earned premium as a result of exiting the assumed reinsurance business.
A $194 increase in net unfavorable prior accident year development, before considering the $2.6 billion of net asbestos and environmental reserve strengthening in 2003. Refer to the Ongoing Operations and Other Operations sections herein.
Reserving for property and casualty losses is an estimation process. As additional experience and other relevant claim data become available, reserve levels are adjusted accordingly. Such adjustments of reserves related to claims incurred in prior years are a natural occurrence in the loss reserving process and are referred to as “reserve development.” Reserve development that increases previous estimates of ultimate loss costs is called “reserve strengthening.” Reserve development that decreases previous estimates of ultimate loss costs is called “reserve releases.” Reserve development can influence the comparability of year over year underwriting results and is set forth in the paragraphs and tables that follow. The “prior accident year development” in the following table represents the ratio of reserve development to earned premiums. For a detailed discussion of the Company’s reserve policies, see Notes 1, 11 and 12 of Notes to Consolidated Financial Statements and the discussion in Critical Accounting Estimates.
A rollforward of liabilities for unpaid claims and claim adjustment expenses by segment for Property & Casualty follows:
The “loss and loss expense paid ratio” represents the ratio of paid claims and claim adjustment expenses to earned premiums.
“Prior accident year development (pts)” represents the ratio of prior accident year development to earned premiums
In 2005, the current accident year provision for claim and claim adjustment expenses of $6.7 billion included net catastrophe loss and loss adjustment expenses of $351, of which $264 related to Hurricanes Katrina, Rita and Wilma. The following table shows current accident year catastrophe impacts in 2005, including reinstatement premium owed to reinsurers:
Included within prior accident year development for the year ended December 31, 2005 are the following reserve strengthenings (releases).
During the year ended December 31, 2005, the Company’s reestimates of prior accident year reserves included the following significant reserve changes.
Strengthened workers’ compensation reserves for claim payments expected to emerge after 20 years of development by $120. For workers’ compensation claims involving permanent disability, it is particularly difficult to estimate how such claims will develop more than 20 years after the year the claims were incurred. The revision was based on modeling using new techniques and extensive data gathering. The $120 of reserve strengthening represented 3% of the Company’s net reserves for workers’ compensation claims as of December 31, 2004.
Strengthened assumed reinsurance reserves by $85, principally for accident years 1997 through 2001. In recent years, the Company has seen an increase in reported losses above previous expectations and this increase in reported losses contributed to the reserve re-estimates. Assumed reinsurance exposures are inherently less predictable than direct insurance exposures because the Company may not receive notice of a reinsurance claim until the underlying direct insurance claim is mature. The reserve strengthening of $85 represents 6% of the $1.3 billion of net Reinsurance reserves within Other Operations as of December 31, 2004. 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, molestation, silica, pharmaceutical products and other long-tail liabilities.
Strengthened environmental reserves by $37 as a result of an environmental reserve evaluation completed during the third quarter of 2005. While the review found no apparent underlying cause or change in the claim environment, loss estimates for individual cases changed based upon the particular circumstances of each account. The $37 of reserve strengthening represented 1% of the Company’s net reserves for asbestos and environmental claims as of December 31, 2004.
The Company’s estimates of net loss and loss expenses arising from Hurricanes Charley, Frances, Ivan and Jeanne are based on information from reported claims and estimates of reinsurance recoverables on ceded losses. In the third quarter of 2004, the Company reinstated the limits under its reinsurance programs that were exhausted by the 2004 hurricanes, resulting in additional ceded premium of $17, which is reflected as a reduction in earned premium.
Included within prior accident year development for the year ended December 31, 2004 are the following reserve strengthenings (releases).
Strengthened reserves for construction defects claims by $190, representing 11% of the Company’s $1.8 billion of net reserves for general liability claims as of December 31, 2004. The Company’s construction defects claims, which relate primarily to accident years prior to 2000, have experienced increasing severity, particularly due to losses from contractors in California.
Includes transfer of reserves from Ongoing to Other Operations pursuant to the MacArthur settlement.
“Prior accident year development (pts)” represents the ratio of prior accident year development to earned premium.
Included within prior accident year development for the year ended December 31, 2003 are the following reserve strengthenings (releases).
Strengthened reserves in Specialty Commercial by $52, primarily as a result of losses in the bond and professional liability lines of business. The bond reserve strengthening was isolated to a few severe contract surety claims related to accident year 2002. The professional liability reserve strengthening involved a provision for anticipated settlements of reinsurance obligations for contracts outstanding at the time of the original acquisition of Reliance Group Holdings’ auto residual value portfolio in the third quarter of 2000.
The table below shows the range of annual reserve re-estimates experienced by The Hartford over the past five years. The amount of prior accident year development (as shown in the reserve rollforward) for a given calendar year is expressed as a percent of the beginning calendar year reserves, net of reinsurance. The percentage relationships presented are significantly influenced by the facts and circumstances of each particular year and by the fact that only the last five years are included in the range. Accordingly, these percentages are not intended to be a prediction of the range of possible future variability. See “Impact of key assumptions on reserve volatility” within Critical Accounting Estimates for further discussion of the potential for variability in recorded loss reserves.
The potential variability of the Company’s Property and 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 general, over the long term, the Company would expect the variability of its Personal Lines reserve estimates to be relatively less than the variability of the reserve estimates for its other property and casualty segments. The Company would expect the degree of variability of the remaining segments’ reserve estimates, from lower variability to higher variability, to be generally Business Insurance, Specialty Commercial, and Other Operations. The actual relative variability could prove to be different than anticipated.
The Company has several catastrophe reinsurance programs, including reinsurance treaties that cover property and workers’ compensation losses aggregating from single catastrophe events.
In addition to the reinsurance protection provided by The Hartford’s principal catastrophe reinsurance program, in November 2004, the Company purchased two fully collateralized, four-year reinsurance coverages for losses sustained from qualifying hurricane and earthquake loss events. The Company purchased this reinsurance from Foundation Re, a Cayman Islands reinsurance company, which financed the provision of reinsurance through the issuance of $248 in catastrophe bonds to investors under two separate bond tranches. The first coverage provides reinsurance protection above the Company’s principal reinsurance program and covers losses arising from large hurricane loss events affecting the Gulf and Eastern Coast of the United States. The coverage reinsures 45% of $400 in losses in excess of an index loss trigger equating to approximately $1.3 billion in Hartford losses. The index trigger has an estimated probability of attachment of approximately 1-in-100 years. The second coverage purchased by the Company reinsures 90% of $75 in losses in excess of an index loss trigger equating to approximately $125 in Hartford losses arising from qualifying hurricane and earthquake events. Qualifying hurricane and earthquake events are those which occur in the year following a large hurricane or earthquake event that has an estimated occurrence probability of 1-in-100 years. If industry loss estimates as of December 31, 2005 prove to be correct, neither Hurricane Katrina, Rita or Wilma would trigger a recovery under this program. Accordingly, the Company has not recorded any recoveries from Foundation Re.
hurricanes and from California, Pacific Northwest, and New Madrid earthquake events. Foundation Re financed the provision of this additional reinsurance through the issuance of $105 of catastrophe bonds to investors.
To manage the potential credit risk resulting from the use of reinsurance, a Reinsurance Security Committee, representing several disciplines within the Company (i.e. underwriting, legal, accounting, senior management), evaluates the credit standing, financial performance, management and operational quality of each potential reinsurer. Through that process, the committee maintains a list of reinsurers approved for participation on all treaty and facultative reinsurance placements. The Company’s approval designations reflect the differing credit exposure associated with various classes of business. Participation authorizations are categorized along property, short-tail casualty and long-tail casualty lines. In addition to defining participation eligibility, the Company regularly monitors each active reinsurer’s credit risk exposure in the aggregate and limits that exposure based upon independent credit rating levels.
Written premium is a statutory accounting financial measure which represents the amount of premiums charged for policies issued, net of reinsurance, during a fiscal period. Earned premium is a GAAP and statutory measure. Premiums are considered earned and are included in the financial results on a pro rata basis over the policy period. Management believes that written premium is a performance measure that is useful to investors as it reflects current trends in the Company’s sale of property and casualty insurance products. Statutory accounting principles allow companies to report written premium for workers’ compensation business in either the period the premiums are billed or the period the policies incept. Prior to the fourth quarter of 2005, premiums for most workers’ compensation policies were recognized as written in the period the premiums were billed. In the fourth quarter of 2005, the Company changed its statutory accounting practice for workers’ compensation premium to recognize the premium as written in the period the policies incept,
The difference between written premiums and earned premiums is attributable to the change in unearned premium reserve.
Earned premium growth of $486 in Business Insurance was primarily driven by new business premium growth outpacing non-renewals in the prior 12 months. Earned premium growth of $165 in Personal Lines was primarily driven by new business growth outpacing non-renewals in auto and the effect of earned pricing increases in homeowners.
Business Insurance and Personal Lines earned premiums increased by $867 due to earned pricing increases and new business premium growth outpacing non-renewals.
Net income for Ongoing Operations includes underwriting results for each of its segments, income from servicing business, net investment income, other expenses and net realized capital gains (losses), net of related income taxes.
A $171 decrease in current accident year catastrophe losses. Catastrophe losses in 2005 included $264 of losses from Hurricanes Katrina, Rita and Wilma, whereas catastrophe losses in 2004 included $394 of losses from Hurricanes Charley, Frances, Ivan and Jeanne,
A $75 release of workers’ compensation reserves in 2005 related to accident years 2003 and 2004, and
Reserve strengthening of $33 related to the third quarter 2004 hurricanes.
A $67 increase in net investment income, primarily as a result of an increase in underwriting cash flow, partially offset by a decrease in the before-tax investment yield, and
A $53 decrease in net realized capital gains due to lower net realized gains on the sale of fixed maturity investments, and
A $362 improvement in current accident year underwriting results before catastrophes, with a corresponding 3.1 point improvement in the combined ratio before catastrophes and prior accident year development, and
Partially offsetting these improvements were factors decreasing underwriting results and increasing the combined ratio:
The $362 improvement in current accident year underwriting results before catastrophes is due to earned premium growth and an improvement in the combined ratio before catastrophes and prior accident year development, partially offset by the effect of a $90 decrease in earned premium on retrospectively rated policies recorded in 2004. The combined ratio before catastrophes and prior accident year development improved 3.1 points, to 89.7, primarily due to strong earned pricing, an improvement in non-catastrophe current accident year loss and loss adjustment expenses and a 0.9 point improvement in the expense ratio.
Earned premiums for Business Insurance increased $486, or 11%, in 2005, primarily due to new business growth outpacing non-renewals in both small commercial and middle market over the preceding twelve months and modest earned pricing increases in small commercial, partially offset by earned pricing decreases in middle market.
Growth in small commercial earned premium was driven primarily by growth in workers’ compensation and package business for both Select Xpand and traditional Select. New business written premium for small commercial increased by $6, as an increase in new business for workers’ compensation was largely offset by a decrease in new business for package and commercial auto. Premium renewal retention for small commercial increased from 83% to 86% in 2005, excluding the impact of modest written pricing increases.
Growth in middle market earned premium was driven primarily by growth in workers’ compensation and marine, partially offset by a decrease in property and commercial auto. New business written premium for middle market increased by $22 for the year ended December 31, 2005, mostly related to workers’ compensation business. Premium renewal retention for middle market increased from 83% to 86%, excluding the impact of written pricing decreases, as stronger retention on smaller accounts was partially offset by a decrease in retention on larger accounts.
Written pricing for small commercial increased 4% in the last six months of 2004 and 2% in 2005.
Written pricing for middle market decreased 2% in the last six of 2004 and 5% in 2005.
Growth in small commercial earned premiums was driven primarily by written premium growth for Select Xpand. The new business premium growth of $172 in Small Commercial was due primarily to growth from the Select Xpand product and growth from an increase in the number of agents, partially offset by the moderation in written pricing increases.
Premium renewal retention remained strong, decreasing slightly from 87% for the year ended December 31, 2003 to 85% for the year ended December 31, 2004. Written pricing decreases for middle market during 2004 contributed to the decrease in premium renewal retention.
For the year ended December 31, 2004, earned pricing increased 7% for small commercial and 3% for middle market. As substantially all premiums in the segment are earned over a 12 month policy period, earned pricing changes for the year ended December 31, 2004 primarily reflect written pricing increases of 9% during the last six months of 2003 and 2% in 2004.
A $58 decrease in current accident year catastrophe losses. Catastrophe losses in 2005 for Hurricanes Katrina, Rita and Wilma were $68 compared to catastrophe losses in 2004 for Hurricanes Charley, Frances, Ivan and Jeanne of $98,
A $50 strengthening of workers’ compensation reserves during 2005 related to reserves for claim payments expected to emerge after 20 years of development,
A $40 strengthening of general liability reserves during 2005 for accident years 2000-2003 due to higher than anticipated loss payments beyond four years of development, and
Partially offsetting the improvements in underwriting results was a $40 increase in current accident year catastrophe losses due to losses from Hurricanes Charley, Frances, Ivan and Jeanne during the third quarter of 2004.
Management expects written pricing trends in 2006 to be affected by increased competition. While the increase in written pricing for small commercial business was 2% in 2005, management expects written pricing for small commercial to be flat to slightly negative for 2006. For middle market business, pricing continued to decline in the fourth quarter of 2005, particularly for property business in geographic areas not prone to catastrophes and in non-property lines of business. While written pricing for middle market business in 2005 declined by 5%, management believes that pricing declines will lessen somewhat as higher reinsurance costs are reflected in the market. Loss costs are expected to increase in 2006 as increasing claim severity is expected to outpace favorable claim frequency. As a result of the anticipated slight decrease in written pricing and increase in loss costs, management expects the current accident year loss and loss expense ratio for Business Insurance to increase moderately in 2006.
Earned premiums increased $165, or 5%, due primarily to earned premium growth in both AARP and Agency, partially offset by a reduction in Other Affinity and Omni.
AARP earned premium grew $150, or 7%, reflecting an increase in the penetration of the AARP target market and the effect of direct marketing programs to increase premium writings, particularly in auto.
Agency earned premium grew $90, or 10%, as a result of continued growth of the Dimensions class plans first introduced in 2004. Dimensions, which has been rolled out to 41 states for auto and 37 states for homeowners, allows Personal Lines to write a broader class of risks.
Auto earned premium grew $106, or 4%, primarily from growth in AARP and Agency, offset by a decline in Omni and Other Affinity auto business. Before considering the decline in Omni and Other Affinity business, auto earned premium grew $240, or 8%. Homeowners earned premium grew $59, or 7%, due to growth in AARP and Agency business, partially offset by a decline in Other Affinity business. Consistent with the growth in earned premium, the number of policies in force has increased in auto and homeowners from 2,166,922 and 1,348,573, respectively, as of December 31, 2004 to 2,222,688 and 1,384,364, respectively, as of December 31, 2005. The growth in policies in force does not correspond directly with the growth in earned premiums due to the effect of earned pricing changes and because policy in force counts are as of a point in time rather than over a period of time.
Auto new business written premium was $426 in 2005, down $43 from the prior year, due primarily to a $52 decline in Omni new business and, to a lesser extent, a decline in Agency and Other Affinity new business, partially offset by an increase in AARP new business. Homeowners’ new business written premium was $131 in 2005, up $16 from the prior year, primarily due to an increase in Agency new business written premium.
Premium renewal retention for automobile decreased from 89% to 87% and premium renewal retention for homeowners decreased from 100% to 94%, primarily due to a decrease in retention of Agency business.
Written pricing for automobile increased 2% in the last six months of 2004 but was flat in 2005.
Earned premiums increased $264 due to growth in both AARP and Agency, partially offset by a reduction in Other Affinity earned premium. Earned premiums for Omni were flat from 2003 to 2004.
For the year ended December 31, 2004, new business premiums in AARP and Agency were $311 and $167, respectively, which was up from $226 and $105, respectively, for the year ended December 31, 2003.
Premium renewal retention for automobile decreased from 91% to 89%. The decrease in premium renewal retention for automobile was driven largely by the impact of declining written pricing increases. Premium renewal retention for homeowners decreased from 101% to 100%, also due to declining written pricing increases.
Written pricing for homeowners increased 13% in the last six months of 2003 and 9% in 2004.
A $95 reduction in prior accident year reserves for allocated loss adjustment expenses, predominantly related to auto liability claims, and
A $58 improvement in current accident year underwriting results derived from earned premium growth at a combined ratio less than 100.0, as well as from a decrease in the combined ratio before catastrophes and prior accident year development of 1.0 point, from 88.2 to 87.2.
The 1.0 point improvement in the combined ratio before catastrophes and prior accident year development was primarily due to a lower current accident year loss and loss adjustment expense ratio for auto liability claims and earned pricing increases for homeowners business slightly outpacing increases in non-catastrophe property loss costs, partially offset by the effect of the $24 increase in reinstatement premiums. The lower current accident year loss and loss adjustment expense ratio for auto liability claims was consistent with the favorable prior accident year development on auto liability allocated loss adjustment expense reserves recognized in 2005. Within homeowners, an increase in loss costs was due entirely to increasing claim severity. The expense ratio increased by 0.6 points, to 23.7, primarily due to $31 of hurricane-related assessments in 2005.
In 2004, underwriting results increased $8 and the combined ratio remained relatively flat at 96.0. Net prior accident year development was not significant in either 2004 or 2003. As a result, the net increase in underwriting results was principally driven by a $142 improvement resulting from earned premium growth at a combined ratio less than 100.0 and from a decrease in the combined ratio before catastrophes and prior accident year development of 3.5 points, from 91.7 to 88.2. Largely offsetting this improvement was a $124 increase in current accident year catastrophe losses due to losses from hurricanes Charley, Frances, Ivan and Jeanne during the third quarter of 2004.
The 3.5 point decrease in the combined ratio before catastrophes and prior year development was primarily due to earned pricing increases and favorable claim frequency, partially offset by increased claim severity. The expense ratio remained relatively flat at 23.1%, despite earned premium growth, because of higher commissions as a result of increased Agency business and increased other underwriting expenses.
In 2006, the Personal Lines segment is expected to deliver written premium growth in the mid-single digits, including growth from both AARP and Agency. In 2006, the Company will continue to pursue a number of strategies to promote growth and profitability. Within the AARP business, growth is expected through an increase in marketing to AARP members, including the expansion of its AARP direct response television marketing initiative. Within the Agency business, these strategies include refinement of its Dimensions class
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 bond, professional liability, specialty casualty and livestock 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, loss control and performance measurement through Specialty Risk Services.
Earned premiums for the Specialty Commercial segment increased by $31, or 2%, due to a $247 increase in casualty, bond, professional liability and other earned premiums, partially offset by a $216 decrease in property earned premiums.
Casualty earned premiums grew $152, or 24%, primarily because earned premium in 2004 included a $90 decrease in earned premiums under retrospectively-rated policies. The remaining growth of $62 was largely attributable to the effect of earned pricing increases, partially offset by a decrease in new business growth. In 2005 and 2004, a single captive insurance program accounted for earned premium of $241 and $226, respectively. While this program was not renewed, the non-renewal is not expected to have a significant impact on Specialty Commercial’s underwriting results in 2006.
Professional liability earned premium increased $10, or 3%, primarily due to a decrease in the portion of risks ceded to outside reinsurers, partially offset by earned pricing decreases.
Bond earned premium grew $36, or 24%, primarily as a result of an increase in contract surety business and a decrease in ceded premiums, partially offset by a slight decrease in premium renewal retention.
Underwriting results decreased by $112, with a corresponding 6.3 point increase in the combined ratio to 109.4. Underwriting results of ($53) in 2004 included a $90 decrease in earned premiums under retrospectively rated policies. Before the decrease in earned premiums under retrospectively-rated policies, underwriting results decreased by $202, principally driven by the following factors:
A $40 increase in unfavorable prior accident year loss development. Prior accident year loss development of $109 in 2005 consisted primarily of $70 of reserve strengthening for workers’ compensation reserves for claim payments expected to emerge after 20 years of development and $20 of reserve development for large deductible workers’ compensation reserves. Reserve development in 2005 also included a release of reserves for directors and officers insurance related to accident years 2003 and 2004 and strengthening of prior accident year reserves for contracts that provide auto financing gap coverage and auto lease residual value coverage; the release and offsetting strengthening were each approximately $80. Prior accident year loss development of $69 in 2004 included $167 of reserve strengthening for construction defect claims, a release of $116 in September 11 reserves and strengthening in large deductible workers’ compensation reserves and a release in other liability reserves, each approximately $150.
A $17 increase in unfavorable prior accident year loss development. Prior accident year loss development of $69 in 2004 included $167 of reserve strengthening for construction defect claims, a release of $116 in September 11 reserves and strengthening in large deductible workers’ compensation reserves and a release in other liability reserves, each approximately $150. Prior accident year loss development of $52 in 2003 consisted primarily of $20 of reserve strengthening for a few severe contract surety claims related to accident year 2002 and a $25 provision for anticipated settlements on reinsurance obligations for contracts outstanding at the time of the original acquisition of Reliance Group Holdings’ auto residual value portfolio in the third quarter of 2000.
Specialty Commercial is comprised of businesses that provide specialized or customized products within niche markets. Management expects each of these businesses to maintain underwriting discipline in 2006 in an increasingly competitive environment. Accordingly, written premium growth is not a primary objective for the Specialty Commercial segment. Rather, the Company will grow opportunistically where risks are adequately priced to achieve targeted returns. Management expects to grow written premium in 2006 primarily in property and professional liability. The growth in property will likely come from new business growth and written pricing increases. A decrease in the percentage of risks ceded to reinsurers will likely contribute to the growth in professional liability written premium. Largely offsetting this growth, casualty written premiums will likely decline given the non-renewal of a captive insurance program which represented $241 of written premium in 2005. The non-renewal of this program is not expected to have a significant impact on underwriting results.
A $222 increase in underwriting results, primarily due to a $197 decrease in prior year loss development. Reserve development in 2005 included $85 of reserve strengthening for assumed reinsurance, $37 of environmental reserve strengthening, and a $20 increase in the allowance for uncollectible reinsurance. In 2004, reserve development was driven by a $181 provision for the reinsurance recoverable asset associated with older, long-term casualty liabilities, $170 of reserve strengthening for assumed reinsurance, and $75 of environmental reserve strengthening, which was partially offset by a $97 release of September 11 reserves.
A $70 decrease in income tax benefit (expense) reflecting an increase in income before taxes.
A $2.4 billion increase in underwriting results, primarily due to a $2.4 billion decrease in prior year loss development. Reserve development in 2004 included a $181 provision for the reinsurance recoverable asset associated with older, long-term casualty liabilities, $170 of reserve strengthening for assumed reinsurance, and $75 of environmental reserve strengthening, which was partially offset by a $97 release of September 11 reserves. In 2003, reserve development was driven by $2.6 billion of asbestos reserve strengthening. The $346 decrease in earned premiums and related decrease of $266 in current year benefits, claims and claim adjustment expenses were the result of the Company’s decision to exit from the assumed reinsurance business in the second quarter of 2003.
A $768 decrease in income tax benefit reflecting a decrease in the loss before taxes.
Given the factors and emerging trends described above, the Company believes the actuarial tools and other techniques it employs to estimate the ultimate cost of claims for more traditional kinds of insurance exposure are less precise in estimating reserves for its asbestos and environmental exposures. For this reason, the Company relies on exposure-based analysis to estimate the ultimate costs of these claims and regularly evaluates new information in assessing its potential asbestos and environmental exposures.
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 or late-emerging 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 collectibility associated with asbestos, environmental, and other claims recoverable from reinsurers.
“All Other” also includes unallocated loss adjustment expense reserves and the allowance for uncollectible reinsurance.
Gross of reinsurance, asbestos and environmental reserves, including liabilities in Ongoing Operations, were $3,845 and $432, respectively, as of December 31, 2005, $4,322 and $501, respectively, as of December 31, 2004, and $5,884 and $542, respectively, as of December 31, 2003.
The one year and average three year net paid amounts for asbestos claims, including Ongoing Operations, are $215 and $526, respectively, resulting in a one year net survival ratio of 10.7 and a three year net survival ratio of 4.4 (12.7 excluding the MacArthur payments). Net survival ratio is the quotient of the net carried reserves divided by the average annual payment amount and is an indication of the number of years that the net carried reserve would last (i.e. survive) if the future annual claim payments were consistent with the calculated historical average.
The Company has been evaluating and closely monitoring assumed reinsurance reserves in Other Operations. For the years ended December 31, 2004 and December 31, 2003, the Company booked unfavorable reserve development of $170 and $129, respectively, related to HartRe assumed reinsurance. The Company reviewed certain of HartRe’s assumed reinsurance reserves during the first and second quarters of 2005. Unfavorable trends continued into 2005 and, as a result, the Company increased reserves by $12 and $73 in
During the second quarters of 2005 and 2004, the Company completed its annual evaluations of the reinsurance recoveries associated with older, long-term casualty liabilities reported in the Other Operations segment. In conducting these reviews, the Company used its most recent detailed evaluations of ceded liabilities reported in the segment, including its estimate of future claims, the reinsurance arrangements in place and the years of potential reinsurance available. In each of these reviews, the Company also 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 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, and contemplates recoveries under ceded reinsurance contracts and settlements of disputes that could be different than the ceded liabilities. As a result of the evaluation in the second quarter of 2005, the Company increased its allowance for uncollectible reinsurance by $20 to reflect deterioration in the credit ratings of certain reinsurers and the Company’s opinion as to the ability of certain reinsurers to pay claims in the future. As a result of the evaluation in the second quarter of 2004, the Company reduced its estimated net reinsurance recoverable by $181, which was comprised of a $126 reduction of ceded amounts and a $55 increase in the allowance for uncollectible reinsurance. In the second quarter of 2004, the Company also consolidated within the “all other” category its allowance for reinsurer credit quality and disputes that might affect reinsurance coverage associated with Other Operations into a single allowance.
During the second quarter of 2005, the Company completed its annual asbestos reserve evaluation. As part of this evaluation, the Company reviewed all of its open direct domestic insurance accounts exposed to asbestos liability as well as assumed reinsurance accounts and certain closed accounts. The Company also examined its London Market exposures for both direct insurance and assumed reinsurance. The evaluation indicated no change in the overall gross or net reserves.
On December 19, 2003, Hartford Accident and Indemnity Co. (“Hartford A&I”) entered into a settlement agreement with MacArthur Co. and its subsidiary, Western MacArthur Co. Under the settlement agreement, during the first quarter of 2004, Hartford A&I paid $1.15 billion into an escrow account owned by Hartford A&I. The funds were held in the escrow account until conditions precedent to the settlement occurred. On April 22, 2004, the funds were disbursed from the escrow account into a trust established for the benefit of present and future asbestos claimants pursuant to the bankruptcy plan. The settlement payments were accounted for as a reduction in unpaid claim and claim adjustment expenses during the first quarter of 2004.
In the first quarter of 2003, several events occurred that in the Company’s view confirmed the existence of a substantial long-term deterioration in the asbestos litigation environment. As a result of these worsening conditions, the Company conducted a comprehensive evaluation of its asbestos exposures in an effort to project, beginning at the individual account level, the effect of these trends on the Company’s estimated total exposure to asbestos liability. Based on the Company’s evaluation of the deteriorating conditions, the Company strengthened its gross and net asbestos reserves by $3.9 billion and $2.6 billion, respectively. The reserve strengthening related primarily to policies effective in 1985 or prior years. The Company had incorporated an absolute asbestos exclusion in most of its general liability policies written after 1985.
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, 2005 of $2.7 billion ($2.3 billion and $360 for asbestos and environmental, respectively) is within an estimated range, unadjusted for covariance, of $2.0 billion to $3.1 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. Due to these uncertainties, 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.
Excludes asbestos and environmental paid and incurred loss and LAE reported in Ongoing Operations. Total gross claim and claim adjustment expenses paid in Ongoing Operations for the twelve months ended December 31, 2005, 2004, and 2003 includes $23, $11, and $13, respectively, related to asbestos and environmental claims. Total gross claim and claim adjustment expenses incurred in Ongoing Operations for the twelve months ended December 31, 2005, 2004, and 2003 includes $17, $14, and $13, respectively, related to asbestos and environmental claims.
The Hartford’s investment portfolios are primarily divided between Life and Property & Casualty. The investment portfolios of Life and Property & Casualty are managed by HIMCO, a wholly-owned subsidiary of The Hartford. HIMCO manages the portfolios to maximize economic value, while attempting to generate the income necessary to support the Company’s various product obligations, within internally established objectives, guidelines and risk tolerances. The portfolio objectives and guidelines are developed based upon the asset/liability profile, including duration, convexity and other characteristics within specified risk tolerances. The risk tolerances considered include, for example, asset and credit issuer allocation limits, maximum portfolio below investment grade (“BIG”) holdings and foreign currency exposure. The Company attempts to minimize adverse impacts to the portfolio and the Company’s results of operations due to changes in economic conditions through asset allocation limits, asset/liability duration matching and through the use of derivatives. For a further discussion of how the investment portfolio’s credit and market risks are assessed and managed, see the Investment Credit Risk and Capital Markets Risk Management sections of the MD&A.
Fluctuations in interest rates affect the Company’s return on, and the fair value of, fixed maturity investments, which comprised approximately 72% and 80% of the fair value of its invested assets as of December 31, 2005 and 2004, respectively. Other events beyond the Company’s control could also adversely impact the fair value of these investments. Specifically, a downgrade of an issuer’s credit rating or default of payment by an issuer could reduce the Company’s investment return.
The Company invests in private placement securities, mortgage loans and limited partnership arrangements in order to further diversify its investment portfolio. These investment types comprised approximately 18% and 16% of the fair value of its invested assets as of December 31, 2005 and 2004, respectively. These security types are typically less liquid than direct investments in publicly traded fixed income or equity investments. However, generally these securities have higher yields to compensate for the liquidity risk.
The fair value for fixed maturity securities is largely determined by one of three primary pricing methods: independent third party pricing service market quotations, independent broker quotations or pricing matrices, which use data provided by external sources. With the exception of short-term securities for which amortized cost is predominantly used to approximate fair value, security pricing is applied using a hierarchy or “waterfall” approach whereby prices are first sought from independent pricing services with the remaining unpriced securities submitted to brokers for prices or lastly priced via a pricing matrix.
Derivative instruments are reported at fair value based upon either pricing valuation models, which utilize independent third party data as inputs, or broker quotations. Other than the GMWB rider and the associated reinsurance contracts, which are discussed in the Critical Accounting Estimates section of the MD&A under “Valuation of Guaranteed Minimum Withdrawal Benefit Derivatives”, approximately 81% and 69% of derivatives, based upon notional values, were priced via valuation models, while the remaining 19% and 31% of derivatives were priced via broker quotations, as of December 31, 2005 and 2004, respectively.
Fixed maturity investments increased $281, or 1%, since December 31, 2004, primarily the result of positive operating cash flows, product sales and a decrease in long-term interest rates, substantially offset by an increase in short-term to intermediate-term interest rates, credit spread widening and foreign currency depreciation in comparison to the U.S. dollar for foreign denominated securities. Equity securities held for trading increased $10.4 billion, or 76%, since December 31, 2004, due to positive cash flow primarily generated from sales and deposits related to variable annuity products sold in Japan and positive performance of the underlying investment funds supporting the Japanese variable annuity product, partially offset by foreign currency depreciation in comparison to the U.S. dollar. Policy loans decreased $646, or 24%, since December 31, 2004, as a result of certain policy loan surrenders. Mortgage loans increased $590, or 64%, since December 31, 2004, as a result of a decision to increase Life’s investment in this asset class primarily due to its attractive yields and diversification opportunities.
Represents annualized net investment income (excluding income related to equity securities held for trading) divided by the monthly weighted average invested assets at cost or amortized cost, as applicable, excluding equity securities held for trading, the collateral received associated with the securities lending program and consolidated variable interest entity minority interests.
The Japanese fixed annuity contract hedges amount consists of the foreign currency transaction remeasurements associated with the yen denominated fixed annuity contracts offered in Japan and the corresponding offsetting cross currency swaps. Although the Japanese fixed annuity contracts are economically hedged, the net realized capital losses result from the mixed attribute accounting model, which requires fixed annuity liabilities to be recorded at cost but the associated derivatives to be reported at fair value. The net realized capital losses in 2005 resulted from rising Japanese interest rates, and in the first half of the year, a decrease in U.S. interest rates. For additional discussion of the Japanese fixed annuity contract hedges see the Capital Markets Risk Management section of the MD&A under “Market Risk-Life” and Note 4 of Notes to Consolidated Financial Statements. The periodic net coupon settlements on credit derivatives and the Japan fixed annuity cross currency swaps includes the net periodic income/expense or coupon associated with the swap contracts. The net loss for 2005 is associated with the Japan fixed annuity cross currency swaps and results from the interest rate differential between U.S. and Japanese interest rates. The Japanese fixed annuity product was first offered by the Company in the fourth quarter 2004. The adverse change in 2005 in comparison to 2004 primarily resulted from a full year of the Japanese fixed annuity product swap accruals in 2005.
In 2005, gross gains were primarily within fixed maturities and included corporate, foreign government securities and CMBS. Corporate securities were sold primarily to reduce the Company’s exposure to certain lower credit quality issuers. The sale proceeds were primarily re-invested into higher credit quality securities. The gains on sales of corporate securities were primarily the result of credit spread tightening since the date of purchase. Foreign securities were sold primarily to reduce the foreign currency exposure in the portfolio due to the expected near term volatility in foreign exchange rates and to capture gains resulting from credit spread tightening since the date of purchase. The CMBS sales resulted from a decision to divest securities that were backed by a single asset due to the then scheduled expiration of the Terrorism Risk Insurance Act at the end of 2005. Gains on these sales were realized as a result of an improved credit environment and interest rate declines from the date of purchase.
and, therefore, have a gradual impact on the overall portfolio yield. The weighted average yield on new invested asset purchases in 2004 of approximately 4.9%, before-tax, was below the average portfolio yield.
Investment objectives for non-guaranteed separate accounts, which consist of the participants’ account balances, vary by fund account type, as outlined in the applicable fund prospectus or separate account plan of operations. Non-guaranteed separate account products include variable annuities (except those sold in Japan), variable universal life insurance contracts and variable corporate owned life insurance. The assets and liabilities associated with variable annuity products sold in Japan do not meet the criteria to be recognized as a separate account because the assets are not legally insulated from the Company. Therefore, these assets are included with the Company’s general account assets effective January 1, 2004. As of December 31, 2005 and 2004, the Company’s non-guaranteed separate accounts totaled $150.9 billion and $140.0 billion, respectively.
Due to significant holdings in tax-exempt investments, after-tax net investment income and yield are also included.
In 2004, the yield on average invested assets decreased slightly from the prior year as a result of new investment purchases at rates below the average portfolio yield due to the continued low interest rate environment. Since the Company invests primarily in long-term fixed rate debt securities, changes in long-term interest rates impact the yield on new asset purchases and, therefore, have a gradual impact on the overall portfolio yield. The weighted average yield on new asset purchases in 2004 of approximately 4.9%, before-tax, was below the average portfolio yield.
Net realized capital gains for 2004 decreased $120 as compared to the prior year as a result of lower net realized gains on sales of fixed maturity securities, partially offset by lower other-than-temporary impairments. For further discussion of other-than-temporary impairments, see the Other-Than-Temporary Impairments commentary in this section of the MD&A.
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, 2005 and 2004, Corporate held $298 and $159, respectively, of fixed maturity investments. In addition, Corporate held $7 of other investments as of December 31, 2004.
The Company utilized qualitative and quantitative analyses to assess whether it was the primary beneficiary of the VIEs. The qualitative considerations included the Company’s co-investment in relation to the total CLO issuance. The quantitative analysis included calculating the variability of the CLO issuance based upon statistical techniques utilizing historical normalized default and recovery rates for the average credit quality of the initial referenced bank loan portfolio.
The Company has a 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 market value and a realized loss is recorded in the Company’s consolidated statements of operations. For further discussion regarding the Company’s other-than-temporary impairment policy, see “Evaluation of Other-Than-Temporary Impairments on Available-for-Sale Securities” included in the Critical Accounting Estimates section of the MD&A and Note 1 of Notes to Consolidated Financial Statements.
During 2005 there were no significant other-than-temporary impairments (e.g. $15 or greater) recorded on any single security or issuer. Other-than-temporary impairments recorded on ABS primarily related to deterioration of the underlying collateral supporting several securities and included $3 recorded on aircraft lease receivables related to one major U.S. carrier. These receivables are secured by certain older aircraft that recently experienced a significant decline in value. Other-than-temporary impairments recorded on equity securities primarily related to variable rate perpetual preferred securities issued by one highly-rated financial services company. These securities had sustained a decline in market value for an extended period of time as a result of issuer credit spread widening. Other-than-temporary impairments recorded on corporate securities were primarily the result of the Company’s uncertainty regarding its intent and ability to retain the investment for a period of time sufficient to allow for an anticipated recovery, not to the Company’s expectations regarding the issuers’ payments based upon the contractual terms of the securities. The circumstances giving rise to the decline in value of these corporate securities since the date of purchase and potential impact on other material holdings of these issuers are as follows:
Also included in the corporate securities other-than-temporary impairment amount for 2005 was $9 recorded on securities related to two major automotive manufacturers. The market values of these securities had fallen due to a downward adjustment in earnings and cash flow guidance primarily due to sluggish sales, rising employee and retiree benefit costs and an increased debt service burden. These investments continue to perform in accordance with the contractual terms of the securities. As of December 31, 2005, the Company held approximately $137 of securities issued by these two companies in a total net unrealized loss position of $7. Substantially all of the securities in an unrealized loss position, as of December 31, 2005, were depressed only to a minor extent and, as a result, the unrealized losses were deemed to be temporary in nature.
The $30 of the other-than-temporary impairments recorded on equity securities primarily related to various diversified mutual funds. The market values of these funds had fallen since the date of purchase due to declines in primarily the equity markets and were not expected to recover within a reasonable period of time. Due to the severity of the price depression and length of time the holdings were in an unrealized loss position, these securities were deemed to be other-than-temporarily impaired.
derivative contracts, other than exchange traded contracts and currency forward contracts, be governed by an International Swaps and Dealers Association Master Agreement which is structured by legal entity and by counterparty and permits right of offset. To date, the Company has not incurred any losses on derivative instruments due to counterparty nonperformance.
Total return swaps and credit spreadlocks involve the periodic exchange of payments with other parties, at specified intervals, calculated using the agreed upon index and notional principal amounts. Generally, no cash or principal payments are exchanged at the inception of the contract. Typically, at the time a swap is entered into, the cash flow streams exchanged by the counterparties are equal in value. As of December 31, 2005 and 2004, the notional value of total return swaps and credit spreadlocks totaled $1.9 billion and $1.5 billion, respectively, and the fair value totaled $5 and $6, respectively.
At the January 2006 Federal Open Market Committee (“FOMC”) meeting, the Federal Reserve increased the target federal funds rate by 25 basis points to 4.50%, a 225 basis point increase from year-end 2004 levels. The FOMC stated that although recent economic data has been uneven, the expansion in economic activity appears solid, core inflation has stayed relatively low in recent months and longer-term inflation expectations remain contained. They noted that some further increases may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. The Company believes the Federal Reserve is approaching the end of its rate tightening cycle with an increase or two possible during the first half of 2006. Ultimately, the level of rate increases will be largely dependent on future inflationary data. The risk of inflation could increase for a number of reasons including an increase in energy and commodity prices, an acceleration of wage rates, a slow down of productivity growth, an increase in U.S. budget or trade deficits or the U.S. dollar significantly depreciating in comparison to foreign currencies. Increases in future interest rates may result in lower fixed maturity valuations.
As of December 31, 2005 and 2004, the Company held no issuer of a BIG security with a fair value in excess of 4% of the total fair value for BIG securities. Total BIG securities decreased since December 31, 2004, as a result of a decision to reduce exposure to lower credit quality assets resulting from the securities’ significant credit spread tightening and re-investment in higher quality securities.
The following table presents the Company’s unrealized loss aging for total fixed maturity and equity securities classified as available-for-sale on a consolidated basis, as of December 31, 2005 and 2004, by length of time the security was in an unrealized loss position.
The increase in the unrealized loss amount since December 31, 2004, is primarily the result of an increase in short-term through intermediate-term interest rates as well as credit spread widening and foreign currency depreciation in comparison to the U.S. dollar for foreign denominated securities offset in part by asset sales, a decrease in long-term interest rates and other-than-temporary impairments taken during the year. For further discussion, see the economic commentary under the Consolidated Fixed Maturities by Type table in this section of the MD&A.
The average security unrealized loss at December 31, 2005 and 2004, as a percentage of amortized cost was less than 3% and 2%, respectively. As of December 31, 2005 and 2004, fixed maturities represented $750, or 99%, and $252, or 95%, respectively, of the Company’s total unrealized loss associated with securities classified as available-for-sale. There were no fixed maturities, as of December 31, 2005 and 2004, with a fair value less than 80% of the security’s amortized cost basis for six continuous months other than certain ABS and CMBS subject to EITF Issue No. 99-20. Other-than-temporary impairments for certain ABS and CMBS are recognized if the fair value of the security, as determined by external pricing sources, is less than its cost or amortized cost and there has been a decrease in the present value of the expected cash flows since the last reporting period. There were no ABS or CMBS included in the table above, as of December 31, 2005 and 2004, for which management’s best estimate of future cash flows adversely changed during the reporting period for which an impairment has not been recorded. For further discussion of the other-than-temporary impairments criteria, see “Evaluation of Other-Than-Temporary Impairments on Available-for-Sale Securities” included in the Critical Accounting Estimates section of the MD&A and Note 1 of Notes to Consolidated Financial Statements.
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. In addition, for securitized financial assets with contractual cash flows (e.g. ABS and CMBS), projections of expected future cash flows may change based upon new information regarding the performance of the underlying
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.
Life’s exposure to interest rate risk relates to the market price and/or cash flow variability associated with changes in market interest rates. 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 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 CMOs. The fair value of Life’s fixed maturities was $50.8 billion and $50.5 billion at December 31, 2005 and 2004, 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. During periods of declining interest rates, paydowns on MBS and CMOs increase as the underlying mortgages are prepaid. During such periods, the Company generally will not be able to re-invest the proceeds of any such prepayments at comparable yields. Conversely, during periods of rising interest rates, the rate of prepayments generally declines, exposing the Company to the possibility of asset/liability cash flow and yield mismatch. The weighted average
duration of the fixed maturity portfolio was approximately 5.3 and 5.0 years as of December 31, 2005 and 2004, respectively. In 2005, the duration of certain Life portfolios were modestly lengthened, which generated additional interest income.
The Company also manages the risk of certain insurance liabilities similarly to 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.
At December 31, 2005 and 2004, notional amounts pertaining to derivatives utilized to manage interest rate risk totaled $10.6 billion and $9.9 billion, respectively ($7.5 billion and $7.7 billion, respectively, related to investments and $3.1 billion and $2.2 billion, respectively, related to life liabilities). The fair value of these derivatives was $(22) and $41 as of December 31, 2005 and 2004, respectively.
The fixed liabilities included above represented approximately 45% and 50% of Life’s general account liabilities as of December 31, 2005 and 2004, respectively. The assets supporting the fixed liabilities are monitored and managed within rigorous duration guidelines using scenario simulation techniques, and are evaluated on an annual basis, in compliance with regulatory requirements.
The after-tax change in fair value of the invested asset portfolios that support certain universal life-type contracts and other insurance contracts are shown in the following table. The cash flows associated with these liabilities are less predictable than fixed liabilities.
The Company’s operations are significantly influenced by changes in the equity markets. The Company’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. Prolonged and precipitous declines in the equity markets can have a significant effect 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. Lower assets under management will have a negative effect on the Company’s financial results, primarily due to lower fee income related to the Retail, Retirement Plans, Institutional and International and, to a lesser extent, the Individual Life segment, 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.
In addition, prolonged declines in the equity market may also decrease the Company’s expectations of future gross profits, which are utilized to determine the amount of DAC to be amortized in a given financial statement period. A significant decrease in the Company’s future estimated gross profits would require the Company to accelerate the amount of DAC amortization in a given period, potentially causing a material adverse deviation in that period’s net income. Although an acceleration of DAC amortization would have a negative effect on the Company’s earnings, it would not affect the Company’s cash flow or liquidity position.
In the U.S., the Company sells variable annuity contracts that offer various guaranteed death benefits. The Company maintains a liability, under SOP 03-1, for the death benefit costs of $158, as of December 31, 2005. Declines in the equity market may increase the Company’s net exposure to death benefits under these contracts. The majority of the contracts with the guaranteed death benefit feature are sold by the Retail Products Group segment. For certain guaranteed death benefits, The Hartford pays the greater of (1) the account value at death; (2) the sum of all premium payments less prior withdrawals; or (3) the maximum anniversary value of the contract, plus any premium payments since the contract anniversary, minus any withdrawals following the contract anniversary. For certain guaranteed death benefits sold with variable annuity contracts beginning in June 2003, the Retail Products Group segment pays the greater of (1) the account value at death; or (2) the maximum anniversary value; not to exceed the account value plus the greater of (a) 25% of premium payments, or (b) 25% of the maximum anniversary value of the contract. The Company currently reinsures a significant portion of these death benefit guarantees associated with its in-force block of business.
In Japan, the Company offers certain variable annuity products with both a guaranteed death benefit and a guaranteed income benefit. The Company maintains a liability for these death and income benefits, under SOP 03-1, of $50 as of December 31, 2005. Declines in equity markets as well as a strengthening of the Japanese Yen in comparison to the U.S. dollar may increase the Company’s exposure to these guaranteed benefits. This increased exposure may be significant in extreme market scenarios. For the guaranteed death benefits, the Company pays the greater of (1) account value at death; (2) a guaranteed death benefit which, depending on the contract, may be based upon the premium paid and/or the maximum anniversary value established no later than age 80, as adjusted for withdrawals under the terms of the contract. The guaranteed income benefit guarantees to return the contract holder’s initial investment, adjusted for any earnings withdrawals, through periodic payments that commence at the end of a minimum deferral period of 10, 15 or 20 years as elected by the contract holder.
In addition, the Company offers certain variable annuity products with a GMWB rider. GMWB is accounted for under SFAS No. 133. Declines in the equity market may increase the Company’s exposure to benefits under the GMWB contracts. For all contracts in effect through July 6, 2003, the Company entered into a reinsurance arrangement to offset its exposure to the GMWB for the remaining lives of those contracts. As of July 6, 2003, the Company exhausted all but a small portion of the reinsurance capacity for new business under the current arrangement and has been ceding only a very small number of new contracts subsequent to July 6, 2003. Substantially all new contracts with the GMWB are not covered by reinsurance. These unreinsured contracts are expected to generate volatility in net income as the underlying embedded derivative liabilities are recorded at fair value each reporting period, resulting in the recognition of net realized capital gains or losses in response to changes in certain critical factors including capital market conditions and policyholder behavior. In order to minimize the volatility associated with the unreinsured GMWB liabilities, the Company established an alternative risk management strategy. During the third quarter of 2003, the Company began hedging its unreinsured GMWB exposure using interest rate futures, Standard and Poor’s (“S&P”) 500 and NASDAQ index put options and futures contracts. During the first quarter of 2004, the Company entered into Europe, Australasia and Far East (“EAFE”) Index swaps to hedge GMWB exposure to international equity markets. The hedging program involves a detailed monitoring of policyholder behavior and capital markets conditions on a daily basis and rebalancing of the hedge position as needed. While the Company actively manages this hedge position, hedge ineffectiveness may result due to factors including, but not limited to, policyholder behavior, capital markets dislocation or discontinuity and divergence between the performance of the underlying funds and the hedging indices.
The net effect of the change in value of the embedded derivative net of the results of the hedging program was a $46 loss and $8 gain before deferred policy acquisition costs and tax effects for the years ended December 31, 2005 and 2004, respectively. As of December 31, 2005, the notional and fair value related to the embedded derivatives, the hedging strategy and reinsurance was $45.5 billion and $166, respectively. As of December 31, 2004, the notional and fair value related to the embedded derivatives, the hedging strategy, and reinsurance was $37.7 billion and $170, respectively.
The functional currency of the Japanese operation is the Japanese yen. Accordingly, the premiums, claims, commissions and investment income are paid or received in yen. In addition, most of the Japanese operation’s investments are yen denominated. In 2003, Life had entered into yen denominated forwards to hedge a substantial portion of the yen to U.S. dollar exchange rate volatility related to the net investment in the Japanese operation. The net investment in the Japanese operation was approximately $673 as of December 31, 2004. During the third quarter of 2005, the Company terminated its yen denominated forwards. The notional and fair value of the contracts terminated during the third quarter of 2005 was $408 and $17, respectively. At December 31, 2004, the derivatives used to hedge the net investment in the Japanese operation had a total notional and fair value of $401 and $(23), respectively. The after-tax net gains (losses) included in the foreign currency transaction adjustment associated with the net investment hedge was $12, $(14), and $(3) as of December 31, 2005, 2004, and 2003, respectively.
The yen based fixed annuity product is written by Hartford Life Insurance KK (“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 with primarily pay variable U.S. dollar receive fixed yen, zero coupon currency swaps (“currency swaps”). As of December 31, 2005, the notional value and fair value of the currency swaps were $1.7 billion and $(179), 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 loss of $23 and a net gain of $2 for the years ended December 31, 2005 and 2004, respectively, which includes the changes in value of the currency swaps and the yen fixed annuity contract remeasurement, was recorded in net realized capital gains and losses.
The primary exposure to interest rate risk in Property & Casualty relates to its fixed maturity securities, including corporate bonds, ABS, municipal bonds, CMBS and CMOs. The fair value of these investments was $25.3 billion and $24.4 billion at December 31,
The following table provides an analysis showing the estimated after-tax change in the fair value of Property & Casualty’s fixed income investments and related derivatives, assuming 100 basis point upward and downward parallel shifts in the yield curve as of December 31, 2005 and 2004. Certain financial instruments, such as limited partnerships, have been omitted from the analysis due to the fact the investments are accounted for under the equity method and generally lack sensitivity to interest rate changes.
As of December 31, 2005, a decrease in interest rates has a greater impact on the change in fair value of the fixed income investments and related derivatives than an increase in interest rates, as compared to December 31, 2004, due to the fact that there is greater positive convexity in the portfolios as a result of increases in interest rates during 2005 as well as the prepayment of certain asset classes, primarily municipalities.
Based on the fair values of Property & Casualty’s non-U.S. dollar denominated securities and derivative instruments as of December 31, 2005 and 2004, management estimates that a 10% unfavorable change in exchange rates would decrease the fair values by an after-tax total of approximately $50 and $63, 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 hypothetical illustration of the potential 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.
than usual realized capital gains and losses or the Company would enter the capital markets to raise further funds to provide the requisite liquidity. For a discussion and tabular presentation of the Company’s current contractual obligations by period including those related to its Life and Property & Casualty insurance refer to the Off-Balance Sheet and Aggregate Contractual Obligations section below.
The Hartford endeavors to maintain a capital structure that provides financial and operational flexibility to its insurance subsidiaries, ratings that support its competitive position in the financial services marketplace (see the Ratings section below for further discussion), and strong shareholder returns. As a result, the Company may from time to time raise capital from the issuance of stock, debt or other capital securities. The issuance of common stock, debt or other capital securities could result in the dilution of shareholder interests or reduced net income due to additional interest expense.
The new reserve methodologies and SMR standards only apply to capital requirements for Japanese regulatory purposes, and are not directly related to results under accounting principles generally accepted in the United States. The Company has decided to adopt the Standard methodology. It was expected that the impact of adopting the Standard methodology, on the Company’s Japanese operations, based on the Company’s assessment, could have required as much as $400 - $650 of additional capital during 2005. During the third quarter of 2005, the Company received Connecticut regulatory approval and consummated a transaction to reinsure guaranteed minimum income benefit risk associated with the sale of variable annuities in Japan to Hartford Life and Annuity Insurance Company, a U.S. subsidiary. This reinsurance strategy substantially eliminated the additional capital requirement in Japan. The Company believes that optimization of its capital management globally is a dynamic process. Therefore, management regularly evaluates its global capital position and may make further adjustments using reinsurance, hedging and other strategies from time to time.
in its Japanese operations to be included as part of the aggregate statutory capital (for the purposes of regulatory and rating agency capital adequacy measures) of HLA.
Dividends to the Company from its insurance subsidiaries are restricted. The payment of dividends by Connecticut-domiciled insurers is limited under the insurance holding company laws of Connecticut. Under these laws, the insurance subsidiaries may only make their dividend payments out of unassigned surplus. These laws require notice to and approval by the state insurance commissioner for the declaration or payment of any dividend, which, together with other dividends or distributions made within the preceding twelve months, exceeds the greater of (i) 10% of the insurer’s policyholder surplus as of December 31 of the preceding year or (ii) net income (or net gain from operations, if such company is a life insurance company) for the twelve-month period ending on the thirty-first day of December last preceding, in each case determined under statutory insurance accounting principles. In addition, if any dividend of a Connecticut-domiciled insurer exceeds the insurer’s earned surplus, it requires the prior approval of the Connecticut Insurance Commissioner. The insurance holding company laws of the other jurisdictions in which The Hartford’s insurance subsidiaries are incorporated (or deemed commercially domiciled) generally contain similar (although in certain instances somewhat more restrictive)
On May 15, 2001, HLI filed with the SEC a shelf registration statement (Registration No. 333-60944) 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, 2005, HLI had $1.0 billion remaining on its shelf.
[1] Replaced by $1.6 billion Five-Year Competitive Advance and Revolving Credit Facility Agreement on September 7, 2005. For further information, see below.
The Credit Agreement provides for up to $1.6 billion of unsecured credit. Of the total availability under the Credit Agreement, up to $250 is available to support borrowing by HLI alone, and up to $100 is available to support letters of credit issued on behalf of The Hartford, HLI or other subsidiaries of The Hartford.
As of December 31, 2005, the Company’s Japanese operation has a ¥2.0 billion yen, approximately $17, line of credit with a Japanese bank with no outstanding borrowings under this facility.
• The Company has outstanding forward purchase contracts associated with the Company’s equity units under which the Company will issue between 17.8 and 22.2 million shares of common stock, depending on the stock price on the date of issuance, and receive proceeds of approximately $1.02 billion in 2006. See further disclosure in Notes 2 and 14 of Notes to Consolidated Financial Statements.
The following table identifies the Company’s aggregate contractual obligations due by payment period:
• 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 will likely 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 2006 do not include payments that will be made on claims incurred in 2006 on policies that were in force as of December 31, 2005. In addition, the table does not include future cash flows related to the receipt of premiums that will be used, in part, to fund loss payments.
[2] Estimated life, annuity and disability obligations include death and disability claims, policy surrenders, policyholder dividends and trail commissions offset by expected future deposits and premiums on in-force contracts. Estimated contractual policyholder obligations are based on mortality, morbidity and lapse assumptions comparable with Life’s historical experience, modified for recent observed trends. Life has also assumed market growth and interest crediting consistent with assumptions used in amortizing deferred acquisition costs. In contrast to this table, the majority of Life’s obligations are recorded on the balance sheet at the current account values and do not incorporate an expectation of future market growth, interest crediting, or future deposits. Therefore, the estimated contractual policyholder obligations presented in this table significantly exceed the liabilities recorded in reserve for future policy benefits and unpaid claims and claim adjustment expenses, other policyholder funds and benefits payable and separate account liabilities. Due to the significance of the assumptions used, the amounts presented could materially differ from actual results. As separate account obligations are legally insulated from general account obligations, the separate account obligations will be fully funded by cash flows from separate account assets. Life expects to fully fund the general account obligations from cash flows from general account investments and future deposits and premiums.
[5] As of December 31, 2005, the Company has accepted cash collateral of $1.2 billion in connection with the Company’s securities lending program and derivative instruments. Since the timing of the return of the collateral is uncertain, the return of the collateral has been included in the payments due in less than 1 year.
Pension expense reflected in the Company’s net income was $137, $104 and $120 in 2005, 2004 and 2003, respectively. The Company estimates its 2006 pension expense will be approximately $147, based on current assumptions.
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 in actual asset returns for the Plan of $176 and $289 for the years ended December 31, 2005 and 2004, respectively, as compared to expected returns of $221 and $201 for the years ended December 31, 2005 and 2004, 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 unrecognized net losses continues to exceed the allowable amortization corridor as defined under SFAS No. 87. Based on the 5.50% discount rate selected as of December 31, 2005 and taking into account estimated future minimum funding, the difference between actual and expected performance in 2005 will increase annual pension expense in future years. The increase in pension expense will be approximately $2 in 2006 and will increase ratably to an increase of approximately $8 in 2010.
In 2006, the Company’s equity unit notes will be remarketed and the underlying stock purchase agreements will be exercised. For additional information regarding this remarketing, see Note 14 of Notes to Consolidated Financial Statements.
The following discussion describes the Company’s debt financing activities for 2005.
In December 2005, the Company issued $100 of commercial paper and used the proceeds, together with other sources, to fund a $300 contribution to its defined benefit plan.
The Hartford declared $350 and paid $345 in dividends to shareholders in 2005, declared $331 and paid $325 in dividends to shareholders in 2004 and declared $300 and paid $291 in dividends to shareholders in 2003.
The funded status of the Company’s pension and postretirement plans is dependent upon many factors, including returns on invested assets and the level of market interest rates. Declines in the value of securities traded in equity markets coupled with declines in long-term interest rates have had a negative impact on the funded status of the plans. As a result, the Company recorded a minimum pension liability as of December 31, 2005, and 2004, which resulted in an after-tax reduction of stockholders’ equity of $620 and $480 respectively. This minimum pension liability did not affect the Company’s results of operations.
For additional information on stockholders’ equity and AOCI see Notes 15 and 16, respectively, of Notes to Consolidated Financial Statements.
2005 Compared to 2004 - The increase in cash from operating activities was primarily the result of the funding of $1.15 billion in settlement of the MacArthur litigation in 2004 and increased net income as compared to the prior year period. Cash provided by financing activities increased primarily due to higher net receipts from policyholder’s accounts related to investment and universal life contracts and increased proceeds from stock option exercises in 2005 as compared to the prior year period. Also contributing to the increase in cash provided by financing activities was a decrease in debt repayments in 2005 as compared to the prior year period. Net purchases of available-for-sale securities accounted for the majority of cash used for investing activities.
2004 Compared to 2003 - Cash from operating activities primarily reflects premium cash flows in excess of claim payments. The decrease in cash provided by operating activities was due primarily to the $1.15 billion settlement of the MacArthur litigation in 2004. Cash provided by financing activities decreased primarily due to lower proceeds from investment and universal life-type contracts as a result of the adoption of SOP 03-1, decreased capital raising activities, repayment of commercial paper and early retirement of junior subordinated debentures in 2004. The decrease in cash from financing activities and operating cash flows invested long-term accounted for the majority of the change in cash used for investing activities.
Japan Life Operation was valued in accordance with prescribed statutory accounting practices. Prior to September 1, 2005, Japan Life Operations was included in Life Operations.
As of December 31, 2005 the implementation of C-3 Phase II Capital requirements had a positive impact on The Hartford’s life insurance companies’ NAIC RBC ratio.
On December 22, 2005, the President signed the Terrorism Risk Insurance Extension Act of 2005 (“TRIEA”) extending the Terrorism Risk Insurance Act of 2002 (“TRIA”) through the end of 2007. TRIA provides a backstop for insurance-related losses resulting from any “act of terrorism” certified by the Secretary of the Treasury, in concurrence with the Secretary of State and Attorney General, that result in industry losses in excess of $50 in 2006 and $100 in 2007. Under the program, the federal government would pay 90% of covered losses from a certified act of terrorism in 2006 after an insurer’s losses exceed 17.5% of the Company’s eligible direct commercial earned premiums in 2005, up to a combined annual aggregate limit for the federal government and all insurers of $100 billion. In 2007, the federal government would pay 85% of covered losses from a certified act of terrorism after an insurer’s losses exceed 20% of the Company’s eligible direct commercial earned premiums in 2006, 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.
TRIA requires all property and casualty insurers, including The Hartford, to make terrorism insurance available in all of their covered commercial property and casualty insurance policies (as defined in TRIA and amended in TRIEA). TRIA applies to a significant portion of The Hartford’s commercial property and casualty contracts, but it specifically excludes some of The Hartford’s other insurance business, including commercial auto, surety, burglary and theft, farm owners multi-peril, professional liability, livestock insurance, reinsurance and personal lines business. TRIA also does not apply to group life insurance contracts.
In addition, other tax proposals and regulatory initiatives which have been or are being considered by Congress could have a material effect on the insurance business. These proposals and initiatives include changes pertaining to the tax treatment of insurance companies and life insurance products and annuities, repeal or reform of the estate tax and comprehensive federal tax reform. The nature and timing of any Congressional action with respect to these efforts is unclear.
pay certain claims of the insolvent insurer. A particular state’s fund assesses its members based on their respective written premiums in the state for the classes of insurance in which the insolvent insurer was engaged. Assessments are generally limited for any year to one or two percent of premiums written per year depending on the state. Such assessments paid by The Hartford approximated $46 in 2005, $26 in 2004 and $26 in 2003.