Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") addresses the financial condition of The Hartford Financial Services Group, Inc. and its subsidiaries ("The Hartford" or the "Company") as of December 31, 1998, compared with December 31, 1997, and its results of operations for the three years ended December 31, 1998, 1997 and 1996. This discussion should be read in conjunction with the Consolidated Financial Statements and related Notes beginning on page.
Certain of the statements contained herein (other than statements of historical fact) are forward-looking statements. Such forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 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 Hartford. There can be no assurance that future developments will be in accordance with management's expectations or that the effect of future developments on The Hartford will be those anticipated by management. Actual results could differ materially from those expected by The Hartford, depending on the outcome of certain factors, including those described with the forward-looking statements herein.
Consolidated Results of Operations: Operating Summary 11 North American Property & Casualty 13 Commercial 14 Personal 15 Reinsurance 16 Life 17 International 20 Other Operations 22 Reserves 23 Environmental and Asbestos Claims 23 Investments 25 Capital Markets Risk Management 28 Capital Resources and Liquidity 39 Regulatory Initiatives and Contingencies 41 Effect of Inflation 43 Accounting Standards 43
Net income for 1996 includes other charges related to environmental and asbestos reserve increases, net of taxes, of $429 in North American Property & Casualty and $81 in Other Operations (as discussed in the Environmental and Asbestos Claims section), recognition of losses on GIC business of $169 (as discussed in the Life section) and other, primarily foreign tax-related items, of $2 in each of North American Property & Casualty and the Life segment and $10 in Other Operations.
The effective tax rates for 1998, 1997 and 1996 were 26%, 25% and 20%, respectively, excluding the impact of other items, as discussed above, 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 pre-tax 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 1998, 1997 and 1996 were $407, $(37) and $170, respectively. (For additional information, see Note 14 of Notes to Consolidated Financial Statements.)
On May 21, 1998, the Board of Directors authorized a two-for-one stock split effected in the form of a 100% stock dividend distributed on July 15, 1998 to shareholders of record as of June 24, 1998. The following table represents per common share data, restated to reflect the effect of the stock split, and return on equity for the past three years:
1998 1997 1996 - - ----------------------------------------------------------------- Basic earnings per share $4.36 $5.64 ($0.42) Weighted average common shares outstanding 232.8 236.0 234.5 Diluted earnings per share $4.30 $5.58 ($0.42) Weighted average common shares outstanding and dilutive potential common shares 236.2 238.9 234.5 Return on equity [1] 18.7% 28.3% (2.3)% - - ----------------------------------------------------------------- [1] Calculated by dividing net income (loss) by average equity excluding unrealized gain, after-tax. In 1997 and 1996, return on equity excluding other items (as discussed earlier) from net income (loss) was 20.5% and 13.8%, respectively.
The Hartford's reporting segments consist of Commercial, Personal, Reinsurance, Life, International and Other Operations. While the measure of profit or loss used by The Hartford's management in evaluating performance is core earnings for the Life, International and Other Operations segments, the Commercial, Personal and Reinsurance segments are evaluated by The Hartford's management primarily based upon underwriting results. While not considered a segment, the Company also reports and evaluates core earnings results for North American Property & Casualty, which include the combined underwriting results of the Commercial, Personal and Reinsurance segments, along with income and expense items not directly allocable to these segments such as net investment income and net realized capital gains and losses. Other Operations include operations which have ceased writing new business. Also, included in Other Operations is the effect of an approximate 19% minority interest in HLI's operating results.
NET INCOME (LOSS) 1998 1997 1996 - - ----------------------------------------------------------------- N. A. Property & Casualty $ 604 $ 583 $ (151) Life 386 306 24 International 92 110 127 Other Operations [1] (67) 333 (99) - - ----------------------------------------------------------------- NET INCOME (LOSS) $ 1,015 $ 1,332 $ (99) - - -----------------------------------------------------------------
As discussed above, The Hartford's management reviews and evaluates the performance of the three segments within North American Property & Casualty, Commercial, Personal and Reinsurance, primarily on an underwriting results basis. The
combined underwriting results, along with items not directly allocable to the individual segments, are used in determining net income and core earnings of North American Property & Casualty. Items not directly allocable to the individual segments include net investment income, net realized capital gains and losses, other non-underwriting expenses, income taxes and certain other items.
1998 1997 1996 - - ---------------------------------------------------------------- Underwriting results [1] $ (112) $ (82) $ (212) Net other considerations 52 3 15 Net investment income 656 619 531 Interest and other non- underwriting expenses [2] (139) (107) (64) - - ---------------------------------------------------------------- CORE EARNINGS $ 457 $ 433 $ 270 - - ---------------------------------------------------------------- [1] 1996 excludes the impact of a $429, after-tax, environmental and asbestos charge. [2] Excludes expenses related to other considerations.
Commercial provides workers' compensation, property, automobile, liability, marine, agricultural and bond coverages to commercial accounts throughout the United States and Canada. Excess and surplus lines business not normally written by standard lines insurers is also provided. Commercial is organized into three customer markets: Business Insurance, Commercial Affinity and Commercial Specialty. Business Insurance provides standard commercial business for small accounts ("Select Customer") and mid-sized insureds. Commercial Affinity provides commercial risk management products and services to members of affinity groups and customers of financial institutions. Commercial Specialty provides insurance through retailers and wholesalers to large commercial clients and insureds requiring a variety of specialized coverages. Its results include the bond lines and First State Management Group, a leading underwriter of excess and surplus lines business produced primarily through wholesale brokers. Agricultural, livestock and marine products are also managed within Commercial Specialty.
retain accounts. In addition, the disposal of IRI in early 1998 and another unit in late 1997, with combined written premiums of $53 in 1997, contributed to the lack of growth in the Commercial segment. Excluding the impact of the disposed businesses, 1998 total Commercial written premiums would have increased 2% over 1997.
Difficult market conditions and intense price competition within many markets of the commercial sector are likely to continue into the foreseeable future. The combined effects of excess capital, decreasing demand and new forms of competition have particularly impacted the mid-to-large commercial accounts markets over the past few years. In response to these conditions, the Commercial segment has undertaken several major strategic actions, with many completed in 1998. Pricing actions in the mid-to-large account marketplace were initiated during 1998 and are expected to have a positive impact on profitability in 1999. Strategic alliances have been formed with several major national and regional banks, insurance and other companies to market commercial products to their customers. Investments in such areas as advertising, product research and development, technology and staff training have continued, in an effort to heighten brand awareness, increase product offerings, further develop alternative distribution channels and improve productivity. Management believes the result of these and other actions taken may counterbalance the negative external factors in the commercial market and position the Commercial segment for improved written premium growth in 1999 and beyond, while maintaining core profitability.
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 five markets: the membership of AARP through a direct marketing operation; customers who prefer local agent involvement through a network of independent agents in the standard personal lines market and in the non-standard automobile market through Omni Insurance Group, Inc. ("Omni"), which was acquired in 1998; customers of financial institutions through an affinity center which began in 1996 and is building from the AARP operation competencies; and customer service for all health insurance products offered through AARP's Health Care Options effective January 1, 1998. AARP's exclusive licensing arrangement continues through the year 2002 for automobile, homeowners and home-based business and through 2007 for
Underwriting results improved by $147 in 1997 over 1996, with a corresponding 6.6 point improvement in the combined ratio. This improvement was primarily due to significantly lower property catastrophe and other severe weather-related losses of $137. Improved automobile and homeowners profitability resulting from expanded cost containment initiatives was partially offset by expenses related to significant investments in future growth initiatives and a $34 dividend to policyholders in two states in recognition of favorable personal lines automobile results.
Intense competition in the personal markets will remain in the foreseeable future, primarily in the personal automobile line. Several major strategic actions have been initiated over the past two years, with many completed in 1998. Aggressive entry into and subsequent expansion in the non-standard personal automobile insurance market through the acquisition of Omni, in early 1998, provides the Personal segment with a highly-regarded and well-established franchise as a leverage for future growth. (For additional information, see the Capital Resources and Liquidity section under "Omni".) Strategic alliances have been formed with several major national and regional banks to market personal products to their customers. The Hartford Customer Services Group contracted with AARP to service its group health insurance plan partners and recipients beginning January 1, 1998. Investments in such areas as advertising, product research and development, agency relations, technology and staff training have continued, in an effort to heighten brand awareness, increase product offerings, further develop alternative distribution channels and improve productivity. As a result of these and other actions taken, management believes the Personal segment is positioned for continued written premium growth increases in 1999 and beyond, while maintaining core profitability.
The Hartford assumes reinsurance worldwide through its ten Hartford Reinsurance Company ("HartRe") offices located in Hartford, San Francisco, Miami, Philadelphia, Toronto, London, Madrid, Munich, Hong Kong and Taipei. HartRe primarily writes treaty reinsurance through professional reinsurance brokers covering various property, casualty, specialty and marine classes of business.
Written premiums increased $23, or 3%, in 1998 primarily due to the acquisition of renewal rights for the reinsurance business of a large Italian insurance company and a significant single finite risk account. Partially offsetting these increases were reductions in North American and European premiums caused by rate reductions arising from market conditions and the impact of unfavorable foreign exchange rates on Hong Kong premiums. Written premiums increased $117, or 20%, in 1997 primarily due to the acquisition in late 1996 of renewal rights for the business of Security Re and San Francisco Re.
On May 22, 1997, HLI, the holding company parent of The Hartford's significant life subsidiaries, completed the initial public offering of approximately 19% of its common stock. (For additional information, see Capital Resources and Liquidity section under "The Offering".)
Revenues increased $1.1 billion, or 23%, to $5.8 billion in 1998 from $4.7 billion in 1997. The increase was due to the continued growth of revenues in the Investment Products operation of $274 and the Individual Life operation of $57 as a result of higher aggregate fees earned on growth in account values due to strong sales and equity market appreciation. Additionally, revenues in the COLI operation increased $587 primarily due to the fourth quarter of 1998 recapture of an in force block of COLI business previously ceded to MBL Life. Higher revenues in the Employee Benefits operation of $109, primarily due to strong sales and renewals, also contributed to the revenue increase.
Employee Benefits operation increased $13 principally due to an increase in group insurance revenue and favorable mortality and morbidity experience.
Core earnings increased $106, or 53%, to $306 in 1997 from $200 in 1996, primarily as a result of an increase in earnings in the Investment Products operation of $107. This growth was the result of increased earnings of $51 from individual annuity products which was driven by fees earned on an increase in total account value due to strong sales and equity market appreciation, as well as a reduction in losses of $50 in the GIC business as a result of actions taken in the third quarter of 1996. Earnings in the Employee Benefits operation increased $13 principally due to growth in group insurance revenue and favorable mortality and morbidity experience. In addition, earnings in the Individual Life operation increased $12 due to fees earned on total account value which grew due to strong sales and equity market appreciation. Partially offsetting these increases was a decrease in core earnings of $27 in Other due primarily to an increase in capital allocated to the operations, as well as higher interest expense as a result of increased indebtedness in conjunction with the Offering. (For additional information, see Capital Resources and Liquidity section under "The Offering" and "Debt".) In addition, the 1997 results were impacted by a $6 operating loss related to the Life segment's international operations.
Revenues in 1998 increased $274, or 18%, to $1.8 billion from $1.5 billion in 1997. This growth was driven by individual annuity revenues which increased $268 over the prior year due to fee income earned on growth in separate account assets. Average individual variable annuity account values increased $14.9 billion, or 38%, to $54.6 billion in 1998 from $39.7 billion in 1997, primarily due to continued strong sales of individual variable annuities as well as equity market appreciation. Individual variable annuity sales reached $9.9 billion and $9.7 billion in 1998 and 1997, respectively. Associated with the strong sales and continued growth in Investment Products, amortization of deferred costs increased $76 and other expenses increased $107 over prior year levels. Substantial growth in total average account values in 1998, coupled with continued operating efficiencies, increased the operation's core earnings $64, or 32%, to $266 in 1998 from $202 in 1997.
Revenues increased $503, or 50%, to $1.5 billion in 1997 from $1.0 billion in 1996. This increase was primarily due to improved individual annuity revenues which increased $253, reflecting a substantial increase in aggregate fees earned as a
result of the operation's growing block of separate account assets. Average individual variable annuity account values increased $13.1 billion to $39.7 billion in 1997 from $26.6 billion in 1996, primarily due to strong sales of individual variable annuities, as well as equity market appreciation. In addition, $205 of the revenue increase was related to GIC business, which was primarily impacted by $219 of net realized capital losses in the third quarter of 1996. Associated with the strong sales and continued growth in this operation, benefits, claims and expenses grew $67 over the prior year. A 27% growth in total average account value in 1997, coupled with operating efficiencies and a reduction in losses of $50 primarily as a result of actions taken in the third quarter of 1996 related to GIC, increased core earnings $107 to $202 in 1997 from $95 in 1996.
The Individual Life operation, which focuses on the high end estate and business planning markets, sells a variety of life insurance products, including variable life, universal life, interest-sensitive whole life and term life insurance.
Revenues in 1997 increased $38, or 8%, to $510 from $472 in 1996. In the first quarter of 1996, a block of business was assumed from Investors Equity Life Insurance Company which increased 1996 revenues by $9. Excluding this transaction, 1997 revenues increased $47, or 10%, as compared to 1996, reflecting the impact of applying cost of insurance charges and variable life fees to a larger block of business. Total account values increased $555, or 17%, to $3.8 billion in 1997 from $3.2 billion in 1996. Total benefits, claims and expenses increased $19, or 5%, to $423 in 1997 from $404 in 1996. The growth in the Individual Life operation's account values, particularly variable life, along with favorable mortality experience contributed to an increase in core earnings of $12 in 1997.
The Employee Benefits operation sells group life and group disability insurance as well as other products including stop loss and supplementary medical coverage to employers and employer sponsored plans. According to the latest results published by Life Insurance Marketing and Research Association (LIMRA), the Company was the second largest provider of group disability insurance in the United States for the nine months ended September 30, 1998.
COLI revenues decreased $380, or 28%, to $980 in 1997 from $1.4 billion in 1996. Expenses also declined, primarily due to a $394 decrease in dividends to policyholders. These decreases were primarily the result of the HIPA Act of 1996 discussed above. Core earnings of $27 in 1997 were consistent with 1996.
The International segment includes direct insurance business written by Zwolsche Algemeene ("Zwolsche") located in the Netherlands, Belgium and Luxembourg, ITT Ercos in Spain, People's Insurance Company Limited ("People's Insurance"), of which The Hartford acquired a 49% interest in January 1998, in Singapore and London & Edinburgh Insurance Group, Ltd. ("London & Edinburgh") in the United Kingdom, until its sale by The Hartford in November 1998, as discussed below. These companies offer property and casualty products in both personal and commercial lines as well as life insurance products and services designed to meet the needs of local customers. In addition, Other primarily represents People's Insurance and home office expenses associated with managing international operations.
On November 16, 1998, The Hartford completed the sale of London & Edinburgh to Norwich Union, a leading provider of general and life insurance in the United Kingdom. The Hartford received approximately $525, before costs of sale, for the ongoing operations of London & Edinburgh. The Hartford retained ownership of Excess Insurance Co. Ltd., London & Edinburgh's property and casualty insurance and reinsurance subsidiary, which discontinued writing new business in 1993. Excess Insurance Co. Ltd. is included in The Hartford's Other Operations segment. The gain from the sale of London & Edinburgh of $33, after-tax, has been reported in the investment results of North American Property & Casualty. London & Edinburgh's operating results are included in the International segment results through the date of sale and, therefore, are not comparable to prior year results.
Core earnings of $42 in 1998 decreased $4, or 9%, from 1997. The decrease in core earnings from 1997 was due to declining automobile underwriting results at ITT Ercos, a slightly higher casualty loss ratio and higher expenses related to Year 2000 and Euro conversion initiatives at Zwolsche and higher home office expenses in Other. Partially offsetting these decreases were a $6 increase at London and Edinburgh due to results reflecting operations through the date of sale. The increase at London & Edinburgh was due to improved personal lines results, including automobile, offset by higher losses from weather events, losses related to professional liability claims and a lower effective tax rate. A negative foreign exchange impact of $1 resulted primarily from weakness in the Guilder.
In 1997, revenues of $1.7 billion were $138, or 9%, higher than 1996, primarily due to new business attributable to an agreement entered into at the end of 1996 with Nationwide Building Society ("Nationwide") at London & Edinburgh to underwrite exclusively the homeowners business of Nationwide's customers. Growth over 1996, excluding Nationwide, was dampened by soft market conditions in the United Kingdom. In addition, the U.S. dollar strengthened against the Guilder and Peseta during 1997 compared to 1996, while weakening against the Sterling which overall had a negative foreign exchange impact on revenues of $17.
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 1998, revenues at Zwolsche of $413 decreased $19, or 4%, from 1997. In local currency, 1998 total revenues decreased by 1%. The decrease in local currency revenues was primarily due to a 22% decrease in net realized capital gains which more than offset net written premium growth of 1% and 2% in property and casualty and life operations, respectively, and overall net investment income growth of 11%. The property and casualty market remained very competitive in 1998 while the life business continued to be reasonably priced. Strengthening in the U.S. dollar against the Guilder resulted in a negative foreign exchange impact on revenues of $14.
In 1997, revenues at Zwolsche 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 the 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, revenues at ITT Ercos of $75 decreased $3, or 4%, over 1996 in U.S. dollars. In local currency, 1997 revenues grew by 13% overall with 27% growth in net written premiums of property and casualty product lines together with 9% growth in life savings and mortgage products. Due to the strengthening U.S. dollar, foreign exchange had an adverse effect of $12 on revenues.
The outlook for ITT Ercos in the Spanish market is for continued strong growth, primarily in automobile. Management expects ITT Ercos will continue to build on its unique centralized service business model and segmented underwriting and pricing skills. ITT Ercos is reviewing various alternative distribution opportunities and has developed an enhanced strategy to grow its life business. Management expects the Spanish market to have growth opportunities in life and savings products in the years ahead.
Other Operations consist of property and casualty operations of The Hartford which have discontinued writing new business. These operations primarily include First State Insurance Company, Fencourt Reinsurance Company, Ltd., Heritage Reinsurance Company, Ltd. and Excess Insurance Company Limited. The primary focus of these operations is the proper disposition of claims, resolving disputes and collecting reinsurance proceeds related largely to business underwritten and reinsured prior to 1985.
Other items for 1997 consisted of a $368 non-taxable equity gain following the sale of approximately 19% of The Hartford's principal Life subsidiary, HLI. (For additional information, see Note 2 of Notes to Consolidated Financial Statements and Capital Resources and Liquidity section under "The Offering".) Other items in 1996 primarily consisted of an increase in environmental and asbestos reserves at First State Insurance Company of $81 as discussed in the Environmental and Asbestos Claims section.
Revenues have remained flat since 1996. Core earnings included a decrease of $72 and $37 in 1998 and 1997, respectively, which represented an approximate 19% minority interest in HLI's operating results. (For additional information regarding HLI's results, see the Life section.) Excluding minority interest, core earnings increased $2 in 1998 over 1997 and $13 in 1997 over 1996.
The Hartford establishes property and casualty reserves to provide for the estimated costs of paying claims made by policyholders or against policyholders. These reserves include estimates for both claims that have been reported and those that have been incurred but not reported, and include estimates of all expenses associated with processing and settling these claims. Estimating the ultimate cost of future claims and claim adjustment expenses is an uncertain and complex process. This estimation process is based largely on the assumption that past developments are an appropriate predictor of future events, and involves a variety of actuarial techniques that analyze experience, trends and other relevant factors. The uncertainties involved with the reserving process have become increasingly unpredictable due to a number of complex factors including social and economic trends and changes in the concepts of legal liability and damage awards. Accordingly, final claim settlements may vary from the present estimates, particularly when those payments may not occur until well into the future.
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 study included a review of identified environmental and asbestos exposures of North American Property & Casualty, along with the U.S. exposures of The Hartford's International segment and exposures of the Other Operations segment. The methodology utilized a ground up analysis of policy, site and exposure level data for a representative sample of The Hartford's claims. The results of the evaluation were extrapolated against the balance of the claim population to estimate the Company's overall exposure for reported claims.
Reserve activity for both reported and unreported environmental and asbestos claims, including reserves for legal defense costs, for the years ended December 31, 1998, 1997 and 1996, was as follows (net of reinsurance):
The Hartford's pre-tax operating income has been impacted over the last three years by incurred environmental and asbestos claims and claim adjustment expenses, net of reinsurance, as follows: $6 in 1998, $2 in 1997 and $925 in 1996.
The Hartford believes that the environmental and asbestos reserves reported at December 31, 1998 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.
An important element of the financial results of The Hartford is return on invested assets. The Hartford's investment activities are divided between North American Property & Casualty, Life, International and Other Operations. The investment portfolios are managed based on the underlying characteristics and nature of each operation's respective liabilities and managed within established risk parameters. (For a further discussion on The Hartford's approach to managing risks, see the Capital Markets Risk Management section.)
The investment objective of North American Property & Casualty is to maximize the economic value while generating after-tax income and sufficient liquidity to meet corporate and policyholder obligations. Investment strategies are developed based on a variety of factors, including business needs, regulatory requirements and tax considerations.
Total invested assets were $15.1 billion at December 31, 1998 and were comprised of fixed maturities of $14.3 billion and other investments of $823, primarily equity securities. At December 31, 1997, total invested assets were $15.0 billion and were comprised of fixed maturities of $13.5 billion and $1.5 billion in other investments, primarily equity securities.
For the year ended December 31, 1998, net investment income (both before and after-tax) increased by 6% over 1997. This increase was the result of higher invested asset levels as a result of repayment of allocated advances by HLI. In addition, the reallocation of assets from equities to fixed maturities throughout the year positively impacted both before and after-tax net investment income. After-tax net investment income was also favorably impacted by the reallocation from taxable to tax-exempt bonds. The decline in before and after-tax yields on average invested assets reflects declining interest rates, primarily impacting taxable bonds.
Net realized capital gains increased to $231 in 1997 from $15 in 1996 primarily as a result of opportunities in a favorable equity market, partially offset by real estate writedowns of $31.
As of December 31, 1998 and 1997, approximately 22.8% and 22.6%, respectively, of the Life segment's fixed maturities were invested in private placement securities (including Rule 144A offerings). Private placement securities are generally less liquid than public securities. However, covenants for private placements are designed to mitigate liquidity risk. Most of the private placement securities in the segment's portfolio are rated by rating agencies.
For the year ended December 31, 1998, total before-tax net investment income increased 27% from 1997, primarily due to an increase in policy loan income as a result of the MBL Recapture. The increase in yields on average invested assets was due to the increase in policy loan income and, to a lesser extent, an increase in fixed maturities rated BBB.
For the year ended December 31, 1997, the decrease in before-tax yield was primarily attributable to declining market interest rates.
There were no net realized capital gains or losses for the year ended December 31, 1998, unchanged from 1997. During 1998, realized capital gains from the sale of fixed maturities and equity securities were offset by after-tax realized capital losses including $21 related to the other than temporary impairment charge associated with asset backed securities securitized and serviced by CFS. (For additional information on CFS, see Note 15 of Notes to Consolidated Financial Statements under "Investments".)
The 1996 capital losses of $219 were primarily attributable to the writedown and sale of certain securities within GIC.
Invested assets, excluding separate accounts, were $1.2 billion at December 31, 1998 and were comprised of fixed maturities of $844 and other investments of $350, primarily equity securities. At December 31, 1997, invested assets, which included London & Edinburgh of $1.7 billion, totaled $2.7
billion and were comprised of fixed maturities of $2.3 billion and other investments of $407, primarily equity securities.
Fixed Maturities by Type - - ------------------------------------------------------------------- 1998 1997 - - ------------------------------------------------------------------- Type Fair Value Percent Fair Value Percent - - -------------------------------------------------------------------
Gov't/Gov't agencies - For. $ 611 72.4% $ 829 36.5% Corporate 109 12.9% 414 18.3% Gov't/Gov't agencies - U.S. -- -- 19 0.8% Short-term 124 14.7% 1,007 44.4% - - ------------------------------------------------------------------- Total fixed maturities $ 844 100.0% $ 2,269 100.0% - - -------------------------------------------------------------------
For the year ended December 31, 1998, net investment income decreased 11% primarily as a result of the sale of London & Edinburgh in November 1998. Excluding London & Edinburgh, net investment income increased 13% despite a continued trend of lower yields in Europe. This growth was primarily due to an increase in life business at Zwolsche in the Netherlands and the acquisition of The Hartford's 49% interest in People's Insurance in Singapore in January 1998.
For the year ended December 31, 1997, both net investment income and yield were relatively flat as compared to 1996.
Invested assets were $2.5 billion at both December 31, 1998 and December 31, 1997 and were mostly comprised of fixed maturities.
Fixed Maturities by Type - - ---------------------------------------------------------------- 1998 1997 - - ---------------------------------------------------------------- Type Fair Value Percent Fair Value Percent - - ----------------------------------------------------------------
Net investment income $ 159 $ 157 $ 149 Yield on average invested assets [1] 6.6% 6.7% 6.5% Net realized capital gains $ 3 $ 1 $ 5 - - ---------------------------------------------------------------- [1] Represents net investment income (excluding net realized capital gains) divided by average invested assets at cost (fixed maturities at amortized cost).
Separate account products are those for which a separate investment and liability account is maintained on behalf of the policyholder. Separate accounts reflect two categories of risk assumption: non-guaranteed separate accounts totaling $81.3 billion as of December 31, 1998, wherein the policyholder assumes substantially all the risk and reward, and guaranteed separate accounts totaling $10.3 billion as of December 31, 1998, wherein The Hartford contractually guarantees either a minimum return or the account value to the policyholder. As of December 31, 1997, non-guaranteed separate accounts totaled $59.4 billion and guaranteed separate accounts totaled $10.7 billion.
The Hartford has established investment credit policies that focus on the credit quality of obligors and counterparties, limit credit concentrations, encourage diversification and require frequent creditworthiness reviews. Investment activity, including setting of policy and defining acceptable risk levels, is subject to regular review and approval by senior management and frequent review by the Company's Finance Committee.
The Company's derivatives counterparty exposure policy establishes market-based credit limits, favors long-term financial stability and creditworthiness, and typically requires credit enhancement/credit risk reducing agreements. Credit risk is measured as the amount owed to the Company based on current market conditions and potential payment obligations between the Company and its counterparties. Credit exposures are quantified weekly and netted, and collateral is pledged to or held by the Company to the extent the current value of derivatives exceed exposure policy thresholds.
As of December 31, 1998 and 1997, over 95% of the fixed maturity portfolio was invested in securities rated investment grade.
U.S. Gov't/Gov't agencies $ 805 4.7% $ 1,083 6.1% agencies AAA 6,570 38.2% 6,337 35.4% AA 3,209 18.7% 3,426 19.1% A 3,409 19.8% 3,096 17.3% BBB 1,508 8.8% 1,352 7.6% BB & below 682 3.9% 767 4.3% Short-term 1,016 5.9% 1,832 10.2% - - ---------------------------------------------------------------- Total fixed maturities $17,199 100.0% $ 17,893 100.0% ================================================================
Fixed Maturities by Credit Quality - - ---------------------------------------------------------------- 1998 1997 - - ---------------------------------------------------------------- Credit Quality Fair Value Percent Fair Value Percent - - ----------------------------------------------------------------
The Company analyzes interest rate risk using various models including multi-scenario cash flow projection models that
forecast cash flows of the liabilities and their supporting investments, including derivative instruments.
The Company uses derivative instruments in its management of market risk consistent with four risk management strategies: hedging anticipated transactions, hedging liability instruments, hedging invested assets and hedging portfolios of assets and/or liabilities. (For additional information of these strategies along with tables reflecting outstanding derivative instruments, see the Property and Casualty Operations and Life Operations discussions below.)
The primary exposure to interest rate risk in the property and casualty operations relates to its fixed maturity investments. Changes in market interest rates directly impact the market value of the fixed maturity securities. In addition, but to a lesser extent, interest rate risk exists on debt issued. Derivative instruments are used periodically to manage interest rate risk and as a result, their value will change as market rates change, generally in the opposite direction of the item being hedged. The total notional amount of derivatives used for hedging interest rate risk as of December 31, 1998 and 1997, was $75 and $125, respectively.
The principal amounts of the fixed and variable rate fixed maturity portfolios, along with the respective weighted average coupons ("WAC") by estimated maturity year at December 31, 1998, are reflected in the following table. Comparative totals are included as of December 31, 1997. Expected maturities differ from contractual maturities due to call or prepayment provisions. The weighted average coupon on variable rate securities is based on spot rates as of December 31, 1998 and 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 increase in fixed rate callable bonds from 1997 to 1998 was primarily due to the reallocation of taxable bonds to tax-exempt municipal bonds. The decrease in fixed rate other bonds was partially due to the sale of London & Edinburgh which held over $1.6 billion in fixed maturities at December 31, 1997, and to the reallocation to tax-exempt bonds.
The table below provides information as of December 31, 1998 on debt obligations and QUIPS and reflects principal cash flows and related weighted average interest rate by maturity year. Comparative totals are included as of December 31, 1997.
Currency exchange risk also exists with respect to investments in foreign equity securities. Forward foreign contracts with a notional amount of $43 and $51 were used to manage this risk at December 31, 1998 and 1997, respectively. Exposure to currency exchange risk on the Sterling has decreased from 1997 due to the sale of London & Edinburgh.
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, the Company's exposure is not significant as the policyholder assumes substantially all of the investment risk.
The table below provides information as of December 31, 1998 on debt obligations and TruPS and reflects principal cash flows and related weighted average interest rate by maturity year. Comparative totals are included as of December 31, 1997.
Liability Hedging -- Several products obligate the life operations to credit a return to the contractholder which is indexed to a market rate. To hedge risks associated with these products, the life operation typically enters into interest rate swaps to convert the contract rate into a rate that trades in a more liquid and efficient market. This hedging strategy enables the life operations to customize contract terms and conditions to customer objectives and satisfies the operation's asset/liability matching policy. Additionally, interest rate swaps are used to convert certain fixed contract rates into floating rates, thereby allowing them to be appropriately matched against floating rate assets. The notional amount of derivatives used for liability hedging as of December 31, 1998 and 1997 was $5.2 and $4.3 billion, respectively.
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, 1998 and 1997, was $3.8 and $3.2 billion, respectively.
Long-term Pay Out Liabilities -- Products in this category are long-term in nature and may contain significant actuarial (including mortality and morbidity) pricing and cash flow risks. The cash flows 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 differ from those anticipated, resulting in an investment return lower than that assumed in pricing. Product examples include structured settlement contracts, on-benefit annuities (i.e., the annuitant is currently receiving benefits thereon) and long-term disability contracts. Contract duration is generally 6 to 10 years.
Change in Net Economic Value 1998 1997 ----------------------------------------- Basis point shift - 100 + 100 - 100 + 100 - - -------------------------------------------------------------------- Amount $ 7 $ (16) $ 5 $ (10) Percent of liability value 0.05% (0.10)% 0.03% (0.06)% - - --------------------------------------------------------------------
Capital resources and liquidity represent the overall financial strength of The Hartford and its ability to generate strong cash flows from each of the business segments and borrow funds at competitive rates to meet operating and growth needs. The capital structure of The Hartford consists of debt, minority interest and equity for the past three years summarized as follows:
The Hartford's total capitalization, excluding unrealized gain on securities, net of tax, increased by $499 as of December 31, 1998 compared to 1997. This change primarily was the result of earnings and additional net borrowings, partially offset by dividends declared on The Hartford's common stock and the effect of treasury stock acquired, net of reissuances for incentive and stock purchase plans.
The Hartford's total capitalization excluding unrealized gain on securities, net of tax, increased by $1.7 billion in 1997 from 1996. This change primarily was the result of earnings, effects of the Offering (see below) and additional net borrowings, partially offset by dividends declared on The Hartford's common stock. The Company's debt to equity and debt to capitalization ratios (both excluding unrealized gain on securities, net of tax) improved in 1997 as compared to 1996, primarily as a result of earnings and the impact of the Offering, partially offset by increased debt.
The 26 million shares sold in the Offering represented approximately 19% of the equity ownership in HLI and approximately 4% of the combined voting power of HLI's Class A and Class B common stock. The Hartford owns all of the 114 million outstanding shares of Class B common stock of HLI, representing approximately 81% of the equity ownership in HLI and approximately 96% of the combined voting power of HLI's Class A and Class B common stock. Holders of Class A common stock generally have identical rights to the holders of Class B common stock except that the holders of Class A common stock are entitled to one vote per share while holders of Class B common stock are entitled to five votes per share on all matters submitted to a vote of HLI's stockholders. Also, each share of Class B common stock is convertible into one share of Class A common stock (a) upon the transfer of such share of Class B common stock by the holder thereof to a non-affiliate (except where the shares of Class B common stock so transferred represent 50% or more of all the outstanding shares of common stock, calculated without regard to the difference in voting rights between the classes of common stock) or (b) in the event that the number of shares of outstanding Class B common stock is less than the 50% of all the common stock then outstanding. As of December 31, 1998, The Hartford continued to maintain an approximate 81% equity ownership in HLI.
In connection with the Offering, The Hartford reported a $368 equity gain in 1997 related to the increased value of its equity ownership in HLI. Management used 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.
Total debt in 1998 increased $56 compared to a $241 increase in the prior year. The Hartford used the proceeds of these net additional borrowings for general corporate purposes. (For additional information regarding Debt, see Note 6 of Notes to Consolidated Financial Statements.)
Dividends - The Hartford declared $199 and paid $197 in dividends to shareholders in 1998, and declared $189 and paid $190 in 1997.
On October 15, 1998, The Hartford's Board of Directors approved a 5% increase in the quarterly dividend to $0.22 per share, payable January 4, 1999 to shareholders of record as of December 1, 1998.
Treasury Stock - During 1998, The Hartford repurchased 10,759,773 shares of its common stock in the open market at a total cost of $547 under the Company's $1.0 billion repurchase program announced in December 1997. Some of these repurchased shares were reissued pursuant to certain stock-based benefit plans.
A.M. Duff & Standard Best Phelps & Poor's Moody's - - ---------------------------------------------------------------- Insurance Ratings: Hartford Fire A+ AA AA Aa3 Hartford Life Insurance Company A+ AA+ AA Aa3 Hartford Life & Accident A+ AA+ AA Aa3 Hartford Life & Annuity A+ AA+ AA Aa3 - - ---------------------------------------------------------------- Other Ratings: The Hartford Financial Services Group, Inc.: Senior debt a+ A+ A A2 Commercial paper D-1 A-1 P-1 Hartford Capital I and II quarterly income preferred securities a+ A BBB+ a2 Hartford Life, Inc.: Senior debt a+ A+ A A2 Commercial paper -- D-1 A-1 P-1 Hartford Life, Inc.: Capital I trust preferred securities a+ A BBB+ a2 - - ----------------------------------------------------------------
The total amount of statutory dividends which may be paid to The Hartford Financial Services Group, Inc. by its insurance subsidiaries in 1999, without prior approval, is $852.
(effective December 31, 1994) and life companies (effective December 31, 1993). The requirements consist of formulas which identify companies that are undercapitalized and require specific regulatory actions. RBC is calculated for property and casualty companies after adjusting capital for certain underwriting, asset, credit and off-balance sheet risks. The RBC formula for life companies establishes capital requirements relating to insurance, business, asset and interest rate risks. As of December 31, 1998, each of The Hartford's insurance subsidiaries within North American Property & Casualty and the Life segment had more than sufficient capital to meet the NAIC's RBC requirements.
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 by North American Property & Casualty 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 reflected the investment of the additional proceeds generated by operating and financing activities.
Operating cash flows in each of the last three years have been more than adequate to meet liquidity requirements.
On February 12, 1998, The Hartford completed the purchase of all outstanding shares of Omni Insurance Group, Inc. ("Omni"), a holding company of two non-standard auto insurance subsidiaries licensed in 25 states and the District of Columbia. The Hartford paid cash of $31.75 per share, plus transaction costs, for a total of $189. The acquisition has been reported as a purchase transaction and accordingly, the results of Omni's operations have been included in The Hartford's consolidated financial statements from the closing date of the transaction.
In all states, insurers licensed to transact certain classes of insurance are required to become members of an insolvency fund. In most states, in the event of the insolvency of an insurer writing any such class of insurance in the state, all members of the fund are assessed to pay certain claims of the insolvent insurer. A particular state's fund assesses its members based on their respective written premiums in the state for the classes of insurance in which the insolvent insurer is engaged. Assessments are generally limited for any year to one or two percent of premiums written per year depending on the state. Such assessments paid by The Hartford approximated $23 in 1998, $19 in 1997 and $14 in 1996.
The Year 2000 issue relates to the ability or inability of computer hardware, software and other information technology ("IT") systems, as well as non-IT systems, such as equipment and machinery with imbedded chips and microprocessors, 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 IT and non-IT systems that are in use today were developed years ago when a year was identified using a two-digit date field rather than a four-digit date field. As information and data containing or related to the century date are introduced to date sensitive systems, these systems may recognize the year 2000 as "1900", or not at all, which may result in systems processing information incorrectly. This, in turn, may significantly and adversely affect the integrity and reliability of information databases of IT systems, may cause the malfunctioning of certain non-IT systems, 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.
begun initiative (5), and management currently anticipates that such activity will continue into the fourth quarter of 1999.
The Hartford's Year 2000 efforts include assessing the potential impact on The Hartford of third parties' Year 2000 readiness. The Hartford's third party Year 2000 efforts include the following three main initiatives: (1) identifying third parties which have significant business relationships with The Hartford, including, without limitation, insurance agents, brokers, third party administrators, banks and other distributors and servicers of financial products, and inquiring of such third parties regarding their Year 2000 readiness; (2) evaluating such third parties' responses to The Hartford's inquiries; and (3) based on the evaluation of third party responses (or a third party's failure to respond) and the significance of the business relationship, conducting additional activities with respect to third parties as determined to be necessary in each case. These activities may include conducting additional inquiries, more in-depth evaluations of Year 2000 readiness and plans, and integrated IT systems testing. The Hartford has completed the first third party initiative and, as of early 1999, had substantially completed evaluating third party responses received. The Hartford has begun conducting the additional activities described in initiative (3), and management currently anticipates that it will continue to do so through the end of 1999. However, notwithstanding these third party Year 2000 efforts, The Hartford does not have control over these third parties and, as a result, The Hartford cannot currently determine to what extent future operating results may be adversely affected by the failure of these third parties to adequately address their Year 2000 issues.
If significant Year 2000 problems arise, including problems arising with third parties, failures of IT and non-IT systems could occur, which in turn could result in substantial interruptions in The Hartford's business. In addition, The Hartford's investing activities are an important aspect of its business, and The Hartford may be exposed to the risk that issuers of investments held by it will be adversely impacted by Year 2000 issues. Given the uncertain nature of Year 2000 problems that may arise, especially those related to the readiness of third parties discussed above, management cannot determine at this time whether the consequences of Year 2000 related problems that could arise will have a material impact on The Hartford's financial condition or results of operations.