Included in 2009 and 2008 are impairments of $1.5 billion and $4.0 billion, respectively.
Goodwill impairments in 2009 were $32, after-tax, recorded in Corporate compared to $597, after-tax, in 2008 with $323, after-tax, recorded in Corporate and $274, after-tax, recorded in Life.
Net realized losses of $5.9 billion in 2008 compared to $994 in 2007, which included other-than-temporary impairments of $4.0 billion in 2008 and $483 in 2007.
Excluding net realized capital losses, goodwill impairments and DAC Unlocks, Life operations earnings decreased approximately $500 and Property & Casualty operations earnings decreased approximately $300 from 2007 to 2008. See the segment sections of the MD&A for a discussion on the respective operations’ performance.
The effective tax rates for 2009, 2008 and 2007 were 49%, 40%, and 26%, respectively. The principal causes of the differences between the effective rate and the U.S. statutory rate of 35% for 2009, 2008 and 2007 were tax-exempt interest earned on invested assets and the separate account dividends received deduction (“DRD”). This caused an increase in the tax benefit on the 2009 and 2008 pre-tax losses and a decrease in the tax expense on the 2007 pre-tax income. The effective tax rate for 2009 also includes the tax effect of a non-deductible expense related to the settlement of a contingent obligation to Allianz. For additional information, see Note 13 of the Notes to Consolidated Financial Statements.
The separate account DRD is estimated for the current year using information from the prior year-end, adjusted for current year equity market performance and other appropriate factors, including estimated levels of corporate dividend payments. The actual current year DRD can vary from estimates based on, but not limited to, changes in eligible dividends received by the mutual funds, amounts of distribution from these mutual funds, amounts of short-term capital gains at the mutual fund level and the Company’s taxable income before the DRD. The Company recorded benefits of $181, $176 and $155 related to the separate account DRD in the years ended December 31, 2009, 2008 and 2007, respectively, which included a benefit (charge) in 2009 of $29 related to prior year tax returns, in 2008 of $9 related to a true-up of the prior year tax return, and in 2007 of $(1) related to a true-up of the prior year tax return.
In Revenue Ruling 2007-61, issued on September 25, 2007, the Internal Revenue Service (“IRS”) announced its intention to issue regulations with respect to certain computational aspects of the DRD on separate account assets held in connection with variable annuity contracts. Revenue Ruling 2007-61 suspended Revenue Ruling 2007-54, issued in August 2007 that purported to change accepted industry and IRS interpretations of the statutes governing these computational questions. Any regulations that the IRS may ultimately propose for issuance in this area will be subject to public notice and comment, at which time insurance companies and other members of the public will have the opportunity to raise legal and practical questions about the content, scope and application of such regulations. As a result, the ultimate timing and substance of any such regulations are unknown, but they could result in the elimination of some or all of the separate account DRD tax benefit that the Company receives. Management believes that it is highly likely that any such regulations would apply prospectively only.
The Company receives a foreign tax credit against its U.S. tax liability for foreign taxes paid by the Company including payments from its separate account assets. The separate account foreign tax credit is estimated for the current year using information from the most recent filed return, adjusted for the change in the allocation of separate account investments to the international equity markets during the current year. The actual current year foreign tax credit can vary from the estimates due to actual foreign tax credits passed through by the mutual funds. The Company recorded benefits of $16, $16 and $11 related to the separate account foreign tax credit in the years ended December 31, 2009, 2008 and 2007, respectively. These amounts included benefits related to true-ups of prior years’ tax returns of $3, $4 and $0 in 2009, 2008 and 2007, respectively.
Continued equity market volatility or significant declines in interest rates are also likely to continue to impact the cost and effectiveness of our guaranteed minimum withdrawal benefit (“GMWB”) hedging program and could result in material losses in our hedging program. For more information on the GMWB hedging program, see the Life Equity Product Risk Management section within Capital Markets Risk Management.
Future sales for all products will be influenced by active management of current distribution relationships, responding to the negative impact of recent merger and consolidation activity on existing distribution relationships and the development of new sources of distribution, and the Company’s ratings, as published by the various ratings agencies, while offering competitive and innovative products and product features. The current economic environment poses challenges for future sales; while life insurance products respond well to consumer demand for financial security and wealth accumulation solutions, individuals may be reluctant to transfer funds when market volatility has recently resulted in significant declines in investment values. In addition, the availability and terms of capital solutions in the marketplace, as discussed below, to support universal life products with secondary guarantees, may reduce future growth in these products.
For risk management purposes, Individual Life accepts and retains up to $10 in risk on any one life. Individual Life uses reinsurance where appropriate to protect against the severity of losses on individual claims; however, death claim experience may continue to lead to periodic short-term earnings volatility. In the fourth quarter of 2008, Individual Life began ceding insurance under a new reinsurance structure for all new business excluding term life insurance. The new reinsurance structure allows Individual Life greater flexibility in writing larger policies, while retaining less of the overall risk associated with individual insured lives. This new reinsurance structure will help balance the overall profitability of Individual Life’s business. The financial results of this change in the reinsurance structure will be recognized over time as the percentage of new business subject to the structure grows. This will result in Individual Life recognizing increasing reinsurance premiums while reducing earnings volatility associated with mortality experience over time.
Group Benefits’ sales may fluctuate based on the competitive pricing environment in the marketplace. In this competitive environment the Company has seen weakness in its first quarter 2010 sales. The Company anticipates relatively stable loss ratios and expense ratios over the long-term based on underlying trends in the in-force business and disciplined new business and renewal underwriting. The Company experienced higher disability loss ratios in 2009; however, the Company believes this is within the normal range of volatility.
The future financial results of the Retirement Plans segment will depend on Life’s ability to increase assets under management across all businesses, achieve scale in areas with a high degree of fixed costs and maintain its investment spread earnings on the general account products sold largely in the 403(b)/457 business. Disciplined expense management will continue to be a focus of the Retirement Plans segment as necessary investments in service and technology are made to effect the integration of the acquisitions made in 2008.
Retirement Plans deposits have been negatively impacted by market volatility and by the market declines in 2008 and the first quarter of 2009 as businesses reduce their workforces and offer more modest salary increases and as workers potentially allocate less to retirement accounts in the near term. The impact of the partial equity markets recovery over the last nine months has been offset by a few large case surrenders, resulting in an overall decline in average assets under management compared to 2008. The reduction in average assets under management has strained net income in 2009, and this earnings strain is expected to continue until average account value exceeds the level seen in the first half of 2008.
During the second quarter of 2009, the Company suspended all new sales in International’s Japan and European operations. International is currently in the process of restructuring its operations to maximize profitability and capital efficiency while continuing to focus on risk management and maintaining appropriate service levels.
Profitability depends on the account values of our customers, which are affected by equity, bond and currency markets. Periods of favorable market performance will increase assets under management and thus increase fee income earned on those assets, while unfavorable market performance will have the reverse effect. In addition, higher or lower account value levels will generally reduce or increase, respectively, certain costs for individual annuities to the Company, such as guaranteed minimum death benefits (“GMDB”), guaranteed minimum income benefits (“GMIB”), guaranteed minimum accumulation benefits (“GMAB”) and GMWB. Prudent expense management is also an important component of product profitability. During 2009, the Company took actions to realign our organization and significantly reduce our expense structure which will result in improved earnings over time. The Company continually evaluates opportunities to mitigate the risks associated with International businesses and manage expenses in order to balance costs and earnings stability.
Markets partly recovered in the last three quarters of 2009, after a decline in the first quarter, resulting in increased margins in the second, third, and fourth quarters.
The net income of this segment depends on Institutional’s ability to retain assets under management, the relative mix of business, and net investment spread. Net investment spread, as discussed in Institutional’s Operating section of this MD&A, has declined year over year and management expects net investment spread will remain pressured in the intermediate future due to the low level of market short-term interest rates, increased allocation to lower yielding U.S. Treasuries and short-term investments, and anticipated performance of limited partnerships and other alternative investments.
The Company expects Personal Lines’ written premiums in 2010 will be relatively flat as growth in AARP is expected to be largely offset by a decline in Agency. The Company expects personal auto written premiums will be relatively flat as the effects of increased written premiums from the sale of the Company’s Open Road Advantage product and increased written pricing will likely be offset by actions to reduce written premiums in certain market segments and territories. The Company expects homeowners’ written premiums will also be relatively flat as an increase in written pricing and the cross-sell of AARP homeowners’ insurance to auto policyholders will likely be offset by the effect of rate and underwriting actions to improve profitability.
The Company will continue to use direct marketing to AARP members to drive new business in AARP and will expand the sale of its Open Road Advantage product through independent agents to drive new business in Agency. In all states where the Open Road Advantage product is available, the Company distributes its discounted AARP Open Road Advantage auto product through those independent agents who are authorized to offer the AARP product. The Company expects to expand the sale of the Open Road Advantage auto product to an additional 23 states in 2010.
In 2009, renewal written pricing increased 3% for auto and 5% for home and management expects that renewal written pricing for both auto and homeowners will continue to increase in 2010 driven by rate increases in response to rising loss costs. For both auto and home, management expects that the increase in average written premium per policy in 2010 will not be as significant as the increase in written pricing due primarily to a continued shift to more preferred market segment business (which has lower average premium) and growth in states and territories with lower average premium.
Within the Small Commercial segment, management expects single-digit written premium growth in 2010, due to higher new business premium and stabilization of policy count retention. During 2009, the Company experienced a decrease in both earned audit premium and endorsement premium, primarily as a result of lower payrolls. This resulted in declining average premium on renewed policies, a trend that is expected to continue into the early part of 2010. Small Commercial introduced several initiatives in 2009 including programs aimed at improving policy count retention and new product offerings for package business and expects to introduce a new pricing model for commercial auto in 2010. The workers’ compensation business is expected to produce strong policy growth in 2010 reflecting: our current market position and capabilities; targeted broadening of underwriting capabilities in selected industries; and leveraging the payroll model to both increase penetration in well-established partners and continue developing opportunities with recently added partners including the marketing relationship with Intuit. While renewal written pricing in Small Commercial was flat in 2009, increases are expected in 2010.
The Small Commercial segment’s combined ratio before catastrophes and prior accident year development is expected to be higher in 2010 than the 84.4 achieved in 2009. The increase in the combined ratio results from an expected increase in the current accident year loss and loss adjustment expense ratio, as well as, a higher expense ratio. Small Commercial experienced favorable frequency trends on workers’ compensation and commercial auto claims in recent accident years. Management expects favorable frequency to continue, but at a moderated rate, for the 2010 accident year. Across the Small Commercial lines of business, severity is expected to continue its long-term upward trend. The expense ratio is expected to be higher in 2010 driven by an increase in total underwriting expenses.
Management expects that 2010 written premiums for Middle Market will be higher due to an increase in new business premium, while policy count retention is expected to remain flat. Written premiums in Middle Market decreased by 10% in 2009 as the downturn in the economy reduced exposures across most lines of business, particularly payroll exposures for workers’ compensation and construction lines in marine, which were partially reflected in lower earned audit premium.
The combined ratio before catastrophes and prior accident year development for Middle Market is expected to be higher in 2010 than the 95.1 achieved in 2009 due to an expected increase in the current accident year loss and loss adjustment expense ratio and, to a lesser extent, an increase in the expense ratio. Claim cost severity was favorable on property and marine in 2009. However, management expects that claim cost severity for property and marine claims will return to historically normal levels in 2010 and that severity will continue to increase for general liability and workers’ compensation claims. The Company also expects a continuation of moderately lower frequency in 2010.
In 2010, the combined ratio before catastrophes and prior accident year development for Specialty Commercial is expected to be slightly higher than the 100.1 experienced in 2009 due to an expected increase in the current accident year loss and loss adjustment expense ratio and the dividend ratio, partially offset by a decrease in the expense ratio.
Property & Casualty net investment income is expected to be more favorable in 2010 than in 2009 due to increased allocation of liquid investments to spread based investments, such as investment grade corporate bonds, and more favorable limited partnership results.
The Company has identified the following estimates as critical in that they involve a higher degree of judgment and are subject to a significant degree of variability: property and casualty reserves, net of reinsurance; life estimated gross profits used in the valuation and amortization of assets and liabilities associated with variable annuity and other universal life-type contracts; evaluation of other-than-temporary impairments on available-for-sale securities and valuation allowances on investments; living benefits required to be fair valued; goodwill impairment; valuation of investments and derivative instruments; pension and other postretirement benefit obligations; valuation allowance on deferred tax assets and contingencies relating to corporate litigation and regulatory matters. Certain of these estimates are particularly sensitive to market conditions, and deterioration and/or volatility in the worldwide debt or equity markets could have a material impact on the Consolidated Financial Statements. In developing these estimates management makes subjective and complex judgments that are inherently uncertain and subject to material change as facts and circumstances develop. Although variability is inherent in these estimates, management believes the amounts provided are appropriate based upon the facts available upon compilation of the financial statements.
Reserve estimates can also change over time because of changes in internal company operations. Potential internal factors include (1) periodic changes in claims handling procedures, (2) growth in new lines of business where exposure and loss development patterns are not well established or (3) changes in the quality of risk selection in the underwriting process. In the case of assumed reinsurance, all of the above risks apply. In addition, changes in ceding company case reserving and reporting patterns can create additional factors that need to be considered in estimating the reserves. Due to the inherent complexity of the assumptions used, final claim settlements may vary significantly from the present estimates, particularly when those settlements may not occur until well into the future.
The Company provides an allowance for uncollectible reinsurance, reflecting management’s best estimate of reinsurance cessions that may be uncollectible in the future due to reinsurers’ unwillingness or inability to pay. The Company analyzes recent developments in commutation activity between reinsurers and cedants, recent trends in arbitration and litigation outcomes in disputes between reinsurers and cedants and the overall credit quality of the Company’s reinsurers. Where its contracts permit, the Company secures future claim obligations with various forms of collateral, including irrevocable letters of credit, secured trusts, funds held accounts and group-wide offsets. The allowance for uncollectible reinsurance was $335 as of December 31, 2009, including $226 related to Other Operations and $109 related to Ongoing Operations.
The Hartford, like other insurance companies, categorizes and tracks its insurance reserves for its segments by “line of business”. Furthermore, The Hartford regularly reviews the appropriateness of reserve levels at the line of business level, taking into consideration the variety of trends that impact the ultimate settlement of claims for the subsets of claims in each particular line of business. In addition, within the Other Operations segment, the Company has reserves for asbestos and environmental (“A&E”) claims. Adjustments to previously established reserves, which may be material, are reflected in the operating results of the period in which the adjustment is determined to be necessary. In the judgment of management, information currently available has been properly considered in the reserves established for losses and loss adjustment expenses.
These net loss and loss adjustment expense reserves relate to assumed reinsurance that was moved into Other Operations (formerly known as “HartRe”).
(See Reserving for Asbestos and Environmental Claims within Other Operations for a discussion of how A&E reserves are set)
Auto Liability - Commercial Lines and Short-Tailed General Liability. As with Personal Lines auto liability, the Company performs a variety of techniques, including the paid and reported development methods and frequency / severity techniques. For older, more mature accident years, management finds that reported development techniques are best. For more recent accident years, management typically prefers frequency / severity techniques that make separate assumptions about loss activity above and below a selected capping level.
Workers’ Compensation. Workers’ compensation is the Company’s single largest reserve line of business so a wide range of methods are reviewed in the reserve analysis. Methods performed include paid and reported development, variations on expected loss ratio methods, and an in-depth analysis on the largest states. Paid development patterns are historically very stable in the Company’s workers’ compensation business, so paid techniques are preferred for older accident periods. For more recent periods, paid techniques are less predictive of the ultimate liability since such a low percentage of ultimate losses are paid in early periods of development. Accordingly, for more recent accident periods, the Company generally relies more heavily on a state-by-state analysis and the expected loss ratio approach.
In Personal Lines, reserving estimates are generally less variable than for the Company’s other property and casualty segments because of the coverages having relatively shorter periods of loss emergence. Estimates, however, can still vary due to a number of factors, including interpretations of frequency and severity trends and their impact on recorded reserve levels. Severity trends can be impacted by changes in internal claim handling and case reserving practices in addition to changes in the external environment. These changes in claim practices increase the uncertainty in the interpretation of case reserve data, which increases the uncertainty in recorded reserve levels. In addition, the introduction of new products has led to a different mix of business by type of insured than the Company experienced in the past. Such changes in mix increase the uncertainty of the reserve projections, since historical data and reporting patterns may not be applicable to the new business.
In the Specialty Commercial segment, many lines of insurance are “long-tail”, including large deductible workers’ compensation insurance, as such, reserve estimates for these lines are more difficult to determine than reserve estimates for shorter-tail lines of insurance. Estimating required reserve levels for large deductible workers’ compensation insurance is further complicated by the uncertainty of whether losses that are attributable to the deductible amount will be paid by the insured; if such losses are not paid by the insured due to financial difficulties, the Company would be contractually liable. Another example of reserve variability relates to reserves for directors’ and officers’ insurance. There is potential volatility in the required level of reserves due to the continued uncertainty regarding the number and severity of class action suits, including uncertainty regarding the Company’s exposure to losses arising from the collapse of the sub-prime mortgage market. Additionally, the Company’s exposure to losses under directors’ and officers’ insurance policies is primarily in excess layers, making estimates of loss more complex. The recent financial market turmoil has increased the number of shareholder class action lawsuits against our insureds or their directors and officers and this trend could continue for some period of time.
Recorded reserves for workers’ compensation, net of reinsurance, are $6.5 billion in total for Ongoing Operations. Loss development patterns are a key indicator for this line of business, particularly for more mature accident years. Historically, loss development patterns have been impacted by, among other things, medical cost inflation. The Company has reviewed the historical variation in reported loss development patterns. If the reported loss development patterns change by 4%, the estimated net reserve need would change by $400, in either direction. A 4% change in reported loss development patterns is within historical variation, as measured by the variation around the average development factors as reported in statutory accident year reports.
In the opinion of management, based upon the known facts and current law, the reserves recorded for the Company’s property and casualty businesses at December 31, 2009 represent the Company’s best estimate of its ultimate liability for losses and loss adjustment expenses related to losses covered by policies written by the Company. However, because of the significant uncertainties surrounding reserves, and particularly asbestos exposures, it is possible that management’s estimate of the ultimate liabilities for these claims may change and that the required adjustment to recorded reserves could exceed the currently recorded reserves by an amount that could be material to the Company’s results of operations, financial condition and liquidity.
As part of its quarterly reserve review process, the Company is closely monitoring reported loss development in certain lines where the recent emergence of paid losses and case reserves could indicate a trend that may eventually lead the Company to change its estimate of ultimate losses in those lines. If, and when, the emergence of reported losses is determined to be a trend that changes the Company’s estimate of ultimate losses, prior accident years reserves would be adjusted in the period the change in estimate is made. Such adjustments of reserves are referred to as “reserve development”. Reserve development that increases previous estimates of ultimate cost is called “reserve strengthening”. Reserve development that decreases previous estimates of ultimate cost is called “reserve releases”. Reserve development can influence the comparability of year over year underwriting results and is set forth in the paragraphs and tables that follow.
Included within prior accident years development for the year ended December 31, 2009 were the following reserve strengthenings (releases):
Includes reserve discount accretion of $24, including $7 in Small Commercial, $9 in Middle Market and $8 in Specialty Commercial.
During 2009, the Company’s re-estimates of prior accident years reserves included the following significant reserve changes: Ongoing Operations
Released reserves for Personal Lines auto liability claims by $77 in 2009. Beginning in the first quarter of 2008, management observed an improvement in emerged claim severity for the 2005 through 2007 accident years attributed, in part, to changes made in claim handling procedures in 2007. During 2009, the Company recognized that favorable development in reported severity was a sustained trend for those accident years and, accordingly, management reduced its reserve estimate. In the third quarter of 2009, management also recognized sustained favorable development trends in AARP for accident year 2008 and released reserves for that accident year. The fourth quarter 2009 reserve release is in response to a continuation of these same favorable trends, primarily for accident years 2006 to 2008.
The Company reviewed its allowance for uncollectible reinsurance for Ongoing Operations in the second quarter of 2009 and reduced its allowance for Ongoing Operations by $20 driven, in part, by a reduction in gross ceded loss recoverables. The allowance for uncollectible reinsurance for Ongoing Operations is recorded within the Specialty Commercial segment.
Included within prior accident years development for the year ended December 31, 2008 were the following reserve strengthenings (releases):
Includes reserve discount accretion of $26, including $6 in Small Commercial, $9 in Middle Market, $8 in Specialty Commercial and $3 in Other Operations.
Released commercial auto liability reserves by $27, primarily related to accident years 2002 to 2007. Management has observed fewer than previously expected large losses in accident years 2006 and 2007 and lower than previously expected severity on large claims in accident years 2002 to 2005. In 2008, management recognized that favorable development in reported claim severity was a sustained trend and, accordingly, management reduced its estimate of the reserves. The $27 reserve release represented 9% of the Company’s net reserves for Middle Market commercial auto liability claims as of December 31, 2007.
Prior to the second quarter of 2007, the Company evaluated the adequacy of the reserves for unallocated loss adjustment expenses on a company-wide basis. During the second quarter of 2007, the Company refined its analysis of the reserves at the segment level, resulting in the reallocation of reserves among segments, including a reallocation of reserves from Ongoing Operations to Other Operations.
During the year ended December 31, 2007, the Company’s reestimates of prior accident year reserves included the following significant reserve changes.
Recorded a $30 net release of reserves for Small Commercial package business related to the 2003 to 2006 accident years. Reserve reviews completed during 2007 identified that the frequency of reported liability claims on Small Commercial package business policies for these accident years was lower than the previously expected frequency. In addition, reported loss costs on property coverages have emerged favorably for the 2006 accident year. In recognition of these trends, in the second and fourth quarter of 2007, management reduced reserves by a total of $30. The $30 reserve release represented 3% of the Company’s net reserves for Small Commercial package business claims as of December 31, 2006.
Strengthened general liability reserves by $39 for accident years more than 20 years old, including $25 in Specialty Commercial. The Company has experienced an increase in defense costs for certain mass tort claims and, during 2007, the Company determined that the increase in defense costs was a sustained trend that resulted in an increase in reserves. The $39 reserve strengthening represented 2% of the Company’s net reserves for general liability claims as of December 31, 2006.
Also during 2007, the Company refined its processes for allocating IBNR reserves by accident year, resulting in a reclassification of $347 of IBNR reserves from the 2003 to 2006 accident years to the 2002 and prior accident years. This reclassification of reserves by accident year had no effect on total recorded reserves within any segment or on total recorded reserves for any line of business within a segment.
The following table presents reserve activity, inclusive of estimates for both reported and incurred but not reported claims, net of reinsurance, for Other Operations, categorized by asbestos, environmental and all other claims, for the years ended December 31, 2009, 2008 and 2007.
“All Other” includes unallocated loss adjustment expense reserves. “All Other” also includes The Company’s allowance for uncollectible reinsurance. When the Company commutes a ceded reinsurance contract or settles a ceded reinsurance dispute, the portion of the allowance for uncollectible reinsurance attributable to that commutation or settlement, if any, is reclassified to the appropriate cause of loss.
The one year and average three-year net paid amounts for asbestos claims, including Ongoing Operations, were $192 and $224, respectively, resulting in a one year net survival ratio of 9.9 and a three year net survival ratio of 8.5. Net survival ratio is the quotient of the net carried reserves divided by the average annual payment amount and is an indication of the number of years that the net carried reserve would last (i.e. survive) if the future annual claim payments were consistent with the calculated historical average.
In the fourth quarters of 2009, 2008 and 2007, the Company completed evaluations of certain of its non-asbestos and non-environmental reserves, including its assumed reinsurance liabilities. Based on this evaluation in 2009, the Company recognized unfavorable prior year development of $35, principally driven by higher projected unallocated loss adjustment expenses. The Company recognized favorable prior year development of $30 and $18 in 2008 and 2007, respectively, for its HartRe assumed reinsurance liabilities principally driven by lower than expected reported losses. In 2008 and 2007, the favorable HartRe assumed reinsurance prior year development was offset by unfavorable other non-asbestos and non-environmental prior year development of $30 and $17 in 2008 and 2007, respectively, including $25 of adverse development in 2008 for assumed reinsurance obligations of the Company’s Bermuda operations.
In reporting environmental results, the Company divides its gross exposure into Direct, which is subdivided further as: Accounts with future exposure greater than $2.5, Accounts with future exposure less than $2.5, and Other direct; Assumed Reinsurance; and London Market. The unallocated amounts in the Other direct category include an estimate of the necessary reserves for environmental claims related to direct insureds who have not previously tendered environmental claims to the Company.
Gross Environmental Reserves based on the third quarter 2009 environmental reserve study.
The three year average gross paid amount for total environmental claims is $75, resulting in a three year gross survival ratio of 4.9.
During the second quarters of 2009, 2008 and 2007, the Company completed its annual ground-up asbestos reserve evaluations. As part of these evaluations, the Company reviewed all of its open direct domestic insurance accounts exposed to asbestos liability, as well as assumed reinsurance accounts and its London Market exposures for both direct insurance and assumed reinsurance. Based on this evaluation, the Company increased its net asbestos reserves by $138 in second quarter 2009. For certain direct policyholders, the Company experienced increases in claim severity, expense and costs associated with litigating asbestos coverage matters. Increases in severity and expense were most prevalent among certain, peripheral defendant insureds. The Company also experienced unfavorable development on its assumed reinsurance accounts driven largely by the same factors experienced by the direct policyholders. In the second quarter of 2008, the Company found estimates for individual cases changed based upon the particular circumstances of each account. These changes were case specific and not as a result of any underlying change in the current environment. The net effect of these changes resulted in a $50 increase in net asbestos reserves. In 2007, these evaluations resulted in no addition to the Company’s net asbestos reserves. The Company currently expects to continue to perform an evaluation of its asbestos liabilities annually.
The Other Major Asbestos Defendants subcategory represents insureds included in Tiers 1 and 2, as defined by Tillinghast that are not Wellington signatories and have not entered into structured settlements with The Hartford. The Tier 1 and 2 classifications are meant to capture the insureds for which there is expected to be significant exposure to asbestos claims.
Gross Asbestos Reserves based on the second quarter 2009 asbestos reserve study.
“All Time Paid” represents the total payments with respect to the indicated claim type that have already been made by the Company as of the indicated balance sheet date. “All Time Ultimate” represents the Company’s estimate, as of the indicated balance sheet date, of the total payments that are ultimately expected to be made to fully settle the indicated payment type. The amount is the sum of the amounts already paid (e.g. “All Time Paid”) and the estimated future payments (e.g. the amount shown in the column labeled “Total Reserves”).
Includes 25 open accounts at both June 30, 2009 and 2008.
Excludes asbestos and environmental paid and incurred loss and LAE reported in Ongoing Operations. Total gross losses and LAE incurred in Ongoing Operations for the years ended December 31, 2009, 2008 and 2007 includes $17, $15 and $9, respectively, related to asbestos and environmental claims. Total gross losses and LAE paid in Ongoing Operations for the years ended December 31, 2009, 2008 and 2007 includes $20, $12 and $10, respectively, related to asbestos and environmental claims.
The establishment of Property and Casualty reserves is an estimation process, using a variety of methods, assumptions and data elements. Ultimate losses may vary significantly from the current estimates. Many factors can contribute to these variations and the need to change the previous estimate of required reserve levels. Subsequent changes can generally be thought of as being the result of the emergence of additional facts that were not known or anticipated at the time of the prior reserve estimate and/or changes in interpretations of information and trends.
Life Estimated Gross Profits Used in the Valuation and Amortization of Assets and Liabilities Associated with Variable Annuity and Other Universal Life-Type Contracts
Beginning with the second quarter of 2009, the Company now determines EGPs from a single deterministic reversion to mean (“RTM”) separate account return projection which is an estimation technique commonly used by insurance entities to project future separate account returns. Through this estimation technique, the Company’s DAC model is adjusted to reflect actual account values at the end of each quarter. Through consideration of recent market returns, the Company will unlock, or adjust, projected returns over a future period so that the account value returns to the long-term expected rate of return, providing that those projected returns do not exceed certain caps or floors. This DAC Unlock for future separate account returns is determined each quarter. Under RTM, the expected long term weighted average rate of return is 7.1% and 5.6% for U.S. and Japan, respectively. The expected long-term equity total rate of return is 9.5% and 8.5% for the U.S. and Japan, respectively, and the expected long-term fixed income rate of return is 6.0% and 4.0% for the U.S. and Japan, respectively.
The after-tax impact on the Company’s assets and liabilities as a result of the Unlocks for years ended 2009, 2008 and 2007, were:
As a result of the Unlock, Retail reserves increased $522, pre-tax, offset by an increase in reinsurance recoverables of $279, pre-tax. International reserves increased $357, pre-tax, offset by an increase in reinsurance recoverables of $34, pre-tax.
The most significant contributor to the Unlock was a result of actual separate account returns being significantly below our aggregated estimated return for the period from October 1, 2008 to March 31, 2009, offset by actual returns being greater than our aggregated estimated return for the period from April 1, 2009 to December 31, 2009.
The Company has a monitoring process overseen by a committee of investment and accounting professionals that identifies investments that are subject to an enhanced evaluation on a quarterly basis to determine if an other-than-temporary impairment (“impairment”) is present for AFS securities or a valuation allowance is required for mortgage loans. This evaluation is a quantitative and qualitative process, which is subject to risks and uncertainties. For further discussion of the accounting policies, see the Significant Investment Accounting Policies Section in Note 5 of the Notes to Consolidated Financial Statements. For a discussion of results, see Other-Than-Temporary Impairments within the Investment Credit Risk section of the MD&A.
Fair values for GMWB and GMAB contracts are calculated based upon internally developed models because active, observable markets do not exist for those items. The fair value of the Company’s guaranteed benefit liabilities, classified as embedded derivatives, and the related reinsurance and customized freestanding derivatives is calculated as an aggregation of the following components: Best Estimate Claims Costs; Credit Standing Adjustment; and Margins. The resulting aggregation is reconciled or calibrated, if necessary, to market information that is, or may be, available to the Company, but may not be observable by other market participants, including reinsurance discussions and transactions. The Company believes the aggregation of these components, as necessary and as reconciled or calibrated to the market information available to the Company, results in an amount that the Company would be required to transfer, or receive, to or from market participants in an active liquid market, if one existed, for those market participants to assume the risks associated with the guaranteed minimum benefits and the related reinsurance and customized derivatives. The fair value is likely to materially diverge from the ultimate settlement of the liability as the Company believes settlement will be based on our best estimate assumptions rather than those best estimate assumptions plus risk margins. In the absence of any transfer of the guaranteed benefit liability to a third party, the release of risk margins is likely to be reflected as realized gains in future periods’ net income. Each of the components described below are unobservable in the marketplace and require subjectivity by the Company in determining their value.
correlations of market returns across underlying indices based on actual observed market returns and relationships over the ten years preceding the valuation date;
On a daily basis, the Company updates capital market assumptions used in the GMWB liability model such as interest rates and equity indices. On a weekly basis, the blend of implied equity index volatilities are updated. The Company continually monitors various aspects of policyholder behavior and may modify certain of its assumptions, including living benefit lapses and withdrawal rates, if credible emerging data indicates that changes are warranted. At a minimum, all policyholder behavior assumptions are reviewed and updated, as appropriate, in conjunction with the completion of the Company’s comprehensive study to refine its estimate of future gross profits during the third quarter of each year.
This assumption makes an adjustment that market participants would make to reflect the risk that guaranteed benefit obligations or the GMWB reinsurance recoverables will not be fulfilled (“nonperformance risk”). As a result of sustained volatility in the Company’s credit default spreads, during 2009 the Company changed its estimate of the Credit Standing Adjustment to incorporate observable Company and reinsurer credit default spreads from capital markets, adjusted for market recoverability. Prior to the first quarter of 2009, the Company calculated the Credit Standing Adjustment by using default rates published by rating agencies, adjusted for market recoverability. For twelve months ended December 31, 2009 and 2008, the credit standing adjustment resulted in a pre-tax gain of $154 and $6.
Assumption updates, including policyholder behavior assumptions, affected best estimates and margins for a total realized gain pre-tax of $566 and $470 for the years ended December 31, 2009 and 2008, respectively. For the year ended December 31, 2007, these updates affected best estimates resulting in a pre-tax realized loss of $(158).
For additional information on the Company’s GMWB liability, see Equity Risk within the Capital Markets Risk Management section of MD&A for additional sensitivities.
Goodwill balances are reviewed for impairment at least annually or more frequently if events occur or circumstances change that would indicate that a triggering event has occurred. A reporting unit is defined as an operating segment or one level below an operating segment. Most of the Company’s reporting units, for which goodwill has been allocated, are equivalent to the Company’s operating segments as there is no discrete financial information available for the separate components of the segment or all of the components of the segment have similar economic characteristics. The 401(k), 457 and 403(b) components of Retirement Plans have been aggregated into one reporting unit; the variable life, universal life and term life components of Individual Life have been aggregated into one reporting unit; the private placement life insurance and institutional investment products components of the Institutional Solutions Group have been aggregated into one reporting unit; the group disability and group life components of Group Benefits have been aggregated into one reporting unit; and the homeowners and automobile components of Personal Lines have been aggregated into one reporting unit. In circumstances where the components of an operating segment constitute a business for which discrete financial information is available and segment management regularly reviews the operating results of that component such as with Other Retail, which combined with Individual Annuity constitutes the Retail operating segment, Hartford Financial Products, and Federal Trust Corporation, the Company has classified those components as reporting units.
As of December 31, 2009, the Company had goodwill allocated to the following reporting units:
In 2009, the Company completed the acquisition of Federal Trust Corporation which resulted in additional goodwill of $168 in Corporate.
As of December 31, 2008, the Company had goodwill allocated to the following reporting units:
The Company acquired Federal Trust Corporation (“FTC”) on June 24, 2009 for $10, resulting in goodwill of $168. No adverse events or impairment triggers have occurred since acquisition that would cause the Company to believe the bank’s fair value has declined below its carrying value. The Company will complete its annual impairment test for FTC’s goodwill in the second quarter of 2010.
See Note 8 of the Notes to Consolidated Financial Statements for information on the results of goodwill impairment tests performed in 2008 and 2007.
The Hartford’s investments in fixed maturities include bonds, redeemable preferred stock and commercial paper. These investments, along with certain equity securities, which include common and non-redeemable preferred stocks, are classified as “available-for-sale” (“AFS”) and are carried at fair value. The after-tax difference from cost or amortized cost is reflected in stockholders’ equity as a component of Other Comprehensive Income (Loss), after adjustments for the effect of deducting the life and pension policyholders’ share of the immediate participation guaranteed contracts and certain life and annuity deferred policy acquisition costs and reserve adjustments. The equity investments associated with the variable annuity products offered in Japan are recorded at fair value and are classified as “trading” with changes in fair value recorded in net investment income. Policy loans are carried at outstanding balance. Mortgage loans are recorded at the outstanding principal balance adjusted for amortization of premiums or discounts and net of valuation allowances. Short-term investments are carried at amortized cost, which approximates fair value. Limited partnerships and other alternative investments are reported at their carrying value with the change in carrying value accounted for under the equity method and accordingly the Company’s share of earnings are included in net investment income. Recognition of limited partnerships and other alternative investment income is delayed due to the availability of the related financial information, as private equity and other funds are generally on a three-month delay and hedge funds are on a one-month delay. Accordingly, income for the years ended December 31, 2009, 2008 and 2007 may not include the full impact of current year changes in valuation of the underlying assets and liabilities, which are generally obtained from the limited partnerships and other alternative investments’ general partners. Other investments primarily consist of derivatives instruments which are carried at fair value.
The fair value is the amount at which the security could be exchanged in a current transaction between knowledgeable, unrelated willing parties using inputs, including assumptions and estimates, a market participant would utilize. As the estimated fair value of a security utilizes assumptions and estimates, the amount that may be realized may differ significantly.
Derivative instruments classified as Level 3 include complex derivatives, primarily consisting of equity options and swaps, interest rate derivatives which have interest rate optionality, certain credit default swaps, and long-dated interest rate swaps. These derivative instruments are valued using pricing models which utilize both observable and unobservable inputs and, to a lesser extent, broker quotations. A derivative instrument that is priced using both observable and unobservable inputs will be classified as a Level 3 financial instrument in its entirety if the unobservable input is significant in developing the price. The Company utilizes derivative instruments to manage the risk associated with certain assets and liabilities. However, the derivative instrument may not be classified with the same fair value hierarchy level as the associated assets and liabilities.
Pursuant to accounting principles related to the Company’s pension and other postretirement obligations to employees under its various benefit plans, the Company is required to make a significant number of assumptions in order to calculate the related liabilities and expenses each period. The two economic assumptions that have the most impact on pension and other postretirement expense are the discount rate and the expected long-term rate of return on plan assets. In determining the discount rate assumption, the Company utilizes a discounted cash flow analysis of the Company’s pension and other postretirement obligations and currently available market and industry data. The yield curve utilized in the cash flow analysis is comprised of bonds rated Aa or higher with maturities primarily between zero and thirty years. Based on all available information, it was determined that 6.00% and 5.75% were the appropriate discount rates as of December 31, 2009 to calculate the Company’s pension and other postretirement obligations, respectively. Accordingly, the 6.00% and 5.75% discount rates will also be used to determine the Company’s 2010 pension and other postretirement expense, respectively. At December 31, 2008, the discount rate was 6.25% for both pension and other postretirement expense.
Pension expense reflected in the Company’s results was $137, $122 and $131 in 2009, 2008 and 2007, respectively. The Company estimates its 2010 pension expense will be approximately $186, based on current assumptions. To illustrate the impact of these assumptions on annual pension expense for 2010 and going forward, a 25 basis point decrease in the discount rate will increase pension expense by approximately $14 and a 25 basis point change in the long-term asset return assumption will increase/decrease pension expense by approximately $10.
Deferred tax assets represent the tax benefit of future deductible temporary differences and operating loss and tax credit carryforwards. Deferred tax assets are measured using the enacted tax rates expected to be in effect when such benefits are realized if there is no change in tax law. Under U.S. GAAP, the Company tests the value of deferred tax assets for impairment on a quarterly basis at the entity level within each tax jurisdiction, consistent with the Company’s filed tax returns. Deferred tax assets are reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion, or all, of the deferred tax assets will not be realized. The determination of the valuation allowance for our deferred tax assets requires management to make certain judgments and assumptions. In evaluating the ability to recover deferred tax assets, the Company has considered all available evidence including past operating results, the existence of cumulative losses in the most recent years, forecasted earnings, future taxable income, and prudent and feasible tax planning strategies. In the event the Company determines that it most likely would not be able to realize all or part of the Company’s deferred tax assets in the future, an increase to the valuation allowance would be charged to earnings in the period such determination is made. Likewise, if it is later determined that it is more likely than not that those deferred tax assets would be realized, the previously provided valuation allowance would be reversed. The Company’s judgment and assumptions are subject to change given the inherent uncertainty in predicting future performance, which is impacted by such things as policyholder behavior, competitor pricing, new product introductions, and specific industry and investment market conditions.
In management’s judgment, the net deferred tax asset will more likely than not be realized. Included in the deferred tax asset is the expected tax benefit attributable to net operating losses of $308, consisting of U.S. losses of $18, which expire from 2012-2021, and foreign losses of $290. The foreign losses have no expiration. A valuation allowance of $86 has been recorded which consists of $6 related primarily to U.S and $80 related to foreign operations. No valuation allowance has been recorded for realized or unrealized losses. In assessing the need for a valuation allowance, management considered taxable income in prior carryback years, future taxable income and tax planning strategies that include holding debt securities with market value losses until recovery, selling appreciated securities to offset capital losses, and sales of certain corporate assets. Such tax planning strategies are viewed by management as prudent and feasible and will be implemented if necessary to realize the deferred tax asset. However, we anticipate limited ability, going forward, to recognize a full tax benefit on realized losses, which will result in additional valuation allowances. If interest rates rise, we may also experience an increased likelihood of recording a valuation allowance on previously recognized realized capital losses.
The Company considers several measures and ratios in assessing the performance its life and property and casualty underwriting businesses. The following discussions include the more significant ratios and measures of profitability for the years ended December 31, 2009, 2008 and 2007. Management believes that these ratios and measures are useful in understanding the underlying trends in The Hartford’s businesses. However, these performance indicators should only be used in conjunction with, and not in lieu of, net income for The Hartford as a whole. These ratios and measures may not be comparable to other performance measures used by the Company’s competitors.
Life is organized into six reporting segments, Retail Products Group (“Retail”), Individual Life, Group Benefits, Retirement Plans, International and Institutional Solutions Group (“Institutional”). Through Life, the Company provides retail and institutional investment products such as variable and fixed annuities, mutual funds, private placement life insurance and retirement plan services, individual life insurance products including variable universal life, universal life, interest sensitive whole life and term life; and group benefit products, such as group life and group disability insurance.
After-tax margin, excluding realized gains (losses) or DAC Unlock is a non-GAAP financial measure that the Company uses to evaluate, and believes are important measures of, segment operating performance. After-tax margin is the most directly comparable U.S. GAAP measure. The Hartford believes that the measure after-tax margin, excluding realized gains (losses) and DAC Unlock provides investors with a valuable measure of the performance of the Company’s on-going businesses because it reveals trends in our businesses that may be obscured by the effect of realized gains (losses) or quarterly DAC Unlocks. Some realized capital gains and losses are primarily driven by investment decisions and external economic developments, the nature and timing of which are unrelated to insurance aspects of our businesses. Accordingly, these non-GAAP measures exclude the effect of all realized gains and losses that tend to be highly variable from period to period based on capital market conditions. The Hartford believes, however, that some realized capital gains and losses are integrally related to our insurance operations, so after-tax margin, excluding the realized gains (losses) and DAC Unlock should include net realized gains and losses on net periodic settlements on the Japan fixed annuity cross-currency swap. These net realized gains and losses are directly related to an offsetting item included in the statement of operations such as net investment income. DAC Unlocks occur when the Company determines based on actual experience or other evidence, that estimates of future gross profits should be revised. As the DAC Unlock is a reflection of the Company’s new best estimates of future gross profits, the result and its impact on the DAC amortization ratio is meaningful; however, it does distort the trend of after-tax margin. After-tax margin, excluding realized gains (losses) and DAC Unlock should not be considered as a substitute for after-tax margin and does not reflect the overall profitability of our businesses. Therefore, the Company believes it is important for investors to evaluate both after-tax margin, excluding realized gains (losses) and DAC Unlock and after-tax margin when reviewing the Company’s performance.
DAC amortization ratio, excluding realized gains (losses) and DAC Unlock is a non-GAAP financial measure that the Company uses to evaluate, and believes is an important measure of, segment operating performance. DAC amortization ratio is the most directly comparable U.S. GAAP measure. The Hartford believes that the measure DAC amortization ratio, excluding realized gains (losses) and DAC Unlock provides investors with a valuable measure of the performance of the Company’s on-going businesses because it reveals trends in our businesses that may be obscured by the effect of realized gains (losses) or quarterly DAC Unlocks. Some realized capital gains and losses are primarily driven by investment decisions and external economic developments, the nature and timing of which are unrelated to insurance aspects of our businesses. Accordingly, these non-GAAP measures exclude the effect of all realized gains and losses that tend to be highly variable from period to period based on capital market conditions. The Hartford believes, however, that some realized capital gains and losses are integrally related to our insurance operations, so amortization of deferred policy acquisition costs and the present value of future profits (DAC amortization ratio), which is typically expressed as a percentage of pre-tax income before the cost of this amortization (an approximation of actual gross profits) and excludes the effects of realized capital gains and losses, excluding the realized gains (losses) and DAC Unlock should include net realized gains and losses on net periodic settlements on the Japan fixed annuity cross-currency swap. These net realized gains and losses are directly related to an offsetting item included in the statement of operations such as net investment income. DAC Unlocks occur when the Company determines based on actual experience or other evidence, that estimates of future gross profits should be revised. As the DAC Unlock is a reflection of the Company’s new best estimates of future gross profits, the result and its impact on the DAC amortization ratio is meaningful; however, it does distort the trend of DAC amortization ratio. DAC amortization ratio, excluding realized gains (losses) and DAC Unlock should not be considered as a substitute for DAC amortization ratio and does not reflect the overall profitability of our businesses. Therefore, the Company believes it is important for investors to evaluate both DAC amortization ratio, excluding realized gains (losses) and DAC Unlock and DAC amortization ratio when reviewing the Company’s performance.
Traditional insurance type products, such as those sold by Group Benefits, collect premiums from policyholders in exchange for financial protection for the policyholder from a specified insurable loss, such as death or disability. These premiums together with net investment income earned from the overall investment strategy are used to pay the contractual obligations under these insurance contracts. Two major factors, new sales and persistency, impact premium growth. Sales can increase or decrease in a given year based on a number of factors, including but not limited to, customer demand for the Company’s product offerings, pricing competition, distribution channels and the Company’s reputation and ratings. Persistency refers to the percentage of policies remaining in-force from year-to-year.
Management evaluates performance of certain products based on net investment spread. These products include those that have insignificant mortality risk, such as fixed annuities, certain general account universal life contracts and certain institutional contracts. Net investment spread is determined by taking the difference between the earned rate, (excluding the effects of realized capital gains and losses, including those related to the Company’s GMWB product and related reinsurance and hedging programs), and the related crediting rates on average general account assets under management. The net investment spreads are for the total portfolio of relevant contracts in each segment and reflect business written at different times. When pricing products, the Company considers current investment yields and not the portfolio average. The determination of credited rates is based upon consideration of current market rates for similar products, portfolio yields and contractually guaranteed minimum credited rates. Net investment spread can be volatile period over period, which can have a significant positive or negative effect on the operating results of each segment. The volatile nature of net investment spread is driven primarily by earnings on limited partnership and other alternative investments and prepayment premiums on securities. Investment earnings can also be influenced by factors such as changes in interest rates, credit spreads and decisions to hold higher levels of short-term investments.
The investment return, or yield, on Property & Casualty’s invested assets is an important element of the Company’s earnings since insurance products are priced with the assumption that premiums received can be invested for a period of time before loss and loss adjustment expenses are paid. For longer tail lines, such as workers’ compensation and general liability, claims are paid over several years and, therefore, the premiums received for these lines of business can generate significant investment income. Due to the need to maintain sufficient liquidity to satisfy claim obligations, the vast majority of Property & Casualty’s invested assets have been held in fixed maturities, including, among other asset classes, corporate bonds, municipal bonds, government debt, short-term debt, mortgage-backed securities and asset-backed securities.
New business written premium represents the amount of premiums charged for policies issues to customers who were not insured with the Company in the previous policy term. New business written premium plus renewal policy written premium equals total written premium.
The catastrophe ratio (a component of the loss and loss adjustment expense ratio) represents the ratio of catastrophe losses incurred in the current calendar year (net of reinsurance) to earned premiums and includes catastrophe losses incurred for both the current and prior accident years. A catastrophe is an event that causes $25 or more in industry insured property losses and affects a significant number of property and casualty policyholders and insurers. The catastrophe ratio includes the effect of catastrophe losses, but does not include the effect of reinstatement premiums.
The combined ratio before catastrophes and prior accident year development represents the combined ratio for the current accident year, excluding the impact of catastrophes. The Company believes this ratio is an important measure of the trend in profitability since it removes the impact of volatile and unpredictable catastrophe losses and prior accident year reserve development.
Underwriting results is a before-tax measure that represents earned premiums less incurred losses, loss adjustment expenses, underwriting expenses and policyholder dividends. The Hartford believes that underwriting results provides investors with a valuable measure of before-tax profitability derived from underwriting activities, which are managed separately from the Company’s investing activities. Within Ongoing Operations, the underwriting segments of Personal Lines, Small Commercial, Middle Market and Specialty Commercial are evaluated by management primarily based upon underwriting results. Underwriting results is also presented for Ongoing Operations and Other Operations. A reconciliation of underwriting results to net income for Ongoing Operations and Other Operations is set forth in their respective discussions herein.
The investment yield, or return, on the Company’s invested assets primarily includes interest income on fixed maturity investments. Based upon the fair value of Property & Casualty’s investments as of December 31, 2009 and 2008, approximately 87% and 82%, respectively, of invested assets were held in fixed maturities. A number of factors affect the yield on fixed maturity investments, including fluctuations in interest rates and the level of principal prepayments. The Company also invests in equity securities, mortgage loans, limited partnership arrangements and other alternative investments. Total Property & Casualty investment yield, after-tax, was 3.1%, 3.2% and 4.4% for the years ended December 31, 2009, 2008 and 2007, respectively.
Individual Annuity’s ROA, excluding realized losses and DAC Unlock, increased primarily due to the impact of the write off of goodwill in 2008 of $274 after-tax or 19.4 bps, partially offset by higher DAC amortization and lower investment spread in 2009.
The decrease in Individual Life’s after-tax margin, excluding realized losses and DAC Unlock, was primarily due to a higher DAC amortization rate, partially offset by a lower effective tax rate and lower operating expenses.
The decrease in Retirement Plans ROA, excluding realized losses and DAC Unlock, was primarily driven by lower returns on fixed maturities and a full year of activity from the businesses acquired in 2008, which produce a lower ROA as they are mutual fund businesses.
The decrease in Institutional’s ROA, excluding realized losses, is primarily due to lower yields on investments.
The decrease in Individual Annuity’s ROA, excluding realized losses and the effect of the DAC Unlock, reflects the write-off of goodwill of $274 after-tax, or 19.4 bps; lower limited partnership and other alternative investment income; and the net effect of lower fees.
The decrease in Individual Life’s after-tax margin, excluding realized losses and the effect of the DAC Unlock, was primarily due to unfavorable mortality expense, partially offset by a lower effective tax rate.
The decrease in Retirement Plans ROA, excluding realized losses and the effect of the DAC Unlock, was primarily driven by an increase in assets under management due to the acquired rights to service $18.7 billion in mutual funds, comprised of $15.8 billion in mutual funds from Sun Life Retirement Services, Inc., and $2.9 billion in mutual funds from Princeton Retirement Group, both of which closed in the first quarter of 2008. The acquired blocks of assets produce a lower ROA as they are comprised of mutual fund assets and assets under management as opposed to traditional annuity contracts. Also contributing to the decrease was lower yields on fixed maturity investments and a decline in limited partnership and other alternative investment income, higher service and technology costs and additional expenses associated with the acquisitions. Partially offsetting these decreases were tax benefits primarily associated with DRD.
The Group Benefit increase in after-tax margin was primarily due to the favorable expense ratio.
International-Japan ROA, excluding realized gains (losses) and the effect of the DAC Unlock, declined due to lower earned fees as a result of declining account values, lower surrender fees due to a reduction in lapses and an increase in the DAC amortization rate due to lower actual gross profits, as well as the accelerated DAC amortization associated with the 3 Win trigger.
The decrease in Institutional’s ROA, excluding realized losses, is primarily due to a decline in limited partnership and other alternative investment income. The decrease is also due to unfavorable mortality and lower yields on fixed maturity investments.
• Earned premium grew 1% in 2009, primarily due to new business growth on both AARP and Agency, partially offset by lower average renewal earned premium on auto business.
• Earned premium declined in all lines of business in 2009, including a larger decrease in property earned premium due to the sale of the Company’s core excess and surplus lines property business.
• In 2009, the 2.8 point increase in the combined ratio before catastrophes and prior accident year development was primarily driven by a 1.9 point increase in the current accident year loss and loss adjustment expense ratio before catastrophes and a 1.2 point increase in the expense ratio.
• Among other factors, the increase in the current loss and loss adjustment expense ratio before catastrophes was driven by an increase for Personal Lines auto and homeowners’ business.
• Favorable reserve development in 2009 included, among other reserve changes, the release of reserves for directors’ and officers’ claims for accident years 2003 to 2008, the release of reserves for general liability claims, primarily related to accident years 2003 to 2007, and the release of workers’ compensation reserves, partially offset by strengthening of reserves for Small Commercial package business. See “Reserve Rollforwards and Development” in the Critical Accounting Estimates section of the MD&A for a discussion of prior accident year reserve development for Ongoing Operations in 2009.
• The earned premium growth rate in 2008 was reduced from moderate earned premium increases in 2007 to no growth in 2008. The decrease in the growth rate was primarily attributable to slightly larger earned pricing decreases in 2008 compared to 2007 and a change to decreasing premium renewal retention since the middle of 2007.
• The catastrophe ratio increased by 3.2 points, primarily due to an increase in current accident year catastrophes in 2008, driven by losses from hurricane Ike and losses from tornadoes and thunderstorms in the South and Midwest.
The change from net income in 2007 to a net loss in 2008 was primarily due to an increase in net realized capital losses and lower net investment income, partially offset by a decrease in net unfavorable prior accident year reserve development. See the Other Operations segment MD&A for further discussion.
Yields calculated using annualized investment income before investment expenses divided by the monthly average invested assets at cost, amortized cost, or adjusted carrying value, as applicable, excluding collateral received associated with the securities lending program and consolidated variable interest entity noncontrolling interests. Included in the fixed maturity yield is other, which primarily relates to fixed maturities (see footnote [3] below). Included in the total net investment income yield is investment expense.
Includes income from derivatives that qualify for hedge accounting and hedge fixed maturities. Also includes fees associated with securities lending activities of $5, $100 and $138, respectively, for the years ended December 31, 2009, 2008 and 2007. The income from securities lending activities is included within fixed maturities.
The circumstances giving rise to the Company’s net realized capital gains and losses are as follows:
• Gross gains and losses on sales for the year ended December 31, 2008 primarily resulted from the decision to reallocate the portfolio to securities with more favorable risk/return profiles. Also included was a gain of $141 from the sale of a synthetic CDO.
• For the year ended December 31, 2009, the net gain on GMWB related derivatives was primarily due to liability model assumption updates related to favorable policyholder experience of $566, the relative outperformance of the underlying actively managed funds as compared to their respective indices of $550, and the impact of the Company’s own credit standing of $154. Additional net gains of $56 resulted from lower implied market volatility and a general increase in long-term interest rates, partially offset by rising equity markets. Increasing equity markets resulted in a loss of $895 related to the Company’s macro hedge program. Total gains related to GMWB hedging in 2009 were $1.5 billion. For further information, see Note 4a of the Notes to Consolidated Financial Statements. In addition, see the Company’s variable annuity hedging program sensitivity disclosures within Capital Markets Risk Management section of the MD&A.
• Other, net losses for the year ended December 31, 2009 primarily resulted in net losses of $463 on credit derivatives where the Company purchased credit protection due to credit spread tightening, $400 related to net additions to valuation allowances on impaired mortgage loans, and approximately $300 from contingent obligations associated with the Allianz transaction. These losses were partially offset by gains of $155 on credit derivatives that assume credit risk due to credit spread tightening, as well as $140 from a change in spot rates related to transactional foreign currency predominately on the internal reinsurance of the Japan variable annuity business, which is offset in accumulated other comprehensive income (loss) (“AOCI”).
For the year ended December 31, 2008, the transition impact related to the adoption of fair value accounting guidance was a reduction in revenues of $616. For further discussion of the fair value guidance transition impact, see Note 4a of the Notes to Consolidated Financial Statements.
For the year ended December 31, 2008, the transition impact related to the adoption of fair value accounting guidance was a reduction in net income of $209. For further discussion of the fair value guidance transition impact, see Note 4a of the Notes to Consolidated Financial Statements.
Net loss improved primarily due to lower net realized capital losses as a result of gains in the variable annuity hedge program in 2009 compared with losses in 2008; 2008 also included the transition impact related to the adoption of fair value accounting guidance, which resulted in a reduction in net income of $209. Additionally, impairment losses were higher in 2008. Also contributing to the lower net loss was the impairment of goodwill attributed to the individual annuity line of business in 2008. These items were offset partially by lower fee income.
• Fee income and other decreased primarily as a result of lower variable annuity and mutual fund fee income due to a decline in average account values. Average variable annuity account values declined from $99.8 billion in 2008 to $77.3 billion in 2009 driven by net outflows of $7.1 billion during 2009 as well as the effect of the equity market declines in 2008 and the first quarter of 2009. Net outflows were driven by surrender activity resulting from the aging of the variable annuity in-force block of business; lower deposits driven by increased competition, particularly competition related to guaranteed living benefits, and volatility in the equity markets. Average retail mutual fund assets under management declined from $42.4 billion to $35.5 billion driven primarily by the effect of the equity market declines in 2008 and the first quarter of 2009, partially offset by net flows of $2.0 billion during 2009.
• Net investment income in 2009 was relatively consistent with 2008 as increased derivative income and an increase in general account assets was largely offset by maintaining a greater percentage of assets in short-term investments and lower yields on fixed maturities.
• Net realized capital losses decreased as a result of the recognition of $1.5 billion of gains on GMWB derivatives in 2009 compared with losses of $631 in 2008; the transition impact related to the adoption of fair value accounting guidance, which resulted in losses of $616 in 2008; and impairment losses of $263 in 2009 compared with $474 in 2008. Partially offsetting these items were losses of $733 in 2009 related to the Company’s macro hedge program compared with gains of $40 in 2008 and net losses on sales of $329 in 2009 compared with net losses of $31 in 2008.
• Amortization of DAC increased primarily due to the higher individual annuity DAC amortization rate in 2009 as compared to 2008 due primarily to Unlock assumption changes made in 2008 and 2009 and lower gross profits in 2009. Additionally, the adoption of fair value accounting guidance at the beginning of the first quarter of 2008 resulted in a DAC benefit.
• Earned Premiums increased primarily due to an increase in life contingent premiums combined with a decrease in reinsurance premiums as a result of the lapsing of business covered by reinsurance and the significant decline in the equity markets.
• Net realized capital losses increased primarily as a result of losses on GMWB derivatives of $631 in 2008 compared with losses of $286 in 2007; the transition impact related to the adoption of fair value accounting guidance, which resulted in losses of $616 in 2008; and impairments of $474 in 2008 compared with $87 in 2007.
• Benefits, losses and loss adjustment expenses increased primarily as a result of the impact of the 2008 Unlock which increased the benefit ratio used in the calculation of GMDB reserves.
• Insurance operating costs and other expenses decreased primarily as a result of lower non deferrable asset based trail commissions due to equity market declines.
Net income increased for the year ended December 31, 2009, driven primarily by lower net realized capital losses. The following other factors contributed to the changes in net income:
• Fee income and other increased primarily due to the impact of the 2009 Unlock “amortization of” unearned revenue reserves of $83 and increased cost of insurance charges of $38 as a result of growth in guaranteed universal life insurance in-force, partially offset by lower variable life fees as a result of equity market declines. For further discussion on the Unlock, see the Critical Accounting Estimates section of the MD&A.
• Earned premiums, which include premiums for ceded reinsurance, decreased primarily due to increased ceded reinsurance premiums due to aging and growth in life insurance in-force.
• Net realized capital losses improved primarily related to lower losses from impairments. For further discussion on impairments, see Other-Than-Temporary Impairments within the Investment Credit Risk section of the MD&A.
• Benefits, losses and loss adjustment expenses increased primarily related to reserve increases on secondary guaranteed universal life products due to aging and growth in life insurance in-force, partially offset by favorable mortality experience.
• Death benefits decreased due to favorable mortality partially offset by an increase in net amount at risk for variable universal life policies caused by equity market declines.
• Amortization of DAC increased primarily as a result of the additional Unlock charges in 2009 compared to 2008. DAC amortization had a partial offset in amortization of unearned revenue reserves, which drove the increase in fee income noted above.
• Fee income and other increased primarily due to an increase in cost of insurance charges of $45 as a result of growth in guaranteed universal life insurance in-force and fees on higher surrenders of $12 due to internal exchanges from non-guaranteed universal life insurance to variable universal life insurance. Partially offsetting these increases are the impacts of the 2008 and 2007 Unlocks as well as lower variable life fees as a result of equity market declines.
• Earned premiums, which include premiums for ceded reinsurance, decreased primarily due to increased ceded reinsurance premiums due to life insurance in-force growth.
• Benefits, losses and loss adjustment expenses increased as a result of higher death benefits consistent with a larger life insurance in-force and unfavorable mortality, as well as the impact of the 2008 Unlock.
The increase in net income for the year ended December 31, 2009, was primarily due to lower net realized capital losses in 2009. The following other factors contributed to the changes in net income:
• The segment’s loss ratio increased primarily due to unfavorable morbidity experience, which was primarily due to unfavorable reserve development from the 2008 incurral loss year and higher new incurred long-term disability claims in 2009.
• The segment’s expense ratio, excluding buyouts increased compared to the prior year due primarily to a commission accrual adjustment recorded in 2009 on financial institutions business.
• Fully insured ongoing sales, excluding buyouts, decreased in 2009 from 2008 primarily due to the competitive marketplace and economic environment.
The decrease in net income for the year ended December 31, 2008, was primarily due to increased net realized capital losses.
• Net investment income decreased primarily as a result of lower yields on fixed maturity investments and lower limited partnership and other alternative investment returns of $33.
• Higher net realized capital losses were primarily driven by higher impairments in 2008 compared to 2007. For further discussion on impairments, see Other-Than-Temporary Impairments within the Investment Credit Risk section of the MD&A.
• The segment’s loss ratio decreased due to favorable disability and medical stop loss experience partially offset by unfavorable mortality.
• 2008 had an income tax benefit compared to an income tax expense in 2007 as a result of higher net realized capital losses. The effective tax rate for 2008 differs from the statutory rate of 35% primarily due to investments in tax exempt securities.
During the year ended December 31, 2008, Life acquired the rights to service assets under administration (“AUA”) from Princeton Retirement Group. Servicing revenues from AUA are based on the number of plan participants and do not vary directly with asset levels. As such, they are not included in assets under management upon which asset based returns are calculated.
The Retirement Plans segment primarily offers customized wealth creation and financial protection for corporate, government and tax-exempt employers through its two business units, 403(b)/457 and 401(k).
• Net realized capital losses increased primarily as a result of realized losses of $56 on non-qualifying derivatives in 2009 compared with $14 of gains in 2008 and mortgage valuation allowances of $38 in 2009, partially offset by OTTI impairment losses of $178 in 2009 compared with $243 in 2008.
• Amortization of DAC decreased as a result of lower gross profits in 2009 than 2008.
• The income tax benefit is greater than the prior year income tax benefit due to a higher loss before income taxes primarily due to the income items discussed above. The effective tax rate differs from the statutory rate of 35% primarily due to the recognition of the DRD.
• Net investment income declined due to a decrease in the returns from limited partnerships and other alternative investments income of $33, partially offset by growth in general account assets.
• The decline in net investment spread is attributable to lower limited partnership returns of 50 bps and lower fixed income returns of 25 bps, partially offset by a reduction in credited rates of 6 bps.
• Net realized capital losses increased primarily due to impairment losses of $243 in 2008 compared with losses of $22 in 2007.
• Insurance operating costs and other expenses increased primarily attributable to operating expenses associated with the acquired businesses. Also contributing to higher insurance operating costs were higher trail commissions resulting from an aging portfolio and higher service and technology costs.
• Amortization of DAC increased as a result of the higher Unlock charge in the third quarter of 2008 of $75 as compared to the Unlock charge in the third quarter of 2007 of $14, partially offset by lower DAC amortization associated with lower gross profits. For further discussion, see Unlocks within the Critical Accounting Estimates section of the MD&A.
The transition impact related to the adoption of fair value accounting guidance was a reduction in revenues of $34, for the year ended December 31, 2008. For further discussion of the fair value guidance transition impact, see Note 4a of the Notes to Consolidated Financial Statements.
Includes the effect of the triggering of the guaranteed minimum income benefit (“GMIB”) for the 3 Win product in 2008, of which $(809) relates to policyholders surrendering and $(181) relates to the current period annuity payments. In 2009, net flows decreased due to the suspension of sales and an additional $(267) related to the current period annuity payments for the 3 Win product.
Excludes the effects of 3 Wins related charges in 2009 and 2008, of $62 and $237, pre-tax, on net income. Including the effects of 3 Wins related charges DAC amortization would have been 48.9% and 77.8%, respectively.
Net loss decreased for the year ended December 31, 2009 as a result of decreased realized capital losses, partially offset by an unfavorable 2009 Unlock. For further discussion on the Unlocks, see Unlocks within the Critical Accounting Estimates section of the MD&A. The following other factors contributed to the changes in net loss:
• Fee income decreased primarily due to lower variable annuity fee income due to a decline in Japan’s average variable annuity account value. Average variable annuity account value declined due to net outflows driven by the suspension of new sales in the second quarter of 2009 as well as the effect of equity market declines in 2008 and the first quarter 2009.
• Benefits, losses and loss adjustment expense increased, driven by an unfavorable Unlock in the first quarter of 2009, a charge related to the 3 Win product of $39, after-tax, and increased claim cost. For further discussion on the Unlocks, see Unlocks within the Critical Accounting Estimates section of the MD&A.
• Gains for the year ended December 31, 2009 were primarily driven by transactional foreign currency gains predominately on the internal reinsurance of the Japan variable annuity business, which is entirely offset in AOCI, resulting from depreciation of the Yen and GMWB derivative gains. These gains were partially offset by the $51 loss on the pending sale of the joint venture interest in ICATU Hartford Seguros, S.A and macro hedge program losses of $163.
• Fee income increased primarily due to growth in Japan’s variable annuity average assets under management. The increase in average assets under management over the prior year was driven by deposits of $3.0 billion and a $6.6 billion increase due to foreign currency exchange translation as the yen strengthened compared to the U.S. dollar. Deposits and favorable foreign currency exchange were offset by unfavorable market performance of $10.9 billion. Net flows have decreased in Japan annuities due the 3 Win trigger and to increased competition from domestic and foreign insurers, particularly competition relating to products offered with living benefit guarantees.
Institutional has historically provided customized investment, insurance and income solutions to select markets through a broad range of products including PPLI owned by corporations and high net worth individuals, institutional annuities, mutual funds owned by institutional investors, structured settlements, stable value contracts and individual products such as income annuities and longevity assurance. During 2009, the Company decided to not actively market or sell certain Institutional products, including: structured settlements, guaranteed investment products, and most institutional annuities.
• Stable Value, net investment spreads were negatively impacted by 166 bps due to lower yields on variable rate securities and maintaining additional liquidity in the Institutional portfolios in the form of short term and U.S. Treasuries. In both periods, the drop in variable rate yields was partially offset by lower credited rates on floating rate liabilities.
• Net realized capital losses were slightly lower due to smaller impairments.
• The income tax benefit was flat due to flat income before taxes.
• Benefits, losses and loss adjustment expenses decreased primarily due to lower reserve increases as the result of lower sales in life contingent business, as well as lower interest credited on liabilities indexed to LIBOR. The decrease was partially offset by an increase in mortality losses of $8.
Includes investment income (loss) and mark-to-market effects of equity securities, trading, supporting the international variable annuity business, which are classified in net investment income with corresponding amounts credited to policyholders within benefits, losses and loss adjustment expenses.
• Insurance operating costs and other expenses increased due to restructuring costs that include severance benefits and other costs associated with the suspension of sales in International’s Japan and European operations as well as other restructuring costs across Life operations of $119. See Note 23 of the Notes to Consolidated Financial Statements for further details on the Company’s restructuring, severance and other costs.
• Net realized capital gains increased due to trading and valuation gains on derivatives, partially offset by increased impairments.
Underwriting results decreased by $160, with a corresponding 4.1 point increase in the combined ratio.
Earned premiums grew by 1% in 2009, primarily due to earned premium growth in AARP, largely offset by earned premium decreases in Agency and Other.
AARP earned premiums grew $66 in 2009, reflecting an increase in new business written premium over the first nine months of 2009, driven by increased direct marketing spend, higher auto policy conversion rates and cross-selling homeowners’ insurance to insureds who have auto policies.
Other earned premiums decreased primarily due to a strategic decision to reduce other affinity business.
• Policy count retention for auto remained flat in 2009 for both AARP and Agency policies, primarily due to stable renewal written pricing increases and policy retention initiatives. Policy count retention for homeowners decreased slightly in 2009, primarily due to a decrease in policy retention for Agency business largely due to the Company’s decision to stop renewing Florida homeowners’ policies.
• The number of policies in-force increased 3% in auto, driven by an increase in both AARP and Agency and increased 2% for homeowners, driven by an increase in AARP.
Current accident year catastrophes decreased by $30 as catastrophe losses in 2008, driven by losses from hurricane Ike and from wind and thunderstorms, were higher than catastrophe losses in 2009, driven by losses from hail and windstorms in Colorado, the Midwest and the Southeast.
Underwriting results decreased by $42, with a corresponding 1.2 point increase in the combined ratio.
Auto earned premium was relatively flat in 2008 as the effect of renewal earned pricing increases of 4% was largely offset by a decrease in new business since the middle of 2007. Homeowners’ earned premium grew 3% largely due to renewal earned pricing increases of 5%.
• Both auto and homeowners’ new business written premium decreased in 2008 including decreases in AARP and Agency. Auto new business decreased by $60, or 14% and homeowners’ new business decreased by $34, or 24%. AARP new business written premium decreased primarily due to lower auto and homeowners’ policy conversion rates, driven by increased competition, including the effect of price decreases by some carriers and the effect of continued advertising among carriers for new business. Agency new business written premium decreased primarily due to price competition driven, in part, by a greater number of agents using comparative rating software to obtain quotes from multiple carriers.
• Policy count retention for auto decreased, driven primarily by a decrease in policy retention for both AARP and Agency business. Policy count retention for homeowners decreased for both AARP and Agency business. The decrease in policy count retention for AARP homeowners’ business was driven by increased price competition by some carriers. The decrease in policy count retention for Agency homeowners’ business was due, in part, to Florida policyholders non-renewing as a result of the Company’s decision to stop renewing Florida homeowners’ policies sold through agents.
• Auto renewal earned pricing increases of 4% represent the portion of the 4% increase in renewal written pricing for 2008 that is reflected in earned premium. In 2008, the Company increased auto insurance rates in certain states for certain classes to maintain profitability in the face of rising loss costs. Renewal written pricing increases in 2008 included the effect of policyholders purchasing newer vehicle models in place of older models. Homeowners’ renewal earned pricing increases of 5% primarily reflected the earning of a blend of mid-single digit renewal written pricing increases recognized over the last nine months of 2007 and renewal written pricing increases recognized in the first nine months of 2008. Renewal written pricing increases in homeowners were largely driven by increases in coverage limits due to rising replacement costs.
• The number of policies in-force decreased slightly for both auto and homeowners, primarily due to a 7% decline in the number of Agency policies in-force, partially offset by a 1% increase in the number of AARP policies in-force.
Current accident year catastrophe losses of $258 in 2008 were higher than current accident year catastrophe losses of $125 in 2007, primarily due to losses from hurricane Ike and tornadoes and thunderstorms in the South and Midwest.
Net favorable reserve development of $51 in 2008 included a $46 release of auto liability reserves, primarily related to accident years 2005 to 2007 and a $24 release of reserves for extra-contractual liability claims under non-standard personal auto policies. Net favorable reserve development of $4 in 2007 included a $16 release of reserves for loss and allocated loss and loss adjustment expenses on Personal Lines auto liability claims for accident years 2002 to 2006.
Amortization of deferred policy acquisition costs increased by $16, driven primarily by the increase in earned premium and the amortization of a higher amount of acquisition costs for AARP business. Insurance operating costs and expenses increased by $11, primarily due to an estimated $10 of assessments owed to TWIA in 2008. The expense ratio increased 0.4 points due to the increase in insurance operating costs and expenses and the amortization of a higher amount of acquisition costs on AARP business.
Underwriting results decreased by $42, with a corresponding 0.7 point increase in the combined ratio.
• Policy count retention decreased slightly due to the impact from declining economic conditions including increased mid-term cancellations. The impact affected all lines of business.
• Renewal earned pricing was flat as an increase in renewal earned pricing for package business was offset by a decrease for workers’ compensation. Renewal earned pricing for the commercial auto business was essentially flat. The earned pricing changes were primarily a reflection of written pricing changes over the last two years. In addition to the effect of written pricing decreases in workers’ compensation, average premium per policy in Small Commercial has declined due to a reduction in the payrolls of workers’ compensation insureds and the effect of declining endorsements.
• The number of policies-in-force increased by 2% in 2009. Despite the growth in policies, earned premiums have decreased by 5%, reflecting the decrease in average premium per policy. The growth or decline in policies in-force does not correspond directly with the change in earned premiums due to the effect of changes in earned pricing and changes in the average premium per policy.
Current accident year catastrophe losses decreased by $78 in 2009, as losses in 2008 from hurricane Ike and tornadoes and thunderstorms in the South and Midwest were higher than catastrophe losses in 2009 from hail and windstorms in Colorado, the Midwest and the Southeast.
Net favorable prior accident year development decreased by $53 in 2009. Net favorable prior accident year development of $36 in 2009 included a $40 release of workers’ compensation reserves related to accident years 2007 and prior, a $33 release of commercial auto liability reserves and a $38 strengthening of reserves for package business. Net favorable prior accident year development of $89 in 2008 included a $92 release of workers’ compensation reserves related to accident years 2000 to 2007.
• Renewal earned pricing decreased for workers’ compensation and commercial auto and was relatively flat for package business. The earned pricing changes during 2008 were primarily a reflection of written pricing changes over the last two years.
Earned premiums for the Middle Market segment decreased by $198 in 2009, primarily driven by decreases in general liability and commercial auto due to earned pricing decreases and the effect of non-renewals outpacing new business. Middle Market workers’ compensation earned premium increased modestly as the effect of an increase in new business written premium was partially offset by lower earned audit premium.
• The number of policies in-force decreased by 2%, partially contributing to the decline in earned premiums.
Net favorable prior accident year reserve development increased by $53. Net favorable prior accident year reserve development of $187 in 2009 included, among other reserve changes, general liability reserve releases of $112 primarily related to accident years 2003 to 2007 and a $52 release of workers’ compensation reserves, primarily related to accident years 2007 and prior. Net favorable reserve development of $134 in 2008 primarily included a $90 release of reserves for high hazard and umbrella general liability claims, primarily related to the 2001 to 2007 accident years, a $64 release of workers’ compensation reserves, primarily related to accident years 2000 to 2007 and a $27 release of commercial auto liability reserves, primarily related to accident years 2002 to 2007, partially offset by a $50 strengthening of reserves for general liability and products liability claims primarily for accident years 2004 and prior.
Underwriting results increased by $12 with a corresponding 0.9 point decrease in the combined ratio.
• New business written premium increased by $26, or 7%, in 2008 as an increase in new business written premium for workers’ compensation was partially offset by a decrease in new business for general liability, marine and commercial auto. While continued price competition and the effect of some state-mandated rate reductions in workers’ compensation has lessened the attractiveness of new business in certain lines and regions, the Company has increased new business for workers’ compensation due, in part, to the effect of targeting business in selected industries and regions of the country.
Underwriting results increased by $99 with a corresponding decrease in the combined ratio of 8.6 points.
Property earned premiums decreased by $66 primarily due to the sale of the Company’s core excess and surplus lines property business. Effective March 31, 2009, the Company sold its core excess and surplus lines property business, to Beazley Group PLC. Concurrent with the sale, the in-force book of business was ceded to Beazley under a separate reinsurance agreement, whereby the Company ceded $26 of unearned premium, net of $10 in ceding commission. The ceding of the unearned premium was reflected as a reduction of written premium as of December 31, 2009.
Professional liability, fidelity and surety earned premium decreased by $42 primarily due to the effects of lower new business and premium renewal retention and earned pricing decreases. The adverse impact of ratings downgrades early in 2009 and the loss of key leadership personnel contributed to a decline in new business and renewal retention.
Current accident year losses and loss adjustment expenses before catastrophes decreased by $99 primarily due to a decrease in earned premiums.
Current accident year catastrophe losses were $45 lower in 2009 as compared to prior year primarily due to losses from hurricane Ike in 2008.
Net favorable prior accident year reserve development of $172 in 2009 included, among other reserve changes, releases of reserves for directors’ and officers’ insurance claims of $127 and a $20 release of reserves for uncollectible reinsurance. Net favorable prior accident year reserve development of $81 in 2008 primarily included a $75 release of reserves for directors’ and officers insurance and errors and omissions insurance claims related to accident years 2003 to 2006.
Amortization of deferred policy acquisition costs decreased by $29 due to the decrease in earned premiums. Insurance operating costs and expenses increased by $11, primarily due to a $23 increase in taxes, licenses and fees due to a $6 increase in the assessment for a second injury fund and $17 reserve strengthening for other state funds and taxes, partially offset by a decrease in policyholder dividends and compensation-related costs. The expense ratio increased by 3.1 points due to the decrease in earned premiums and the increase in insurance operating costs and expenses.
Current accident year catastrophe losses increased $38, primarily due to losses from hurricane Ike.
Prior accident year reserve development changed from net unfavorable prior accident year reserve development of $84 in 2007 to net favorable prior accident year reserve development of $81 in 2008. Net favorable prior accident year reserve development in 2008 primarily included a $75 release of reserves for directors’ and officers insurance and errors and omissions insurance claims related to accident years 2003 to 2006.
The Other Operations segment includes operations that are under a single management structure, Heritage Holdings, which is responsible for two related activities. The first activity is the management of certain property and casualty subsidiaries and operations of the Company that have discontinued writing new business. The second is the management of claims (and the associated reserves) related to asbestos, environmental and other exposures. The Other Operations book of business contains policies written from approximately the 1940s to 2003. The Company’s experience has been that this book of run-off business has, over time, produced significantly higher claims and losses than were contemplated at inception.
Net loss for 2009 decreased by $20 compared to the prior year period, driven primarily by the following:
A $116 decrease in underwriting results, primarily due to a $113 increase in unfavorable prior year loss development. Reserve development in 2009 included $138 of asbestos reserve strengthening and $75 of environmental reserve strengthening as a result of the Company’s annual asbestos and environmental reserve evaluations, partially offset by a decrease of $20 in the allowance for uncollectible reinsurance as a result of the Company’s annual evaluation of reinsurance recoverables. In 2008, reserve development included $50 of asbestos reserve strengthening and $53 of environmental reserve strengthening.
Other Operations reported a net loss of $97 in 2008 compared to net income of $30 in 2007, driven primarily by the following:
A $65 increase in underwriting results, primarily due to a $64 decrease in unfavorable prior year loss development. Reserve development in 2008 included $50 of asbestos reserve strengthening and $53 of environmental reserve strengthening. In 2007, reserve development included $99 principally as a result of an adverse arbitration decision and $25 of environmental reserve strengthening.
• The change was primarily due to approximately $300 in net realized losses related to the settlement of a contingent obligation to Allianz partially offset by realized gains of $70 on the change in fair value of the liability related to warrants issued to Allianz. Additionally, 2008 included realized gains of $110 on the change in fair value of the liability related to warrants issued to Allianz. See Note 21 of the Notes to Consolidated Financial Statements for a further discussion on Allianz.
• The increase in other expenses was a result of $19 in expenses incurred in 2009 from Federal Trust Corporation, a company The Hartford acquired in June of 2009, restructuring costs of $12 and an increase of $17 in the DAC Unlock charge recorded in Corporate. Additionally, 2008 included a benefit of $15 from interest charged by Corporate on the amount of capital held by the Life and Property & Casualty operations in excess of the amount needed to support the capital requirements of the respective operations.
• The change was primarily due to a realized gain of approximately $110 on the change in fair value of the liability related to warrants issued to Allianz in 2008. See Note 21 of the Notes to Consolidated Financial Statements for a further discussion on Allianz.
• The Company’s goodwill impairment test performed during 2008 resulted in a write-down of $323 in Corporate related to the Individual Annuity and International reporting units. See Note 8 of the Notes to Consolidated Financial Statements for a further discussion on Goodwill.
The Hartford’s property and casualty operations have processes to manage risk related to natural disasters, such as hurricanes and earthquakes, and other perils, such as terrorism. The Hartford’s risk management processes include, but are not limited to, disciplined underwriting protocols, exposure controls, sophisticated risk modeling, risk transfer, and capital management strategies.
In managing risk, The Hartford’s management processes involve establishing underwriting guidelines for both individual risks, including individual policy limits, and in aggregate, including aggregate exposure limits by geographic zone and peril. The Company establishes risk limits and actively monitors the risk exposures as a percent of Property & Casualty statutory surplus. For natural catastrophe perils, the Company generally limits its estimated loss to natural catastrophes from a single 250-year event prior to reinsurance to less than 30% of statutory surplus of the Property & Casualty operations and its estimated loss to natural catastrophes from a single 250-year event after reinsurance to less than 15% of statutory surplus of the Property & Casualty operations. From time to time, the estimated loss to natural catastrophes from a single 250-year event prior to reinsurance may fluctuate above or below 30% of statutory surplus due to changes in modeled loss estimates, exposures, or statutory surplus. Currently, the Company’s estimated pre-tax loss to a single 250-year natural catastrophe event prior to reinsurance is less than 30% of the statutory surplus of the Property & Casualty operations and the Company’s estimated pre-tax loss net of reinsurance is less than 15% of statutory surplus of the Property & Casualty operations. For terrorism, the Company monitors its exposure in major metropolitan areas to a single-site conventional terrorism attack scenario, and manages its potential estimated loss, including exposures resulting from the Company’s Group Life operations, to less than $1.3 billion. Among the landmark locations specifically monitored by the Company as of December 31, 2009, the largest estimated modeled loss arising from a single event is approximately $1.1 billion. The Company monitors exposures monthly and employs both internally developed and vendor-licensed loss modeling tools as part of its risk management discipline.
In addition to the reinsurance protection provided by The Hartford’s traditional property catastrophe reinsurance program described above, the Company has fully collateralized reinsurance coverages from Foundation Re, Foundation Re II and Foundation Re III for losses sustained from qualifying hurricane and earthquake loss events and other qualifying catastrophe losses. Foundation Re, Foundation Re II and Foundation Re III are Cayman Islands reinsurance companies which financed the provision of the reinsurance through the issuance of catastrophe bonds. Under the terms of the treaties with Foundation Re, Foundation Re II and Foundation Re III, the Company is reimbursed for losses from natural disaster events using a customized industry index contract designed to replicate The Hartford’s own catastrophe losses, with a provision that the actual losses incurred by the Company for covered events, net of reinsurance recoveries, cannot be less than zero.
As of February 1, 2010, there have been no events that are expected to trigger a recovery under any of the reinsurance programs with Foundation Re, Foundation Re II or Foundation III and, accordingly, the Company has not recorded any recoveries from the associated reinsurance treaties.
The Company’s modeled loss estimates are derived by averaging 21 modeled loss events representing a 250-year return period loss. For the peril of earthquake, the 21 events averaged to determine the modeled loss estimate include events occurring in California as well as the Northwestern, Northeastern, Southeastern and Midwestern regions of the United States with associated magnitudes ranging from 6.1 to 7.9 on the Moment Magnitude scale. For the peril of hurricane, the 21 events averaged to determine the modeled loss estimate include category 3, 4 and 5 events in Florida, as well as other Southeastern and Northeastern region landfalls.
The Company is exposed to losses from terrorist attacks, including losses caused by nuclear, biological, chemical or radiological weapons (“NBCR”) attacks. For terrorism, private sector catastrophe reinsurance capacity is limited and generally unavailable for terrorism losses caused by nuclear, biological, chemical or radiological weapons attacks. As such, the Company’s principal reinsurance protection against large-scale terrorist attacks is the coverage currently provided through the Terrorism Risk Insurance Program Reauthorization Act (“TRIPRA”). On December 26, 2007, the President signed TRIPRA extending the Terrorism Risk Insurance Act of 2002 (“TRIA”) through the end of 2014. TRIPRA provides a backstop for insurance-related losses resulting from any “act of terrorism” certified by the Secretary of the Treasury, in concurrence with the Secretary of State and Attorney General, that result in industry losses in excess of $100. In addition, TRIPRA revised the TRIA definition of a certified “act of terrorism” by removing the requirement that an act be committed “on behalf of any foreign person or foreign interest.” As a result, domestic acts of terrorism can now be certified as “acts of terrorism” under the program, subject to the other requirements of TRIPRA. Under the program, in any one calendar year, the federal government would pay 85% of covered losses from a certified act of terrorism after an insurer’s losses exceed 20% of the company’s eligible direct commercial earned premiums of the prior calendar year, up to a combined annual aggregate limit for the federal government and all insurers of $100 billion. If an act of terrorism or acts of terrorism result in covered losses exceeding the $100 billion annual industry aggregate limit, a future Congress would be responsible for determining how additional losses in excess of $100 billion will be paid.
Among other items, TRIPRA required that the President’s Working Group on Financial Markets (“PWG”) continue to perform an analysis regarding the long-term availability and affordability of insurance for terrorism risk. Among the findings detailed in the PWG’s initial report, released October 2, 2006, were that the high level of uncertainty associated with predicting the frequency of terrorist attacks, coupled with the unwillingness of some insurance policyholders to purchase insurance coverage, makes predicting long-term development of the terrorism risk market difficult, and that there is likely little potential for future market development for NBCR coverage. A December 2008 study by the U.S. Government Accountability Office (“GAO”) found that property and casualty insurers still generally seek to exclude NBCR coverage from their commercial policies when permitted. However, while nuclear, pollution and contamination exclusions are contained in many property and liability insurance policies, the GAO report concluded that such exclusions may be subject to challenges in court because they were not specifically drafted to address terrorist attacks. Furthermore, workers’ compensation policies generally have no exclusions or limitations. The GAO found that commercial property and casualty policyholders, including companies that own high-value properties in large cities, generally reported that they could not obtain NBCR coverage. Commercial property and casualty insurers generally remain unwilling to offer NBCR coverage because of uncertainties about the risk and the potential for catastrophic losses.
The Texas Windstorm Insurance Association provides hail and windstorm coverage to Texas residents of 14 counties along the Texas Gulf coast who are unable to obtain insurance from other carriers. Insurance carriers who write property insurance in the state of Texas, including The Hartford, are required to be members of TWIA and are obligated to pay assessments in the event that TWIA losses exceed funds on hand, the available funds in the Texas Catastrophe Reserve Trust Fund (“CRTF”) and any available reinsurance. Assessments are allocated to carriers based on their share of premium writings in the state of Texas, as defined.
During 2008, the board of directors of TWIA notified its member companies that it would assess them $430 to cover TWIA losses from hurricane Ike. In the third quarter of 2008, the Company accrued a liability of $27 for its estimate of assessments it would ultimately get from TWIA. In the first quarter of 2009, the Company reduced its estimated assessments by $14, from $27 to $13, resulting in a reduction in insurance operating costs and expenses. The Company estimates that of the $13 of accrued assessments for Ike, it will ultimately be able to recoup $8 through premium tax credits.
The following table shows the components of the gross and net reinsurance recoverable as of December 31, 2009 and 2008:
Based on A.M. Best ratings as of December 31, 2009 and 2008, respectively.
To manage the potential credit risk resulting from the use of reinsurance, management and ERM evaluate the credit standing, financial performance, management and operational quality of each potential reinsurer. Through that process, the Company maintains a list of reinsurers approved for participation on all treaty and facultative reinsurance placements. The Company’s approval designations reflect the differing credit exposure associated with various classes of business. Participation authorizations are categorized along property, short-tail casualty and long-tail casualty lines. In addition to defining participation eligibility, the Company regularly monitors each active reinsurer’s credit risk exposure in the aggregate and limits that exposure based upon independent credit rating levels.
The derivative counterparty exposure policy establishes market-based credit limits, favors long-term financial stability and creditworthiness of the counterparty and typically requires credit enhancement/credit risk reducing agreements.
The Company minimizes the credit risk of derivative instruments by entering into transactions with high quality counterparties rated A2/A or better, which are monitored and evaluated by the Company’s risk management team and reviewed by senior management. In addition, the Company monitors counterparty credit exposure on a monthly basis to ensure compliance with Company policies and statutory limitations. The Company also maintains a policy of requiring that derivative contracts, other than exchange traded contracts, certain currency forward contracts, and certain embedded and reinsurance derivatives, be governed by an International Swaps and Derivatives Association Master Agreement which is structured by legal entity and by counterparty and permits right of offset.
Includes structured investments with an amortized cost and fair value of $533 and $433, respectively, as of December 31, 2009 and $526 and $364, respectively, as of December 31, 2008. The underlying securities supporting these investments are primarily diversified pools of investment grade corporate issuers which can withstand a 15% cumulative default rate, assuming a 35% recovery.
The following table presents the Company’s exposure to RMBS supported by sub-prime mortgage loans by current credit quality and vintage year included in the AFS Securities by Type table above. These securities have been affected by deterioration in collateral performance caused by declining home prices and continued macroeconomic pressures including higher unemployment levels. A comparison of fair value to amortized cost is not indicative of the pricing of individual securities as impairments have occurred. Credit protection represents the current weighted average percentage, excluding wrapped securities, of the outstanding capital structure subordinated to the Company’s investment holding that is available to absorb losses before the security incurs the first dollar loss of principal. The ratings associated with the Company’s RMBS may be negatively impacted as rating agencies make changes to their methodologies and continue to monitor security performance.
Includes second lien residential mortgages with an amortized cost and fair value of $42 and $34, respectively, as of December 31, 2009 and $173 and $82, respectively, as of December 31, 2008, which are composed primarily of loans to prime and Alt-A borrowers.
As of December 31, 2009, the weighted average life of the sub-prime residential mortgage portfolio was 4.1 years.
The Company observed significant pressure on commercial real estate market fundamentals throughout 2009 including increased vacancies, rising delinquencies and declining property values and expects continued pressure in the upcoming year. The following tables present the Company’s exposure to CMBS bonds, CRE CDOs and CMBS IOs by current credit quality and vintage year, included in the AFS Securities by Type table above. A comparison of fair value to amortized cost is not indicative of the pricing of individual securities as impairments have occurred. Credit protection represents the current weighted average percentage of the outstanding capital structure subordinated to the Company’s investment holding that is available to absorb losses before the security incurs the first dollar loss of principal. This credit protection does not include any equity interest or property value in excess of outstanding debt. The ratings associated with the Company’s CMBS and CRE CDOs may be negatively impacted as rating agencies continue to make changes to their methodologies and monitor security performance.
As of December 31, 2009, approximately 42% of the underlying CRE CDOs collateral are seasoned, below investment grade securities.
Excludes agricultural and residential mortgage loans. For further information on the total mortgage loan portfolio, see Note 5 of the Notes to Consolidated Financial Statements.
Included in the table above are valuation allowances on mortgage loans held for sale associated with B-note participations and mezzanine loans of $51 and $43, respectively, which had a carrying value of $47 and $96, respectively, as of December 31, 2009.
At origination, the weighted average loan-to-value (“LTV”) rate of the Company’s commercial mortgage loan portfolio was approximately 63%. As of December 31, 2009, the current weighted average LTV rate was approximately 83%. LTV rates compare the loan amount to the value of the underlying property collateralizing the loan. The loan values are updated periodically through property level reviews of the portfolio. Factors considered in the property valuation include, but are not limited to, actual and expected property cash flows, geographic market data and capitalization rates.
As of December 31, 2009, approximately half of the student loan-backed exposure is guaranteed by the Federal Family Education Loan Program, with the remainder comprised of loans to prime borrowers.
Limited partnerships and other alternative investments decreased primarily due to hedge fund redemptions and negative re-valuations of the underlying investments associated primarily with the real estate markets.
As part of the Company’s ongoing security monitoring process, the Company has reviewed its AFS securities in an unrealized loss position and concluded that there were no additional impairments as of December 31, 2009 and 2008 and that these securities have sufficient expected future cash flows to recover the entire amortized cost basis, are temporarily depressed and are expected to recover in value as the securities approach maturity or as CMBS and sub-prime RMBS market spreads return to more normalized levels.
Most of the securities depressed over 20% for nine months or more are supported by real estate related assets, specifically investment grade CMBS bonds, sub-prime RMBS and CRE CDOs, and have a weighted average current rating of A. Current market spreads continue to be significantly wider for securities supported by real estate related assets, as compared to spreads at the security’s respective purchase date, largely due to the continued effects of the recession and the economic and market uncertainties regarding future performance of commercial and residential real estate. The Company reviewed these securities as part of its impairment evaluation process. The Company’s best estimate of future cash flows utilized in its impairment process involves both macroeconomic and security specific assumptions that may differ based on asset class, vintage year and property location including, but not limited to, historical and projected default and recovery rates, current and expected future delinquency rates, property value declines and the impact of obligor re-financing. For these securities in an unrealized loss position where a credit impairment has not been recorded, the Company’s best estimate of expected future cash flows are sufficient to recover the amortized cost basis of the security.
The following tables present the Company’s unrealized loss aging for AFS securities (included in the tables above) continuously depressed over 50% by length of time.
Impairments recognized in earnings were comprised of credit impairments of $1,216, impairments on debt securities for which the Company intended to sell of $156 and impairments on equity securities of $136.
The Company is also exposed to interest rate risk based upon the discount rate assumption associated with the Company’s pension and other postretirement benefit obligations. The discount rate assumption is based upon an interest rate yield curve comprised of bonds rated Aa with maturities primarily between zero and thirty years. For further discussion of interest rate risk associated with the benefit obligations, see Pension and Other Postretirement Benefit Obligations within the Critical Accounting Estimates section of the MD&A and Note 17 of the Notes to Consolidated Financial Statements.
As interest rates decline, certain mortgage-backed securities are more susceptible to paydowns and prepayments. During such periods, the Company generally will not be able to reinvest the proceeds at comparable yields. Lower interest rates will also likely result in lower net investment income, increased hedging cost associated with variable annuities and, if declines are sustained for a long period of time, it may subject the Company to reinvestment risks, higher pension costs expense and possibly reduced profit margins associated with guaranteed crediting rates on certain Life products. Conversely, the fair value of the investment portfolio will increase when interest rates decline and the Company’s interest expense will be lower on its variable rate debt obligations.
The Company believes that an increase in interest rates from the current levels is generally a favorable development for the Company. Rate increases are expected to provide additional net investment income, increase sales of fixed rate Life investment products, reduce the cost of the variable annuity hedging program, limit the potential risk of margin erosion due to minimum guaranteed crediting rates in certain Life products and, if sustained, could reduce the Company’s prospective pension expense. Conversely, a rise in interest rates will reduce the fair value of the investment portfolio, increase interest expense on the Company’s variable rate debt obligations and, if long-term interest rates rise dramatically within a six to twelve month time period, certain Life businesses may be exposed to disintermediation risk. Disintermediation risk refers to the risk that policyholders will surrender their contracts in a rising interest rate environment requiring the Company to liquidate assets in an unrealized loss position. In conjunction with the interest rate risk measurement and management techniques, certain of Life’s fixed income product offerings have market value adjustment provisions at contract surrender. An increase in interest rates may also impact the Company’s tax planning strategies and in particular its ability to utilize tax benefits to offset certain previously recognized realized capital losses.
The Company’s investment portfolios primarily consist of investment grade fixed maturity securities. The fair value of these investments was $71.2 billion and $65.1 billion at December 31, 2009 and 2008, respectively. The fair value of these and other invested assets fluctuates depending on the interest rate environment and other general economic conditions. The weighted average duration of the fixed maturity portfolio was approximately 4.9 and 4.8 years as of December 31, 2009 and 2008, respectively.
At December 31, 2009 and 2008, notional amounts pertaining to derivatives utilized to manage interest rate risk totaled $21.3 billion and $19.3 billion, respectively ($19.7 billion and $17.4 billion, respectively, related to investments and $1.6 billion and $1.9 billion, respectively, related to life liabilities). The fair value of these derivatives was $18 and $457 as of December 31, 2009 and 2008, respectively.
The Company is exposed to credit risk within our investment portfolio and through counterparties. Credit risk relates to the uncertainty of an obligor’s continued ability to make timely payments in accordance with the contractual terms of the instrument or contract. The Company manages credit risk through established investment credit policies which address quality of obligors and counterparties, credit concentration limits, diversification requirements and acceptable risk levels under expected and stressed scenarios. These policies are regularly reviewed and approved by senior management.
In addition to counterparty credit risk, the Company enters into credit derivative instruments to manage credit exposure. The Company purchases credit protection through credit default swaps to economically hedge and manage credit risk of certain fixed maturity investments across multiple sectors of the investment portfolio. The Company has also entered into credit default swaps that assume credit risk to synthetically replicate the characteristics and performance of assets that would otherwise be permissible investments under the Company’s investment policies. Credit spread widening will generally result in an increase in fair value of derivatives that purchase credit protection and a decrease in fair value of derivatives that assume credit risk. These derivatives do not receive hedge accounting treatment and, as such, changes in fair value are reported through earnings. As of December 31, 2009 and 2008, the notional amount related to credit derivatives that purchase credit protection was $2.6 billion and $3.7 billion, respectively, while the fair value was $(50) and $340, respectively. As of December 31, 2009 and 2008, the notional amount related to credit derivatives that assume credit risk was $1.2 billion, while the fair value was $(240) and $(403), respectively. For further information on credit derivatives, see the Investment Credit Risk section of the MD&A and Note 5 of the Notes to Consolidated Financial Statements.
The Company does not have significant equity risk exposure from invested assets. The Company’s primary exposure to equity risk relates to the potential for lower earnings associated with certain of the Life’s businesses such as variable annuities where fee income is earned based upon the fair value of the assets under management. During 2009, Life’s fee income declined $555 or 11%. In addition, Life offers certain guaranteed benefits, primarily associated with variable annuity products, which increases the Company’s potential benefit exposure as the equity markets decline.
The risk associated with the non-U.S. dollar denominated fixed maturities relates to potential decreases in value and income resulting from unfavorable changes in foreign exchange rates. The fair value of the non-U.S. dollar denominated fixed maturities, which are primarily denominated in euro, sterling, yen and Canadian dollars, at December 31, 2009 and 2008, were approximately $1.2 billion and $3.8 billion, respectively.
In order to manage its currency exposures, the Company enters into foreign currency swaps and forwards to hedge the variability in cash flows associated with certain foreign denominated fixed maturities. These foreign currency swap and forward agreements are structured to match the foreign currency cash flows of the hedged foreign denominated securities. At December 31, 2009 and 2008, the derivatives used to hedge currency exchange risk related to non-U.S. dollar denominated fixed maturities had a total notional amount of $480 and $1.6 billion, respectively, and total fair value of $(26) and $39, respectively.
reduce the value of equity securities, trading, for international variable annuities, the related policyholder funds and benefits payable, and the amount of fee income generated from those variable annuities;
The majority of the Company’s U.S. and U.K. variable annuities, and a portion of Japan’s variable annuities, include a GMWB rider. In the second quarter of 2009, the Company suspended all new sales in the U.K. and Japan. The Company’s new variable annuity product, launched in the U.S. in October 2009 does not offer a GMWB. Declines in equity markets will generally increase the Company’s liability for the in-force GMWB riders. A GMWB contract is ‘in the money’ if the contract holder’s guaranteed remaining benefit (“GRB”) is greater than their current account value. As of December 31, 2009 and December 31, 2008, 48% and 88%, respectively, of all unreinsured U.S. GMWB ‘in-force’ contracts were ‘in the money’. For U.S., U.K. and Japan GMWB contracts that were ‘in the money’, the Company’s exposure to the GRB, after reinsurance, as of December 31, 2009 and 2008, was $2.7 billion and $7.7 billion, respectively. However, the Company expects to incur these payments in the future only if the policyholder has an ‘in the money’ GMWB at their death or their account value is reduced to a specified level through contractually permitted withdrawals and/or market declines. If the account value is reduced to the specified level, the contract holder will receive an annuity equal to the remaining GRB. For the Company’s “life-time” GMWB products, this annuity can continue beyond the GRB. As the account value fluctuates with equity market returns on a daily basis and the “life-time” GMWB payments can exceed the GRB, the ultimate amount to be paid by the Company, if any, is uncertain and could be significantly more or less than $2.7 billion. For additional information on the Company’s GMWB liability, see Note 4a of the Notes to Consolidated Financial Statements.
In the second quarter of 2009, the Company suspended all new product sales in Japan. Prior to that, the Company offered certain variable annuity products in Japan with both a GMDB and a GMIB. For the in-force block of Japan business, declines in equity markets, as well as a strengthening of the Japanese yen in comparison to the U.S. dollar and other currencies, will increase the Company’s liability for GMDB and GMIB riders. This increase may be significant in extreme market scenarios. The Company’s total gross exposure (i.e., before reinsurance) to the GMDB and GMIB offered in Japan as of December 31, 2009 is $6.3 billion. However, the Company will incur these payments in the future only if the contract holder has an ‘in the money’ GMDB and GMIB at their death or if their account value is insufficient to fund the benefit. The Company currently reinsures 17% of the GMDB to a third party reinsurer. Under certain of these reinsurance agreements, the reinsurers’ exposure is subject to an annual cap. The Company’s net exposure (i.e. after reinsurance) is $5.2 billion. In addition, as of December 31, 2009, 59% of the account value and 52% of retained net amount at risk is reinsured to a Hartford affiliate. For additional information on the Company’s GMDB and GMIB liability, see Note 9 of the Notes to Consolidated Financial Statements.
The Company has made considerable investment in analyzing market risk exposures arising from: GMDB, GMWB, and GMIB; equity market and interest rate risks; and foreign currency exchange rates. The Company evaluates these risks both individually and, in the aggregate, to determine the financial risk of its products and to judge their potential impacts on U.S. GAAP earnings and statutory surplus. The Company manages the equity market, interest rate and foreign currency exchange risks embedded in its products through product design, reinsurance, customized derivatives, and dynamic hedging and macro hedging programs. The Company recently launched a new variable annuity product with reduced equity risk and has increased GMWB rider fees on new sales of the Company’s legacy variable annuities and the related in-force, as contractually permitted. Depending upon competitors’ reactions with respect to products and related rider charges, the Company’s strategy of reducing product risk and increasing fees may cause a decline in market share.
The Company maintains derivative hedging programs for its product guarantee risk to meet multiple, and in some cases, competing risk management objectives, including providing protection against tail scenario equity market events, providing resources to pay product guarantee claims, and minimizing U.S. GAAP earnings volatility, statutory surplus volatility and other economic metrics.
For additional information on hedging derivatives, see Note 5 of the Notes to Consolidated Financial Statements.
Based on the construction of the Company’s derivative hedging program (both dynamic and macro hedge) as of December 31, 2009, which can change based on capital market conditions, notional amounts and other factors, an independent change in the following capital market factors is likely to have the following impacts. These sensitivities do not capture the impact of elapsed time on liabilities or hedge assets. Additionally, duration varies by hedging strategy and the impact of non parallel shifts will increase U.S. GAAP volatility. Each of the sensitivities set forth below is estimated individually, without consideration of any correlation among the key assumptions. Therefore, it would be inappropriate to take each of the sensitivities below and add them together in an attempt to estimate the volatility in our variable annuity hedging program. In addition, there are other factors, including policyholder behavior and variation in underlying fund performance relative to the hedged index, which could materially impact the GMWB liability. As a result, actual net changes in the value of the GMWB liability, the related dynamic hedging program derivative assets and the macro hedge program derivative assets may vary materially from those calculated using only the sensitivities disclosed below:
Represents the aggregate net impact of a 1% increase or decrease in each of the S&P 500, NASDAQ and EAFE indices.
Represents the aggregate net impact of a 1 basis point parallel shift on the LIBOR yield curve.
The liquidity requirements of the holding company of The Hartford Financial Services Group, Inc. (“HFSG Holding Company”) have been and will continue to be met by HFSG Holding Company’s fixed maturities, short-term investments, and cash of $2.2 billion at December 31, 2009, dividends from the Life and Property & Casualty insurance operations, as well as the issuance of common stock, debt or other capital securities and borrowings from its credit facilities. Expected liquidity requirements of the HFSG Holding Company for the next twelve months include interest on debt of approximately $450, maturity of senior notes of $275, common stockholder dividends, subject to the discretion of the Board of Directors, of approximately $80, and preferred stock dividends of approximately $170.
HFSG Holding Company’s debt maturities over the next twelve months include $275 aggregate principal amount of its 7.9% senior notes that mature in June 2010. In addition, HLI has a capital lease obligation of $73, which was paid in January 2010. For additional information regarding debt, see Notes 12 and 14 in the Notes to Consolidated Financial Statements.
On February 18, 2010, The Hartford’s Board of Directors declared a quarterly dividend of $0.05 per common share payable on April 1, 2010 to common shareholders of record as of March 1, 2010.
While the Company has significant discretion in making voluntary contributions to the U. S. qualified defined benefit pension plan, the Employee Retirement Income Security Act of 1974, as amended by the Pension Protection Act of 2006 and further amended by the Worker, Retiree, and Employer Recovery Act of 2008, and Internal Revenue Code regulations mandate minimum contributions in certain circumstances. The Company made contributions to its pension plans of $201, $2, and $158 in 2009, 2008 and 2007, respectively, and contributions to its other postretirement plans of $46 in 2007. No contributions were made to the other postretirement plans in 2009 and 2008. The Company’s 2009 required minimum funding contribution was immaterial. The Company presently anticipates contributing approximately $200 to its pension plans and other postretirement plans in 2010, based upon certain economic and business assumptions. These assumptions include, but are not limited to, equity market performance, changes in interest rates and the Company’s other capital requirements. The Company does not have a required minimum funding contribution for the U.S. qualified defined benefit pension plan for 2010 and the funding requirements for all of the pension plans is expected to be immaterial.
Dividends to the HFSG Holding Company from its insurance subsidiaries are restricted. The payment of dividends by Connecticut-domiciled insurers is limited under the insurance holding company laws of Connecticut. These laws require notice to and approval by the state insurance commissioner for the declaration or payment of any dividend, which, together with other dividends or distributions made within the preceding twelve months, exceeds the greater of (i) 10% of the insurer’s policyholder surplus as of December 31 of the preceding year or (ii) net income (or net gain from operations, if such company is a life insurance company) for the twelve-month period ending on the thirty-first day of December last preceding, in each case determined under statutory insurance accounting principles. In addition, if any dividend of a Connecticut-domiciled insurer exceeds the insurer’s earned surplus, it requires the prior approval of the Connecticut Insurance Commissioner. The insurance holding company laws of the other jurisdictions in which The Hartford’s insurance subsidiaries are incorporated (or deemed commercially domiciled) generally contain similar (although in certain instances somewhat more restrictive) limitations on the payment of dividends. Dividends paid to HFSG Holding Company by its insurance subsidiaries are further dependent on cash requirements of HLI and other factors. The Company’s property-casualty insurance subsidiaries are permitted to pay up to a maximum of approximately $1.4 billion in dividends to HFSG Holding Company in 2010 without prior approval from the applicable insurance commissioner. Statutory dividends from the Company’s life insurance subsidiaries in 2010 require prior approval from the applicable insurance commissioner. The aggregate of these amounts, net of amounts required by HLI, is the maximum the insurance subsidiaries could pay to HFSG Holding Company in 2010. In 2009, HFSG Holding Company and HLI received $700 in dividends from the life insurance subsidiaries representing the movement of a life subsidiary to HFSG Holding Company, and HFSG Holding Company received $251 in dividends from its property-casualty insurance subsidiaries.
The Hartford endeavors to maintain a capital structure that provides financial and operational flexibility to its insurance subsidiaries, ratings that support its competitive position in the financial services marketplace (see the “Ratings” section below for further discussion), and shareholder returns. As a result, the Company may from time to time raise capital from the issuance of stock, debt or other capital securities and is continuously evaluating strategic opportunities. The issuance of common stock, debt or other capital securities could result in the dilution of shareholder interests or reduced net income due to additional interest expense.
Cumulative dividends on the Series E Preferred Stock will accrue on the liquidation preference at a rate of 5% per annum for the first five years, and at a rate of 9% per annum thereafter. The Series E Preferred Stock has no maturity date and ranks senior to the Company’s common stock. The Series E Preferred Stock is non-voting. Payments on the cumulative dividends are approximately $170 over the next twelve months. The cumulative dividends on preferred stock and related accretion of discount on preferred stock will reduce net income available to common shareholders. Pursuant to the Private Placement Purchase Agreement the Company has certain restrictions on dividends for its common stock, for further information on common stock dividend restrictions see Note 15 in the Notes to Consolidated Financial Statements.
Additionally, this program triggered an anti-dilution provision in The Hartford’s investment agreement with Allianz, which resulted in the adjustment to the warrant exercise price to $25.25 from $25.32 and to the number of shares that may be purchased to 69,314,987 from 69,115,324.
On February 12, 2007, The Hartford entered into a put option agreement (the “Put Option Agreement”) with Glen Meadow ABC Trust, a Delaware statutory trust (the “ABC Trust”), and LaSalle Bank National Association, as put option calculation agent. The Put Option Agreement provides The Hartford with the right to require the ABC Trust, at any time and from time to time, to purchase The Hartford’s junior subordinated notes in a maximum aggregate principal amount not to exceed $500.
The revolving credit facility provides for up to $1.9 billion of unsecured credit through August 9, 2012, which excludes a $100 commitment from an affiliate of Lehman Brothers. Of the total availability under the revolving credit facility, up to $100 is available to support letters of credit issued on behalf of The Hartford or other subsidiaries of The Hartford. Under the revolving credit facility, the Company must maintain a minimum level of consolidated net worth of $12.5 billion. At December 31, 2009, the consolidated net worth of the Company as calculated in accordance with the terms of the credit facility was $22.9 billion. The definition of consolidated net worth under the terms of the credit facility, excludes AOCI and includes the Company’s outstanding junior subordinated debentures and perpetual preferred securities, net of discount. In addition, the Company must not exceed a maximum ratio of debt to capitalization of 40%. At December 31, 2009, as calculated in accordance with the terms of the credit facility, the Company’s debt to capitalization ratio was 15.3%. Quarterly, the Company certifies compliance with the financial covenants for the syndicate of participating financial institutions. As of December 31, 2009, the Company was in compliance with all such covenants.
The Hartford’s Life Japan operations also maintain a line of credit in the amount of $54, or ¥5 billion, which expires January 4, 2011 in support of the subsidiary operations.
Certain of the Company’s derivative agreements contain provisions that are tied to the financial strength ratings of the individual legal entity that entered into the derivative agreement as set by nationally recognized statistical rating agencies. If the insurance operating entity’s financial strength were to fall below certain ratings, the counterparties to the derivative agreements could demand immediate and ongoing full collateralization and in certain instances demand immediate settlement of all outstanding derivative positions traded under each impacted bilateral agreement. The settlement amount is determined by netting the derivative positions transacted under each agreement. If the termination rights were to be exercised by the counterparties, it could impact the insurance operating entity’s ability to conduct hedging activities by increasing the associated costs and decreasing the willingness of counterparties to transact with the insurance operating entity. The aggregate fair value of all derivative instruments with credit-risk-related contingent features that are in a net liability position as of December 31, 2009, is $655. Of this $655, the insurance operating entities have posted collateral of $591 in the normal course of business. Based on derivative market values as of December 31, 2009, a downgrade of one level below the current financial strength ratings by either Moody’s or S&P could require approximately an additional $50 to be posted as collateral. Based on derivative market values as of December 31, 2009, a downgrade by either Moody’s or S&P of two levels below the insurance operating entities’ current financial strength ratings could require approximately an additional $70 of assets to be posted as collateral. These collateral amounts could change as derivative market values change, as a result of changes in our hedging activities or to the extent changes in contractual terms are negotiated. The nature of the collateral that we may be required to post is primarily in the form of U.S. Treasury bills and U.S. Treasury notes.
Property & Casualty holds fixed maturity securities including a significant short-term investment position (securities with maturities of one year or less at the time of purchase) to meet liquidity needs.
Liquidity requirements that are unable to be funded by Property & Casualty’s short-term investments would be satisfied with current operating funds, including premiums received or through the sale of invested assets. A sale of invested assets could result in significant realized losses.
Life’s total general account contractholder obligations are supported by Life’s total general account invested assets and cash of $65.0 billion, which includes a significant short-term investment position, as depicted below, to meet liquidity needs.
The following table summarizes Life’s fixed maturities, short-term investments, and cash, as of December 31, 2009:
In the event customers elect to surrender separate account assets or international statutory separate accounts, Life will use the proceeds from the sale of the assets to fund the surrender, and Life’s liquidity position will not be impacted. In many instances Life will receive a percentage of the surrender amount as compensation for early surrender (surrender charge), increasing Life’s liquidity position. In addition, a surrender of variable annuity separate account or general account assets (see below) will decrease Life’s obligation for payments on guaranteed living and death benefits.
Relates to contracts such as payout annuities or institutional notes, other than guaranteed investment products with an MVA feature (discussed below) or surrenders of term life, group benefit contracts or death and living benefit reserves for which surrenders will have no current effect on Life’s liquidity requirements.
GICs are subject to discontinuance provisions which allow the policyholders to terminate their contracts prior to scheduled maturity at the lesser of the book value or market value. Generally, the market value adjustment reflects changes in interest rates and credit spreads. As a result, the market value adjustment feature in the GIC serves to protect the Company from interest rate risks and limit Life’s liquidity requirements in the event of a surrender.
The Company has unfunded commitments to purchase investments in limited partnerships, private placements and mortgage loans of about $1.2 billion as disclosed in Note 12 of the Notes to Consolidated Financial Statements.
In estimating the timing of future payments by year, the Company has assumed that its historical payment patterns will continue. However, the actual timing of future payments could vary materially from these estimates due to, among other things, changes in claim reporting and payment patterns and large unanticipated settlements. In particular, there is significant uncertainty over the claim payment patterns of asbestos and environmental claims. Also, estimated payments in 2010 do not include payments that will be made on claims incurred in 2010 on policies that were in force as of December 31, 2009. In addition, the table does not include future cash flows related to the receipt of premiums that may be used, in part, to fund loss payments.
Under U.S. GAAP, the Company is only permitted to discount reserves for losses and loss adjustment expenses in cases where the payment pattern and ultimate loss costs are fixed and determinable on an individual claim basis. For the Company, these include claim settlements with permanently disabled claimants. As of December 31, 2009, the total property and casualty reserves in the above table are gross of a reserve discount of $511.
Estimated life, annuity and disability obligations include death and disability claims, policy surrenders, policyholder dividends and trail commissions offset by expected future deposits and premiums on in-force contracts. Estimated life, annuity and disability obligations are based on mortality, morbidity and lapse assumptions comparable with Life’s historical experience, modified for recent observed trends. Life has also assumed market growth and interest crediting consistent with assumptions used in amortizing deferred acquisition costs. In contrast to this table, the majority of Life’s obligations are recorded on the balance sheet at the current account values and do not incorporate an expectation of future market growth, interest crediting, or future deposits. Therefore, the estimated obligations presented in this table significantly exceed the liabilities recorded in reserve for future policy benefits and unpaid losses and loss adjustment expenses, other policyholder funds and benefits payable and separate account liabilities. Due to the significance of the assumptions used, the amounts presented could materially differ from actual results.
Includes contractual principal and interest payments. Long-term debt obligations primarily have fixed rates of interest, for the Company’s junior subordinated debentures, where the interest is fixed for a period of time and then floating, the period of variable interest is computed using prevailing rates at December 31, 2009 and, as such, does not consider the impact of future rate movements. See Note 14 of the Notes to Consolidated Financial Statements for additional discussion of long-term debt obligations.
Consumer notes include principal payments and contractual interest for fixed rate notes and interest based on current rates for floating rate notes. See Note 14 of the Notes to Consolidated Financial Statements for additional discussion of consumer notes.
Includes $1.2 billion in commitments to purchase investments including about $886 of limited partnership, $284 of private placements and $47 of mortgage loans. Outstanding commitments under these limited partnerships and mortgage loans are included in payments due in less than 1 year since the timing of funding these commitments cannot be reliably estimated. The remaining commitments to purchase investments primarily represent payables for securities purchased which are reflected on the Company’s consolidated balance sheet. Also included in purchase obligations is $484 relating to contractual commitments to purchase various goods and services such as maintenance, human resources, information technology, and transportation in the normal course of business. Purchase obligations exclude contracts that are cancelable without penalty or contracts that do not specify minimum levels of goods or services to be purchased.
Does not include estimated voluntary contribution of $200 to the Company’s pension plan in 2010.
The capital structure of The Hartford as of December 31, 2009 and 2008 consisted of debt and stockholders’ equity, as follows:
Total debt of the Company excludes $1.1 billion and $1.2 billion of consumer notes as of December 31, 2009 and 2008, respectively, and $78 of Federal Home Loan Bank advances recorded in other liabilities as of December 31, 2009 that were acquired through the purchase of Federal Trust Corporation in the second quarter of 2009.
• Increased primarily due to decreases in unrealized losses on available-for-sale securities of $5.7 billion primarily due to tightening credit spreads, partially offset by a cumulative effect of accounting change of $912, see Note 1 of the Notes to Consolidated Financial Statements for further information on the cumulative effect of accounting change.
• Total debt has decreased due to the repayment of commercial paper of $375 and payments on capital lease obligations in 2009.
The decrease in cash from operating activities compared to the prior year period was primarily the result of lower premiums, lower fee income and lower net investment income. Net derivative settlements and pay down of collateral under securities lending account for the majority of cash used for investing activities. Cash from financing activities decreased primarily due to net flows decrease in investment and universal life-type contracts of $5.5 billion partially offset by issuances of preferred stock and warrants to Treasury for $3.4 billion and issuance of common stock through a discretionary equity issuance plan of $887 in 2009 and treasury stock acquired in 2008, partially offset by issuance of long-term debt and consumer notes in 2008 and repayments of commercial paper in 2009.
Ratings are an important factor in establishing competitive position in the insurance and financial services marketplace. There can be no assurance that the Company’s ratings will continue for any given period of time or that they will not be changed. In the event the Company’s ratings are downgraded, the level of revenues or the persistency of the Company’s business may be adversely impacted.
The table below sets forth statutory surplus for the Company’s insurance companies. The statutory surplus amount as of December 31, 2008 in the table below is based on actual statutory filings with the applicable U.S. regulatory authorities. The statutory surplus amount as of December 31, 2009 is an estimate, as the respective 2009 statutory filings have not yet been made.
The Company also holds regulatory capital and surplus for its operations in Japan. Using the investment in subsidiary accounting requirements defined in the U.S. National Association of Insurance Commissioners Statements of Statutory Accounting Practices, the Company’s statutory capital and surplus attributed to the Japan operations was $1,311 and $1,718 as of December 31, 2009 and 2008, respectively. However, under the accounting practices and procedures governed by Japanese regulatory authorities, the Company’s statutory capital and surplus was $1.1 billion as of December 31, 2009 and 2008.
The Company received approval from the Connecticut Insurance Department regarding the use of two permitted practices in the statutory financial statements of its Connecticut-domiciled life insurance subsidiaries as of December 31, 2008. The first permitted practice related to the statutory accounting for deferred income taxes. Specifically, this permitted practice modified the accounting for deferred income taxes prescribed by the NAIC by increasing the realization period for deferred tax assets from one year to three years and increasing the asset recognition limit from 10% to 15% of adjusted statutory capital and surplus. The benefits of this permitted practice were not considered by the Company when determining surplus available for dividends. The second permitted practice related to the statutory reserving requirements for variable annuities with guaranteed living benefit riders. Actuarial guidelines prescribed by the NAIC required a stand-alone asset adequacy analysis reflecting only benefits, expenses and charges that are associated with the riders for variable annuities with guaranteed living benefits. The permitted practice allowed for all benefits, expenses and charges associated with the variable annuity contract to be reflected in the stand-alone asset adequacy test. These permitted practices resulted in an increase to Life operations statutory surplus of $987 as of December 31, 2008. The effects of these permitted practices were included in the 2008 Life operations surplus amount in the table above.
The Company’s stockholders’ equity, as prepared using U.S. generally accepted accounting principles (“U.S. GAAP”) was $17.9 billion as of December 31, 2009. The Company’s estimated aggregate statutory capital and surplus, as prepared in accordance with the National Association of Insurance Commissioners’ Accounting Practices and Procedures Manual (“U.S. STAT”) was $14.7 billion as of December 31, 2009. Significant differences between U.S. GAAP stockholders’ equity and aggregate statutory capital and surplus prepared in accordance with U.S. STAT include the following:
The difference between the amortized cost and fair value of fixed maturity and other investments, net of tax, is recorded as an increase or decrease to the carrying value of the related asset and to equity under U.S. GAAP, while U.S. STAT only records certain securities at fair value, such as equity securities and certain lower rated bonds required by the NAIC to be recorded at the lower of amortized cost or fair value.
As the value of certain derivative instruments that do not get hedge accounting decreases, statutory surplus and RBC ratios may decrease.
Life’s exposure to foreign currency exchange risk exists with respect to non-U.S. dollar denominated assets and liabilities. Assets and liabilities denominated in foreign currencies are accounted for at their U.S. dollar equivalent values using exchange rates at the balance sheet date. As foreign currency exchange rates strengthen in comparison to the U.S. dollar, the remeasured value of those non-dollar denominated assets or liabilities will increase causing an increase or decrease to statutory surplus, respectively. In addition, certain of our Life products offer guaranteed benefits which could substantially increase our potential obligation and statutory capital exposure should the yen strengthen versus other currencies.
The Company has reinsured approximately 25% of its risk associated with U.S. GMWB and 44% of its risk associated with the aggregate GMDB exposure. These reinsurance agreements serve to reduce the Company’s exposure to changes in the statutory reserves and the related capital and RBC ratios associated with changes in the equity markets. The Company also continues to explore other solutions for mitigating the capital market risk effect on surplus, such as internal and external reinsurance solutions, migrating towards a more statutory based hedging program, changes in product design, increasing pricing and expense management.