(DOLLAR AMOUNTS IN MILLIONS, EXCEPT PER SHARE DATA, UNLESS OTHERWISE STATED)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SHOULD BE READ IN CONJUNCTION WITH THE CONSOLIDATED FINANCIAL STATEMENTS AND RELATED NOTES BEGINNING ON PAGE.
Distribution 10 Consolidated Results of Operations: Operating Summary 11 North American Property & Casualty 13 Life 16 International 19 Other Operations 21 Reserves 22 Environmental and Asbestos Claims 22 Investments 24 Capital Markets Risk Management 27 Capital Resources and Liquidity 37 Regulatory Initiatives and Contingencies 40 Effect of Inflation 41 Accounting Standards 41
On December 19, 1995, ITT Corporation ("ITT") distributed all of the outstanding shares of common stock of The Hartford to the shareholders of ITT common stock (the "Distribution" or "Spin-off"). As a result of the Distribution, The Hartford became an independent publicly-traded company. "Regular Way" trading of The Hartford's common stock on the New York Stock Exchange (under the symbol "HIG") commenced on December 20, 1995. In connection with this transaction, ITT transferred First State Insurance Company and Fencourt Reinsurance Company, Ltd., both of which were wholly owned companies of ITT, to The Hartford prior to the Distribution. Consistent with the Consolidated Financial Statements and related Notes, the financial information included herein reflects the results of The Hartford as if it were a separate entity for all periods presented. (For additional information regarding the Distribution, see Note 2 of Notes to Consolidated Financial Statements.)
In 1997, core earnings increased $212, or 39%, from 1996 primarily due to a reduction in domestic property catastrophe and other severe weather-related losses of $132, after-tax. Also contributing to the increase were higher net investment income, growth in earnings in the Annuity division, the reduction of incurred environmental and asbestos losses and the reduction of losses in the Guaranteed Investment Contracts division. Soft market conditions related to automobile insurance in the United Kingdom and increased debt service costs partially offset the increase.
Core earnings increased $59, or 12%, to $537 in 1996 from 1995 due primarily to increased revenues earned on a growing annuity asset base, growth in net investment income, increased group insurance premiums and favorable mortality experience, partially offset by after-tax underwriting losses resulting from property catastrophe and other severe weather-related losses in 1996.
Net income for 1997 includes a $368 equity gain resulting from the initial public offering of Hartford Life, Inc. ("HLI"), the holding company parent of The Hartford's significant life insurance subsidiaries, Class A common stock ("The Offering"). (For additional information, see Note 3 of Notes to Consolidated Financial Statements and Capital Resources and Liquidity section under "The Offering".)
As part of the Distribution, The Hartford was allocated amounts originally recorded at the ITT corporate level. The allocations resulted in net income of $14 in 1995. (For more information on liability sharing arrangements related to the Distribution, see Note 2 of Notes to Consolidated Financial Statements.)
The effective tax rates for 1997, 1996 and 1995 were 25%, 20% and 24%, respectively, excluding the impact of other items in 1997 and 1996. The increase in the effective tax rate for 1997 was due to a reduction in the proportionate share of tax-exempt net investment income to total net income for 1997 compared to 1996. Tax-exempt interest earned on invested assets was the principal cause of effective rates lower than the 35% U.S. statutory rate. Income taxes paid/(refunds received) in 1997, 1996 and 1995 were $(37), $170 and $302, respectively. For additional information, see Note 14 of Notes to Consolidated Financial Statements.
1997 1996 1995 - ---------------------------------------------------------------- N. A. Property & Casualty $ 433 $ 270 $ 251 Life 306 200 153 International 46 79 94 Other Operations (36) (12) (20) - ---------------------------------------------------------------- CORE EARNINGS $ 749 $ 537 $ 478 - ----------------------------------------------------------------
Core earnings for the North American Property & Casualty segment were $433, an increase of $163, or 60%, from 1996. The increase was primarily due to a $130, or 61%, improvement in after-tax underwriting results and an $88, or 17%, increase in after-tax net investment income, partially offset by a $36, or 60%, increase in debt service costs. The improved underwriting results were attributable to favorable property catastrophe and other severe weather-related losses in 1997 and a reduction in incurred environmental and asbestos losses. The increase in debt service costs is the result of the 1996 sale of Quarterly Income Preferred Securities and an increase in debt allocated to the North American Property & Casualty segment. (For additional information, see Capital Resources and Liquidity section under "Debt".) In addition, for an analysis of net investment income, see the Investments section.
Core earnings for 1996 of $270 increased $19 from 1995, primarily due to a $53 increase in after-tax net investment income partially offset by a $37 increase in after-tax underwriting loss primarily due to adverse property catastrophe and other severe weather-related losses.
1997 1996 1995 - --------------------------------------------------------------- Underwriting results [1] $ (126) $ (986) $ (270) Net investment income 777 661 646 Net realized capital gains 231 15 29 Miscellaneous expenses, net (155) (89) (71) - --------------------------------------------------------------- OPERATING INCOME (LOSS) $ 727 $ (399) $ 334 - --------------------------------------------------------------- [1] 1996 includes the impact of a $660, before-tax, environmental and asbestos charge.
[2] "Combined ratio" is a common industry measurement of the results of property and casualty insurance underwriting. This ratio is the sum of the ratio of incurred claims and claim expenses to premiums earned (the "loss ratio") and the ratio of underwriting expenses incurred to premiums written (the "expense ratio"). A combined ratio under 100.0 generally indicates an underwriting profit. Federal income taxes, net investment income, deferred policy acquisition costs and other non-underwriting expenses are not reflected in the combined ratio.
Written premiums for this segment increased 1% in 1997 from 1996, while premiums for 1996 were up slightly from 1995. Premiums from the segment's primary target markets of reinsurance, small commercial accounts and AARP grew 10% in 1997 and 6% in 1996, contributing 4% and 2% growth to the total segment in 1997 and 1996, respectively. However, 3% of this segment growth was offset in each year by an 8% and 6% premium reduction in mid-to-large commercial accounts and agency personal lines in 1997 and 1996, respectively.
Underwriting results for 1997 improved $200, or 2.9 combined ratio points, from 1996 primarily from a decrease in property catastrophe and other severe weather-related losses of $204 and a reduction of $67 in incurred environmental and asbestos losses as a result of the charge taken in the third quarter of 1996 upon completion of the Company's environmental and asbestos database study (for further discussion see, the Environmental and Asbestos Claims section). Partially offsetting these two favorable items were expenses related to significant investments in future growth initiatives and dividends to policyholders in two states in recognition of favorable personal lines automobile results.
In 1996, underwriting losses before-tax increased $56, or 0.7 combined ratio points, over 1995 primarily due to a $130 increase in property catastrophe and other severe weather-related losses, most notably several first quarter winter storms and Hurricane Fran in September. Partially offsetting this increase were the impact of two significant losses, net of reinsurance, in 1995: $40 in connection with the settlement of claims against Dow Corning Corporation alleging product defects arising from breast implants, and $32 resulting from the Company's share of a single industrial fire covered by the Industrial Risk Insurance ("IRI") pool.
The North American Property & Casualty segment consists of three major operations: Commercial, Personal and Reinsurance. A description of each operation, including an analysis of underwriting results, follows.
1997 1996 1995 - --------------------------------------------------------------- Written premiums $ 3,190 $ 3,253 $ 3,373 Underwriting results $ (149) $ (206) $ (249) Combined ratio 104.5 105.8 107.1 - ---------------------------------------------------------------
Personal provides automobile, homeowners, home-based business and fire coverages to individuals throughout the United States. Personal is organized to provide customized products and services to three market opportunities: the membership of AARP through a direct marketing operation; customers who prefer local agent involvement through a network of independent agents; and members of other affinity groups through an affinity center which began in 1996 and is building from the AARP operation competencies. AARP's exclusive licensing arrangement continues through the year 2002, thus providing the Company with an important competitive advantage.
Written premiums increased 2% in 1997 compared to a 3% increase in 1996. Both years included strong growth in AARP premium of 7% which is benefiting from the favorable expansion of this demographic group, partially offset by declines in Agency premiums of 7% in 1997 and 4% in 1996. The decline in 1997 was due to the sale of the Company's Canadian personal lines as well as disruption in the incoming flow of business associated with a major strategic shift in emphasis from homeowners to automobile coverages. The 1996 decline was due to selective disinvestment in unprofitable states and underperforming agents. AARP premiums represented 67% of the 1997 Personal premiums, up from 64% in 1996 and 62% in 1995.
Underwriting results for 1997 decreased $4, or 0.5 combined ratio points, from 1996 as favorable worldwide property catastrophe experience was offset by increasingly competitive market conditions which softened premium rate levels. During 1996, HartRe began a strategic shift in its business mix to longer-tailed casualty and specialty lines to provide further growth opportunities and better diversify its portfolio. The expected profitability composition of such longer-tailed lines includes a higher investment income component, which allows for higher targeted combined ratios. As a result of this strategy, along with higher property catastrophe losses, 1996 underwriting results decreased $10 compared with 1995.
Miscellaneous expenses, net of miscellaneous income items, were $155 in 1997, up from $89 in 1996. This increase was primarily due to increased debt service costs of $55 resulting from additional borrowings and a reallocation of corporate debt costs to the North American Property & Casualty segment.
Difficult market conditions and intense price competition within the property and casualty industry show no signs of diminishing in the near term. However, several major strategic actions are underway, with many completed in 1997, which management believes may counterbalance these negative external factors and position the North American Property & Casualty segment for improved written premium growth in 1998 and beyond, while maintaining core profitability. The acquisition of Omni Insurance Group, Inc., which was completed on February 12, 1998, provides Personal immediate access to the non-standard automobile market with a highly-regarded and well-established franchise. (For additional information, see Capital Resources and Liquidity section under "Omni".) Strategic alliances have been formed with several major national and regional banks to market personal and/or commercial products to each banks' customers. The Hartford Customer Services Group contracted with AARP to service its group health insurance plan partners and recipients beginning January 1, 1998. Significant investments have been made in such areas as advertising, product research and development, technology and staff training to heighten brand awareness, increase product offerings, further develop alternative distribution channels and improve productivity. On-going claim initiatives have kept claim cost increases below national trends. As a result of these and other actions and initiatives, management believes the North American Property & Casualty segment stands poised to capitalize on the opportunities that lie ahead.
The Life segment operates in three principal divisions: Annuity, Individual Life Insurance and Employee Benefits. The Life segment also maintains a Guaranteed Investment Contracts ("GIC") division, which is primarily comprised of guaranteed rate contract ("GRC") business written prior to 1995 ("Closed Book GRC") and a Corporate Operation through which it reports net investment income on assets representing surplus not assigned to any of its business divisions and certain other revenue and expenses not specifically allocable to any of its business divisions. On May 22, 1997, HLI, the holding company parent of The Hartford's significant life subsidiaries, completed the Offering of 18.6% of its common stock. (For additional information, see Capital Resources and Liquidity section under "The Offering".)
Revenues increased $290, or 7%, in 1996 as compared to 1995. Excluding revenues associated with COLI and GRC as discussed above, revenues increased $549, or 22%, in 1996 compared to 1995. The increase was primarily due to growth in the Annuity division where revenues increased due to a substantial increase in aggregate fees earned on a larger block of separate account assets as a result of strong annuity sales and stock market appreciation. Additionally, revenues in the Employee Benefits division grew resulting from strong sales and renewals of group insurance premiums.
Core earnings increased $47, or 31%, to $200 in 1996 from $153 in 1995, primarily as a result of (i) an increase in earnings in the Annuity division of $32 and in the Individual Life Insurance division of $7, both of which were driven by an increase in total account value due to strong sales and stock market appreciation, (ii) an increase in earnings of $13 in the Employee Benefits division principally as a result of an increase in group insurance premiums and favorable mortality and morbidity experience and (iii) a reduction in losses of $17 in the GIC division as a result of actions taken in the third quarter of 1996 related to Closed Book GRC, partially offset by a decrease in earnings in the Corporate Operation of $22 due primarily to a favorable guaranty fund adjustment of $10 in 1995 resulting
The Annuity division focuses on the savings and retirement needs of the growing number of individuals who are preparing for retirement or have already retired. The variety of products sold within this division reflects the diverse nature of the market. These include individual variable annuities, fixed market value adjusted (MVA) annuities, deferred compensation and retirement plan services, structured settlement contracts and other special purpose annuity contracts, investment management contracts and mutual funds. The Company was rated the number one writer of variable annuities for 1997 according to the Variable Annuity and Research Data Service (VARDS) with an 11% market share, and sold approximately $869 of mutual funds in its first full year offering the product, resulting in total mutual fund assets of $972 at December 31, 1997.
The Employee Benefits division sells group insurance products, including group life and group disability insurance, and COLI and engages in certain international operations, primarily in South America. According to the latest results published by the Life Insurance Marketing and Research Association (LIMRA) (December 1997), the Company was the second largest provider of group disability insurance for the nine months ended September 30, 1997.
Revenues decreased $190, or 7%, to $2.6 billion in 1997 from $2.8 billion in 1996. This decrease was primarily attributable to the COLI business for which associated revenues decreased $380, or 28%, to $980 from $1.4 billion in 1996. The decrease in COLI revenues is primarily a result of the elimination of sales of leveraged COLI due to the HIPA Act of 1996 which phases out the deductibility of interest on policy loans under leveraged COLI by the end of 1998. Partially offsetting this decrease was an increase in group insurance revenues of $237, or 16%, to $1.7 billion from $1.5 billion in 1996. The increase in revenues is mainly attributable to group life and group disability premium growth, as a result of strong new business sales and renewals. Total benefits, claims and expenses decreased $212, or 8%, to $2.5 billion in 1997 from $2.7 billion in 1996. This decrease generally reflected a decrease in dividends to policyholders of $394, or 62%, primarily due to the elimination of sales of leveraged COLI, partially offset by an increase in group insurance of $216, or 15%, as a result of growth in group life and group disability products. The 1997 results were impacted by a $6 operating loss related to the division's international operations. This loss was primarily attributable to the segment's operations in Argentina, specifically, the Company's 60% investment in ITT Hartford Sudamericana Holdings, S.A. ("Suda"). In November 1997, the Company replaced the Argentine management team with a new management team and purchased the remaining 40% interest in Suda from the local shareholders. The Argentine loss was primarily due to higher than anticipated costs and expenditures. As a result of the factors mentioned above, and the impact of favorable mortality and morbidity results, core earnings in this division increased $6, or 8%, to $85 in 1997 from $79 in 1996.
The GIC division consists of GRC business that is supported by assets held in either the Company's general account or a guaranteed separate account and includes Closed Book GRC. Historically, a significant majority of these contracts were sold as general account contracts with fixed rates and fixed maturities. The Company decided in 1995, after a thorough review of its GRC business, that it would significantly de-emphasize general account GRC, choosing instead to focus its distribution efforts on other products sold through other divisions and selling general account GRC primarily as an accommodation to customers. From 1992 to 1994, the GIC division sold over $5.0 billion of GRC. In contrast, the GIC division sold only $47 and $108 general account GRC in 1997 and 1996, respectively. Consistent with management's expectations, the division had no core earnings in 1997 and expects no material income or loss from the GIC division in the future.
loss of $82, after-tax, was determined to have occurred and was recorded in September 1996. An additional other than temporary impairment loss of $6, after-tax, occurred in the fourth quarter of 1996 bringing the total 1996 impairment to $88. Also, during the third quarter of 1996, Closed Book GRC had asset sales resulting in proceeds of approximately $500 and a realized loss of $55, after-tax. The asset sales were undertaken as a result of liquidity needs and favorable market conditions for certain securities. Other charges of $32, after-tax, were also incurred in the third quarter of 1996.
Management believes that it has developed and implemented strategies to maintain and enhance its position as a market leader within the financial services industry, to continue the Life segment's asset growth and to maximize shareholder value. The Life segment's strong market position in each of its primary businesses, coupled with the growth potential management believes exists in its markets, provides opportunities to increase sales of the Life segment's products and services as individuals increasingly save and plan for retirement, financially protect themselves and their families against disability or death and prepare their estates for an efficient transfer of wealth between generations.
Certain proposed legislative initiatives which could impact the Life segment are discussed in the Regulatory Initiatives and Contingencies section.
The Company expects continued growth in core earnings for the Life segment in 1998.
The International segment includes direct insurance business written by local companies in the United Kingdom, namely ITT London & Edinburgh, the Netherlands and Belgium, Zwolsche Algemeene, and Spain, ITT Ercos. These companies primarily offer property and casualty products in both personal and commercial lines as well as life insurance products designed to meet the needs of local customers. In addition, other operations primarily represent home office expenses associated with managing international operations.
Core earnings for 1997 of $14 decreased $34, or 71%, over 1996. In local currency, core earnings were down 72% as a result of a $31 after-tax decrease in the underwriting results of the automobile line, due to reserve strengthening. The foreign exchange impact on core earnings for 1997 was negligible.
In 1996, revenues at ITT London & Edinburgh of $1.1 billion increased $17, or 2%, over 1995. The increase in revenues was due to improved net investment income of $21, partially offset by a shortfall in written premiums due to the intense competitive climate in the United Kingdom. Personal lines for 1996 under-performed the prior year where shortfalls in automobile were partially offset by improvements in personal credit insurance, including life. Commercial lines sales were also dampened due to the increasingly competitive market. Also, strengthening of the U.S. dollar resulted in negative foreign exchange impacts on revenues of $15.
In 1997, revenues at Zwolsche Algemeene of $432 decreased $27, or 6%, over 1996. In local currency, 1997 total revenues grew by 8% as a result of 28% growth in net realized capital gains and 9% net written premium growth in life savings and mortgage product lines. All property and casualty lines were flat compared to 1996 net written premium levels in local currency terms. Strengthening in the U.S. dollar against the guilder resulted in a negative foreign exchange impact on revenues of $64.
In 1997, core earnings of $33 improved $1, or 3%, over 1996 levels in U.S. dollar terms. In local currency, 1997 core earnings achieved 19% growth due to strong underwriting results; however, this was offset by a negative foreign exchange impact on core earnings of $5.
In 1997, core earnings of $2 decreased $1, or 33%, over 1996 levels in U.S. dollars. In local currency, 1997 core earnings decreased 13%. Despite improved expense ratios, operating performance was down due to worsening underwriting performance and lower yields on the investment portfolio. The strengthening of the U.S. dollar in 1997 had a negligible foreign exchange impact on core earnings.
The Hartford acquired ITT Ercos in May 1995. In 1996, revenues at ITT Ercos of $78 exceeded the eight months reported for 1995 by $27. Core earnings of $3 were $1 higher than 1995. During 1996, the company consolidated its branch offices into one centralized location and reorganized its national sales organization. These actions were taken to improve expense competitiveness and service which will position the company for future growth. The strengthening of the U.S. dollar against the peseta in 1996 resulted in a negative foreign exchange impact on revenues and core earnings of $2 and $1, respectively.
The outlook for 1998 for commercial and personal lines at ITT London & Edinburgh is a continuation of heightened competition. The market currently has excess capacity which will lead to continued soft market pricing in the short term. Continuing competition from direct writing companies and entry by non-traditional risk bearers into markets such as homeowners is anticipated. In connection with the automobile line, management has implemented strong price and underwriting actions in 1997 to improve operational performance. It is expected that these actions will bring about an improvement in the underwriting results of the automobile line in 1998.
The outlook for ITT Ercos in the Spanish market is for moderate growth. It is expected ITT Ercos will continue to build on the improved operational foundation established in 1996 and expense reductions achieved in 1997 to expand its presence in both life and non-life business during 1998.
Other Operations consist of property and casualty operations of The Hartford which have discontinued writing new and renewal business. These operations primarily include First State Insurance Company, Fencourt Reinsurance Company, Ltd., Heritage Reinsurance Company, Ltd. and Excess Insurance Company Limited, which has been reclassified from ITT
Except for the uncertainties related to dispute resolution, reinsurance collection and those discussed in the Environmental and Asbestos Claims section, management does not anticipate the future financial performance of the property and casualty operations of Other Operations to have a material effect on the future operating results of the Company.
The Hartford continually reviews its estimated claims and claim adjustment expense reserves as additional experience and other relevant data become available, and reserve levels are adjusted accordingly. Adjustments to previously established reserves, if any, will be reflected in the operating results of the period in which the adjustment is made. In the judgment of management, all information currently available has been properly considered in the reserves established for claims and claim adjustment expenses. For a discussion of environmental and asbestos claims and the uncertainties related to these reserves, refer to the next section.
The Hartford continues to receive claims asserting damages from environmental exposures and for injuries from asbestos and asbestos-related products, both of which affect the North American Property & Casualty, International and Other Operations segments. Environmental claims relate primarily to pollution and related clean-up costs. With regard to these claims, uncertainty exists which impacts the ability of insurers and reinsurers to estimate the ultimate reserves for unpaid losses and related settlement expenses. The Hartford finds that conventional reserving techniques cannot estimate the ultimate cost of these claims because of inadequate development patterns and inconsistent emerging legal doctrine. For the majority of environmental claims and many types of asbestos claims, unlike any other type of contractual claim, there is almost no agreement or consistent precedent to determine what, if any, coverage exists or which, if any, policy years and insurers or reinsurers may be liable. Further uncertainty arises with environmental claims since claims are often made under policies, the existence of which may be in dispute, the terms of which may have changed over many years, which may or may not provide for legal defense costs, and which may or may not contain environmental exclusion clauses that may be absolute or allow for fortuitous events. Courts in different jurisdictions have reached disparate conclusions on similar issues and in certain situations have broadened the interpretation of policy coverage and liability issues. In light of the extensive claim settlement process for environmental and asbestos claims, involving comprehensive fact gathering, subject matter expertise and intensive litigation, The Hartford established an
Within the property and casualty insurance industry, progress has been made in developing sophisticated, alternative methodologies utilizing company experience and supplemental databases to assess environmental and asbestos liabilities. Consistent with The Hartford's practice of using the best techniques to estimate the Company's environmental and asbestos exposures, a study was initiated in April 1996. The Hartford, utilizing internal staff supplemented by outside legal and actuarial consultants, completed the study in October 1996.
The Hartford's pretax operating earnings have been impacted over the last three years by incurred environmental and asbestos claims and claim adjustment expenses, net of reinsurance, as follows: $2 in 1997, $925 in 1996 and $163 in 1995.
The Hartford believes that the environmental and asbestos reserves reported at December 31, 1997 are a reasonable estimate of the ultimate remaining liability for these claims based upon known facts, current assumptions and The Hartford's methodologies. Future social, economic, legal or legislative developments may alter the original intent of policies and the scope of coverage. The Hartford will continue to evaluate new developments and methodologies as they become available for use in supplementing the Company's ongoing analysis and review of its environmental and asbestos exposures. These future reviews may result in a change in reserves, impacting The Hartford's results of operations in the period in which the reserve estimates are changed. While the effects of future changes in facts, legal and other issues could have a material effect on future results of operations, The Hartford does not expect such changes would have a material effect on its liquidity or financial condition.
Total invested assets were $15.0 billion at December 31, 1997 and were comprised of fixed maturities of $13.5 billion and other investments of $1.5 billion, primarily equity securities. As of December 31, 1997 and 1996, the segment had a minimal amount of real estate.
FIXED MATURITIES BY TYPE - ---------------------------------------------------------------- 1997 1996 - ---------------------------------------------------------------- TYPE FAIR PERCENT FAIR PERCENT VALUE VALUE - ----------------------------------------------------------------
Municipal - tax-exempt $ 7,873 58.5% $ 7,123 63.2% Corporate 2,257 16.8% 2,160 19.1% Commercial MBS 687 5.1% 107 0.9% ABS 559 4.2% 206 1.8% MBS - agency 540 4.0% 213 1.9% CMO 483 3.6% 655 5.8% Gov't/Gov't agencies - For. 459 3.4% 279 2.5% Gov't/Gov't agencies - U.S. 32 0.2% 15 0.1% Municipal - taxable 31 0.2% 68 0.6% Short-term 479 3.6% 419 3.7% Redeemable pref'd stock 56 0.4% 47 0.4% - ---------------------------------------------------------------- TOTAL FIXED MATURITIES $ 13,456 100.0% $ 11,292 100.0% - ----------------------------------------------------------------
During 1997, the North American Property & Casualty segment adjusted its strategy to increase its ownership of taxable bonds, specifically, asset backed securities ("ABS"), commercial mortgage backed securities ("MBS") and corporates. In addition, the segment's percentage ownership of equity securities to total invested assets decreased primarily as a result of opportunities taken in a favorable equity market.
The taxable equivalent duration of the December 31, 1997 fixed maturity portfolio was 4.7 years compared to 5.0 years at December 31, 1996. Duration is defined as the market price sensitivity of the portfolio to parallel shifts in the yield curve.
The table below summarizes the North American Property & Casualty segment's results.
Net realized capital gains increased to $231 in 1997 from $15 in 1996. The increase in net realized capital gains resulted primarily from opportunities in a strong equity market, partially offset by real estate writedowns of $31.
Invested assets, excluding separate accounts, totaled $21.0 billion at December 31, 1997 and were comprised of $16.8 billion of fixed maturities, $3.8 billion of policy loans, and other investments of $363. Policy loans, which had a weighted-average interest rate of 11.2% as of December 31, 1997, are secured by the cash value of the life policy. These loans do not mature in a conventional sense, but expire in conjunction with the related policy liabilities.
There were no net realized capital gains or losses for the year ended December 31, 1997 as compared to net realized capital losses of $219 in 1996 and $4 in 1995. The 1996 capital losses were primarily attributable to the writedown and sale of certain securities within Closed Book GRC.
Invested assets, excluding separate accounts, were $2.7 billion at December 31, 1997 and were comprised of fixed maturities of $2.3 billion and other investments of $407, primarily equity securities.
Gov't/Gov't agencies - For. $ 829 36.5% $ 1,384 63.1% Corporate 414 18.3% 401 18.3% Gov't/Gov't agencies - U.S. 19 0.8% 29 1.3% Short-term 1,007 44.4% 379 17.3% - ---------------------------------------------------------------- TOTAL FIXED MATURITIES $ 2,269 100.0% $ 2,193 100.0% - ----------------------------------------------------------------
For the year ended December 31, 1996, before-tax net investment income totaled $183 compared to $158 in 1995, an increase of 16%. Before-tax yields on average invested assets increased to 7.4% in 1996 from 7.3% in 1995. The change in net investment income reflected the full year of investment results from ITT Ercos (acquired in May, 1995), a change in asset composition favoring longer maturities, and a modest increase in cash flow.
Corporate $ 1,530 61.7% $ 1,458 64.7% Commercial MBS 149 6.0% 88 3.9% ABS 142 5.7% 148 6.6% Gov't/Gov't agencies - U.S. 88 3.5% 141 6.2% Gov't/Gov't agencies - For. 83 3.3% 72 3.2% MBS - agency 56 2.3% 36 1.6% Municipal - taxable 39 1.6% 22 1.0% CMO 27 1.1% 40 1.8% Short-term 357 14.4% 248 11.0% Redeemable preferred stock 9 0.4% -- -- - ---------------------------------------------------------------- TOTAL FIXED MATURITIES $ 2,480 100.0% $ 2,253 100.0% - ---------------------------------------------------------------- INVESTMENT RESULTS
For the year ended December 31, 1996, before-tax net investment income totaled $149 compared to $165 in 1995, a decrease of 10%. Before-tax yields on average invested assets decreased to 6.5% in 1996 from 7.2% in 1995. The decrease in net investment income and yield were due to the sale of fixed maturities late in 1995 in the Fencourt portfolio and reinvestment in securities with substantially lower yields.
Net realized capital gains were $1 in 1997 compared to $5 in 1996 and $30 in 1995, primarily due to gains taken in the Fencourt portfolio in 1995.
The Company is exposed to two primary sources of investment and asset/liability management risk: credit risk, relating to the uncertainty associated with the ability of an obligor or counterparty to make timely payments of principal and/or interest, and market risk, relating to the market price and/or cash flow variability associated with changes in interest rates, securities prices, market indices, yield curves or currency exchange rates. The Company does not hold any financial instruments entered into for trading purposes.
The Company invests primarily in investment grade securities and has established exposure limits, diversification standards and review procedures for all credit risks whether borrower, issuer or counterparty. Creditworthiness of specific obligors is determined by an internal credit evaluation supplemented by consideration of external determinants of creditworthiness, typically ratings assigned by nationally recognized ratings agencies. Obligor, geographic, asset sector and industry concentrations are subject to established limits and monitored on a regular interval.
The Hartford is not exposed to any significant credit concentration risk of a single issuer.
As of December 31, 1997, over 95% of the fixed maturity portfolio was invested in investment-grade securities.
The Hartford has several objectives in managing market risk associated with its property and casualty and life operations. The property and casualty operations attempt to maximize economic value while generating appropriate after-tax income and sufficient liquidity to meet corporate and policyholder obligations. The property and casualty operations have material exposure to interest rate and equity market risk. The life operations are responsible for maximizing after-tax returns within acceptable risk parameters including the management of the interest rate sensitivity of invested assets to that of policyholder obligations. The life operations have material market exposure to interest rate risk associated with its fixed maturity portfolios. The Company continually monitors these exposures and adjusts the composition and profile of its invested assets through both the cash and derivatives markets to manage these risks.
The principal amounts of the fixed and variable rate fixed maturity portfolios, along with the respective weighted average coupons at December 31, 1997, are reflected in the following table by estimated maturity year. Expected maturities differ from contractual maturities due to call or prepayment provisions. The weighted average coupon on variable rate securities is based upon spot rates as of December 31, 1997, and is based primarily on London Interbank Offered Rate ("LIBOR"). Callable bonds and notes are primarily municipal bonds, and are distributed to either call dates or maturity depending on which date produces the most conservative yield. Asset backed securities, collateralized mortgage obligations and mortgage backed securities are distributed to maturity year based on estimates of the rate of future prepayments of principal over the remaining life of the securities. These estimates are developed using prepayment speeds contained in broker consensus data. Such estimates are derived from prepayment speeds previously experienced at interest rate levels projected for the underlying collateral. Actual prepayment experience may vary from these estimates. Financial instruments with certain leverage features have been included in each of the fixed maturity categories. These instruments have not been separately displayed as they were immaterial to the property and casualty operations' investment portfolio.
The property and casualty operations hold a well diversified portfolio of investments in equity securities representing firms in various countries, industries and market segments ranging from small market capitalization stocks to the Standard & Poor's 500 stocks. The risk associated with these securities relates to potential decreases in value resulting from changes in the equity prices.
The following table reflects equity securities owned at December 31, 1997 grouped by major market type.
-------------------------------- EQUITY SECURITIES Fair Value Percent - --------------------------------------------------------------- Domestic Large cap $ 793 45.5% Midcap/small cap 293 16.8% Foreign EAFE [1]/Canadian 562 32.3% Emerging 93 5.4% - --------------------------------------------------------------- Total $ 1,741 100.0% - --------------------------------------------------------------- [1] Europe, Australia, Far East countries index.
Impact of 10% Changes Net Equity ---------------- Company Investment -10% +10% Currency - --------------------- ------------- -------- ------- ----------- ITT London & Edinburgh $362 $(36) $36 Sterling Zwolsche Algemeene 353 (35) 35 Guilder ITT Ercos 53 (1) 1 Pesetas - --------------------- ------------- -------- ------- -----------
The life operations' general and guaranteed separate account 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 the life operations' profitability. Under certain circumstances of interest rate volatility, the life operations could be exposed to disintermediation risk and reduction in net interest rate spread or profit margins. For the life operations' non-guaranteed separate accounts, exposure is not significant as the policyholder assumes substantially all of the investment risk.
The life operations' general account and guaranteed separate account investment portfolios primarily consist of investment-grade, fixed maturity securities, including corporate bonds, asset backed securities, commercial mortgage backed securities and collateralized mortgage obligations. The fair value of these and the life operations' other invested assets fluctuates depending on the interest rate environment and other general economic conditions. During periods of declining interest rates, paydowns on residential mortgage backed securities and collateralized mortgage obligations increase as the underlying mortgages are prepaid. During such periods, the Company generally will not be able to reinvest the proceeds of any such prepayments at comparable yields. Conversely, during periods of rising interest rates, the rate of prepayments generally slows, also exposing the Company to the possibility of asset/liability cash flow and yield mismatch. For further discussion of the Company's risk management techniques to manage this market risk, see the "Asset and Liability Management Strategies Used to Manage Market Risk" discussed below.
As described above, the life operations hold a significant fixed maturity portfolio which includes both fixed and variable rate features. The following table reflects the principal amounts of the life operations' general and guaranteed separate account fixed and variable rate fixed maturity portfolios, at December 31, 1997, along with the respective weighted average coupons, by estimated maturity year. Expected maturities differ from contractual maturities due to call or prepayment provisions. The weighted average coupon on variable rate securities is based upon spot rates as of December 31, 1997, and is primarily based upon LIBOR. Callable bonds and notes are distributed to either call dates or maturity depending on which date produces the most conservative yield. Asset backed securities, collateralized mortgage obligations and mortgage backed securities are distributed to maturity year based on estimates of the rate of future prepayments of principal over the remaining life of the securities. These estimates are developed using prepayment speeds provided in broker consensus data. Such estimates are derived from prepayment speeds previously experienced at the interest rate levels projected for the underlying collateral. Actual prepayment experience may vary from these estimates. Financial instruments with certain leverage features have been included in each of the fixed maturity categories. These instruments have not been separately displayed because they were immaterial to the life investment portfolio.
Anticipatory Hedging -- For certain liabilities, life operations commits to the price of the product prior to receipt of the associated premium or deposit. Anticipatory hedges are routinely executed to offset the impact of changes in asset prices arising from interest rate changes pending the receipt of premium or deposit and the subsequent purchase of an asset. These hedges involve taking a long position in interest rate futures or entering into an interest rate swap with duration characteristics equivalent to the associated liabilities or anticipated investments. The notional amount of anticipatory hedges as of December 31, 1997 was $255.
Asset Hedging -- To meet the various life policyholder obligations and to provide cost effective prudent investment risk diversification, the life operations may combine two or more financial instruments to achieve the investment characteristics of a fixed maturity security or that match an associated liability. The use of derivative instruments in this regard effectively transfers unwanted investment risks or attributes to others. The selection of the appropriate derivative instruments depends on the investment risk, the liquidity and efficiency of the market, and the asset and liability characteristics. The notional amount of asset hedges as of December 31, 1997 was $3.2 billion.
Portfolio Hedging -- The life operation periodically compares the duration and convexity of its portfolios of assets to their corresponding liabilities and enters into portfolio hedges to reduce any difference to desired levels. Portfolio hedges reduce the mismatch between assets and liabilities and offset the potential impact to cash flows caused by changes in interest rates. The notional amount of portfolio hedges as of December 31, 1997 was $3.1 billion.
The following tables provide information as of December 31, 1997 on derivative instruments used in accordance with the aforementioned hedging strategies. For interest rate swaps, caps and floors, the tables present notional amounts with weighted average pay and receive rates for swaps and weighted average strike rates for caps and floors by maturity year. For interest rate futures, the tables present contract amount and weighted average settlement price by expected maturity year.
Indexed -- Products in this category are similar to the fixed rate asset accumulation vehicles but require the life operations to pay a rate that is determined by an external index. The amount and/or timing of cash flows will therefore vary based on the level of the particular index. The primary risks inherent in these products are similar to the fixed rate asset accumulation vehicles, with an additional risk that changes in the index may adversely affect profitability. Product examples include indexed-guaranteed investment contracts with an estimated duration of up to two years.
Matching the duration of investments with respective policyholder obligations is an explicit objective of the life operations' management strategy. The estimated cash flows of insurance policy liabilities based upon internal actuarial assumptions as of December 31, 1997 are reflected in the table below by expected maturity year.
For liabilities whose cash flows are not substantially affected by changes in interest rates ("fixed liabilities") and where investment experience is substantially absorbed by the life operations, the sensitivity of the net economic value (discounted present value of asset cash flows less the discounted present value of liability cash flows) of those portfolios to 100 basis point shifts in interest rates is shown in the table below. These fixed liabilities represent about 60% of the life operations' general and guaranteed separate account liabilities. The remaining liabilities generally allow the life operation significant flexibility to adjust credited rates to reflect actual investment experience and thereby pass through a substantial portion of actual investment experience to the policyholder. The fixed liability portfolios are managed and monitored relative to defined objectives and are analyzed regularly by management for internal risk management purposes using scenario simulation techniques, and evaluated annually consistent with regulatory requirements.
Amount $ 5 $ (10) Percent of liability value 0.03% (0.06%) - ------------------------------- -- ------------ --- ------------
On February 10, 1997, HLI, the holding company parent of The Hartford's significant life insurance subsidiaries, filed a registration statement, as amended, with the Securities and Exchange Commission relating to the initial public offering of HLI Class A common stock (the "Offering"). Pursuant to the Offering on May 22, 1997, HLI sold to the public 26 million shares at $28.25 per share and received proceeds, net of offering expenses, of $687.
In connection with the Offering, The Hartford reported a $368 gain related to the increased value of its equity ownership in HLI. Management used or will use the proceeds from the Offering to reduce certain debt outstanding, to fund growth initiatives and for other general corporate purposes. The Hartford's current intent is to continue to beneficially own at least 80% of HLI, but it is under no contractual obligation to do so.
During 1996, The Hartford expanded its commercial paper program by increasing the maximum allowable outstanding amount of unsecured short-term commercial paper notes from $1.0 billion to $2.0 billion.
On February 14, 1997, HLI filed a shelf registration statement for the issuance and sale of up to $1.0 billion in the aggregate of senior debt securities, subordinated debt securities and preferred stock of HLI. On June 12, 1997, HLI issued and sold $650 of unsecured redeemable long-term debt in the form of notes and debentures. Of this amount, $200 was in the form of 6.90% notes due June 15, 2004, $200 of 7.10% notes due June 15, 2007, and $250 of 7.65% debentures due June 15, 2027. Interest on each of the notes and debentures is payable semi-annually on June 15 and December 15, of each year, commencing December 15, 1997. HLI also issued $50 of short-term debt in the form of commercial paper. HLI used the proceeds from these issuances for the repayment of short-term debt and for other general corporate purposes.
On January 19, 1996, The Hartford and several wholly-owned special purpose trusts ("Hartford Trusts") formed by The Hartford filed with the SEC a shelf registration statement for the potential offering and sale of $500 of debt securities and preferred stock, including up to an aggregate $500 Junior Subordinated Deferrable Interest Debentures of The Hartford and Preferred Securities of the Hartford Trusts which were issued as discussed below. (For additional information, see Notes 7 and 8 of Notes to Consolidated Financial Statements.)
On October 16, 1997, The Hartford declared a dividend on its common stock of $0.40 per share payable on January 2, 1998 to all shareholders of record as of December 1, 1997.
On February 19, 1998, The Hartford's Board of Directors approved a 5% increase in its quarterly dividend to $0.42 per share. The dividend will be payable on April 1, 1998 to shareholders of record as of March 2, 1998. The Hartford expects to continue paying quarterly dividends on its common stock of $0.42 per share throughout 1998. Dividend decisions will be based on, and affected by, a number of factors, including the operating results and financial requirements of The Hartford and the impact of the regulatory restrictions discussed in Liquidity Requirements below.
In December 1997, The Hartford's Board of Directors authorized the repurchase of up to $1.0 billion of the Company's outstanding common stock over a three-year period beginning with the first quarter of 1998. During 1997, to make shares available to employees pursuant to certain stock-based benefit plans, The Hartford repurchased 550,000 shares of its common stock in the open market at a total cost of $45.
A.M. DUFF & STANDARD BEST PHELPS & POOR'S MOODY'S - ---------------------------------------------------------------- INSURANCE RATINGS: Hartford Fire A+ AA AA Aa3 Hartford Life A+ AA+ AA Aa3 Hartford Life & Accident A+ AA+ AA Aa3 The Hartford Life & Annuity A+ AA+ AA Aa3 - ---------------------------------------------------------------- OTHER RATINGS: The Hartford Financial Services Group, Inc.: Senior debt -- A+ A A2 Commercial paper -- D-1 A-1 P-1 Hartford Life, Inc.: Senior debt -- A+ A A2 Commercial paper -- D-1 A-1 P-1 Hartford Capital I and II quarterly income preferred securities -- A A- a2 - ----------------------------------------------------------------
In January 1998, ratings from Duff & Phelps and Standard & Poor's were reaffirmed for The Hartford's significant U.S. member companies. In September 1997, A.M. Best removed the ratings of The Hartford's significant member companies from under review and reaffirmed the ratings.
The liquidity requirements of The Hartford have been and will continue to be met by funds from operations as well as the issuance of commercial paper, debt securities and its credit facility. The principal sources of funds are premiums and investment income as well as maturities and sales of invested assets. The Hartford Financial Services Group, Inc. is a holding company which receives operating cash flow in the form of dividends from its subsidiaries, enabling it to service debt, pay dividends on The Hartford's common stock and pay business expenses.
During 1997, cash provided by operating activities increased from the prior year due primarily to strong revenue growth in the Life segment combined with lower paid losses at the North American Property & Casualty segment resulting from lower property catastrophe and other severe weather-related losses. Cash provided by financing activities increased from the prior year due to proceeds of the Offering partially offset by declines in investment-type contracts written in the Life segment. The increase in cash used for investing activities reflects the investment of the additional proceeds generated by operating and financing activities.
The NAIC has been developing several model laws and regulations, including a Model Investment Law and amendments to the Model Holding Company System Regulatory Act (the "Holding Act Amendments"). The Model Investment Law defines the investments which are permissible for property and casualty and life insurers to hold, and the Holding Act Amendments address the types of activities in which subsidiaries and affiliates may engage. The NAIC adopted these models in 1997 and 1996, but the laws have not been enacted for insurance companies domiciled in the State of Connecticut, such as Hartford Fire Insurance Company. Even if enacted in Connecticut or other states in which The Hartford's subsidiaries are domiciled, it is expected that these laws will neither significantly change The Hartford's investment strategies nor have any material adverse effect on The Hartford's liquidity or financial position.
The NAIC is expected to adopt its codification of Statutory Accounting Principles ("SAP") in early 1998 with a proposed effective date of January 1, 1999. The American Institute of Certified Public Accountants (AICPA) has not yet determined whether SAP will qualify as an Other Comprehensive Basis of Accounting ("OCBOA"). If SAP is granted OCBOA status and is adopted by The Hartford's domiciliary states, the Company will make the necessary changes required for implementation. These changes are not anticipated to have a material impact on the statutory financial statements of the Company.
The Year 2000 issue relates to the ability or inability of computer systems to properly process information and data containing or related to dates beginning with the year 2000 and beyond. The Year 2000 issue exists because, historically, many computer systems that are in use today were developed years ago when a year was identified using a two-digit field rather than a four-digit field. As information and data containing or related to the century date are introduced to computer hardware, software and other systems, date sensitive systems may recognize the year 2000 as "1900", or not at all, which may result in computer systems processing information incorrectly. This, in turn, may significantly and adversely affect the integrity and reliability of information databases and may result in a wide variety of adverse consequences to a company. In addition, Year 2000 problems that occur with third parties with which a company does business, such as suppliers, computer vendors, distributors and others, may also adversely affect any given company.
Beginning in 1990, The Hartford began working on making its computer systems Year 2000 ready, either through installing new programs or replacing systems. In January 1998, The Hartford commenced a company-wide program to further identify, assess and remediate the impact of Year 2000 problems in The Hartford's business segments. The Hartford currently anticipates that this internal program will be substantially completed by the end of 1998, and testing of computer systems will continue through 1999. The costs of addressing the Year 2000 issue that have been incurred by The Hartford through the year ended December 31, 1997 have not been material to The Hartford's financial condition or results of operations. The Hartford will continue to incur costs related to its Year 2000 efforts and is in the process of attempting to determine the approximate total costs to be incurred in the future, which costs are not currently anticipated to be material to the Company's financial condition or results of operations.