The Hartford owns the land and buildings comprising its Hartford location and other properties within the greater Hartford, Connecticut area which total approximately 1.9 million of the 2.2 million square feet owned. In addition, The Hartford leases approximately 5.3 million square feet throughout the United States and approximately 208 thousand square feet in other countries. All of the properties owned or leased are used by one or more of all ten operating segments, depending on the location. For more information on operating segments see Part 1, Item 1, Business of The Hartford - Reporting Segments. The Company believes its properties and facilities are suitable and adequate for current operations.
2004 includes a $216 tax benefit related to agreement with the IRS on the resolution of matters pertaining to tax years prior to 2004. 2003 includes an after-tax charge of $1.7 billion related to the Company’s 2003 asbestos reserve addition, $40 of after-tax expense related to the settlement of a certain litigation dispute, $30 of tax benefit in Life primarily related to the favorable treatment of certain tax items arising during the 1996-2002 tax years, and $27 of after-tax severance charges in Property & Casualty. 2002 includes $76 tax benefit in Life, $11 after-tax expense in Life related to a certain litigation dispute and an $8 after-tax benefit in Life’s September 11 exposure. 2001 includes $440 of after-tax losses related to September 11 and a $130 tax benefit in Life.
Mutual funds are owned by the shareholders of those funds and not by the Company. As a result, they are not reflected in total assets on the Company’s balance sheet.
Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) addresses the financial condition of The Hartford Financial Services Group, Inc. and its subsidiaries (collectively, “The Hartford” or the “Company”) as of December 31, 2005, compared with December 31, 2004, and its results of operations for each of the three years in the period ended December 31, 2005. This discussion should be read in conjunction with the Consolidated Financial Statements and related Notes beginning on page. Certain reclassifications have been made to prior year financial information to conform to the current year presentation.
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.
On October 29, 2004, the New York Attorney General’s Office informed the Company that the Attorney General is conducting an investigation with respect to the timing of the previously disclosed sale by Thomas Marra, a director and executive officer of the Company, of 217,074 shares of the Company’s common stock on September 21, 2004. The sale occurred shortly after the issuance of two additional subpoenas dated September 17, 2004 by the New York Attorney General’s Office. The Company has engaged outside counsel to review the circumstances related to the transaction and is fully cooperating with the New York Attorney General’s Office. On the basis of the review, the Company has determined that Mr. Marra complied with the Company’s applicable internal trading procedures and has found no indication that Mr. Marra was aware of the additional subpoenas at the time of the sale.
The SEC’s Division of Enforcement and the New York Attorney General’s Office are investigating aspects of the Company’s variable annuity and mutual fund operations related to market timing. The Company continues to cooperate fully with the SEC and the New York Attorney General’s Office in these matters. The Company’s mutual funds are available for purchase by the separate accounts of different variable universal life insurance policies, variable annuity products, and funding agreements, and they are offered directly to certain qualified retirement plans. Although existing products contain transfer restrictions between subaccounts, some products, particularly older variable annuity products, do not contain restrictions on the frequency of transfers. In addition, as a result of the settlement of litigation against the Company with respect to certain owners of older variable annuity contracts, the Company’s ability to restrict transfers by these owners has, until recently, been limited. The Company has executed an agreement with the parties to the previously settled litigation which, together with separate agreements between these contract owners and their broker, has resulted in the exchange or surrender of substantially all of the variable annuity contracts that were the subject of the previously settled litigation. Pursuant to an agreement in principle reached in February 2005 with the Board of Directors of the mutual funds, the Company has
To date, none of the SEC’s and New York Attorney General’s market timing investigation, the SEC’s directed brokerage investigation, or the New York Attorney General’s and Connecticut Attorney General’s single premium group annuity investigation has resulted in the initiation of any formal action against the Company by these regulators. However, the Company believes that the SEC, the New York Attorney General’s Office, and the Connecticut Attorney General’s Office are likely to take some action against the Company at the conclusion of the respective investigations. The Company is engaged in active discussions with the SEC, the New York Attorney General’s Office and the Connecticut Attorney General’s Office. The potential timing of any resolution of any of these matters or the initiation of any formal action by any of these regulators is difficult to predict. The Company recorded a charge of $66, after-tax, to establish a reserve for the market timing and directed brokerage matters in the first quarter of 2005. Based on recent developments, the Company recorded an additional charge of $36, after-tax, in the fourth quarter of 2005 to increase the reserve for the market timing, directed brokerage and single premium group annuity matters. This reserve is an estimate; in view of the uncertainties regarding the outcome of these regulatory investigations, as well as the tax-deductibility of payments, it is possible that the ultimate cost to the Company of these matters could exceed the reserve by an amount that would have a material adverse effect on the Company’s consolidated results of operations or cash flows in a particular quarterly or annual period.
On May 24, 2005, the Company received a subpoena from the Connecticut Attorney General’s Office seeking information about the Company’s participation in finite reinsurance transactions in which there was no substantial transfer of risk between the parties. The Company is cooperating fully with the Connecticut Attorney General’s Office in this matter.
Reinsurance recoverables include an estimate of the amount of gross loss and loss adjustment expense reserves that may be ceded under the terms of the reinsurance agreements, including incurred but not reported unpaid losses. The Company calculates its ceded reinsurance projection based on the terms of any applicable facultative and treaty reinsurance, including an estimate of how incurred but not reported losses will ultimately be ceded by reinsurance agreement. Accordingly, the Company’s estimate of reinsurance recoverables is subject to similar risks and uncertainties as the estimate of the gross reserve for unpaid claim and claim adjustment expenses.
The Hartford, like other insurance companies, categorizes and tracks its insurance reserves for its segments by “line of business”, such as property, auto physical damage, auto liability, commercial multi-peril package business, workers’ compensation, general liability
professional liability and bond. 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 claims and claim adjustment expenses. Incurred but not reported (IBNR) reserves represent the difference between the estimated ultimate cost of all claims and the actual reported loss and loss adjustment expenses (“reported losses”). Reported losses represent cumulative loss and loss adjustment expenses paid plus case reserves for outstanding reported claims. Company actuaries evaluate the total reserves (IBNR and case reserves) on an accident year basis. An accident year is the calendar year in which a loss is incurred, or, in the case of claims-made policies, the calendar year in which a loss is reported.
The following table shows loss and loss adjustment expense reserves by line of business and by operating segment as of December 31, 2005, net of reinsurance:
These net loss and loss adjustment expense reserves relate to assumed reinsurance underwritten by Reinsurance operations that were moved into Other Operations (formerly known as “HartRe”).
a low percentage of ultimate losses are reported in that time frame. Accordingly, for any given accident year, the rate at which losses emerge in the early periods is generally not as reliable an indication of the ultimate loss costs as it would be for shorter-tail lines of business. The estimation of reserves for these lines of business in the early stages of loss emergence is therefore largely influenced by prior accident years’ loss ratios and expected changes to earned pricing, loss costs, mix of business, ceded reinsurance and other factors that are expected to affect the loss ratio. For later periods of loss emergence, methods which incorporate actual paid losses and case reserves and a development pattern assumption are given more weight in estimating ultimate losses.
The final step in the quarterly reserve review involves a comprehensive review by senior reserving actuaries who apply their judgment and, in concert with senior management, determine the appropriate level of reserves to record. Numerous factors are considered in this determination process including, but not limited to, the assessed reliability of key loss trends and assumptions that may be significantly influencing the current actuarial indications, the maturity of the accident year, pertinent trends observed over the recent past, the level of volatility within a particular line of business, and the improvement or deterioration of actuarial indications in the current period as compared to the prior periods. In general, changes are made more quickly to more mature accident years and less volatile lines of business. At year-end 2005, total recorded net reserves excluding asbestos and environmental and excluding the allowance for uncollectible reinsurance are 0.6% higher than the actuarial indication of the reserves. Annually, as part of the statutory reporting requirements, IBNR is allocated to accident year by statutory line of business. This work forms the basis for the loss development table and reserve re-estimates table shown in the “Business” section.
Within the commercial segments and the Other Operations segment, the Company has exposure to claims asserted for bodily injury as a result of long-term or continuous exposure to harmful products or substances. Examples include, but are not limited to, pharmaceutical products, latex gloves, silica and lead paint. The Company also has exposure to claims from construction defects, where property damage or bodily injury from negligent construction is alleged. The Company also has exposure to claims asserted against religious institutions and other organizations relating to molestation or abuse. Such exposures may involve potentially long latency periods and may implicate coverage in multiple policy periods. These factors make reserves for such claims more uncertain than other bodily injury or property damage claims. With regard to these exposures, the Company is monitoring trends in litigation, the external environment, the similarities to other mass torts and the potential impact on the Company’s reserves.
Recorded reserves for general liability, net of reinsurance, are $1.9 billion across Business Insurance and Specialty Commercial. Reported loss development patterns are a key assumption for this line of business, particularly for more mature accident years. Historically, assumptions on reported loss development patterns have been impacted by, among other things, emergence of new types of claims (e.g. construction defect claims) or a shift in the mixture between smaller, more routine claims and larger, more complex claims. The Company has reviewed the historical variation in reported loss development patterns. If the reported loss development patterns change by 10%, a change that is within historical variation, the estimated net reserve need would change by $300, in either direction.
Similar to general liability, assumed casualty reinsurance is affected by reported loss development pattern assumptions. In addition to the items identified above that would affect both direct and reinsurance liability claim development patterns, there is also an impact to assumed reporting patterns for any changes in claim notification from ceding companies to the reinsurer. Recorded net reserves for assumed reinsurance business, excluding asbestos and environmental liabilities, within Other Operations were $1.1 billion as of December 31, 2005. If the development patterns underlying the Company’s net reserves for HartRe assumed casualty reinsurance are incorrect by 10 points, the estimated net reserve need would change by $287, in either direction.
Once the gross ultimate exposure for indemnity and allocated claim adjustment expense is determined for its insureds by each policy year, the Company calculates its ceded reinsurance projection based on any applicable facultative and treaty reinsurance and the Company’s experience with reinsurance collections.
In the case of the reserves for asbestos exposures, factors contributing to the high degree of uncertainty include inadequate loss development patterns, plaintiffs’ expanding theories of liability, the risks inherent in major litigation, and inconsistent emerging legal doctrines. Furthermore, over time, insurers, including the Company, have experienced significant changes in the rate at which asbestos claims are brought, the claims experience of particular insureds, and the value of claims, making predictions of future exposure from past experience uncertain. For example, in the past few years, insurers in general, including the Company, have experienced an increase in the number of asbestos-related claims due to, among other things, plaintiffs’ increased focus on new and previously peripheral defendants and an increase in the number of insureds seeking bankruptcy protection as a result of asbestos-related liabilities. Plaintiffs and insureds have sought to use bankruptcy proceedings, including “pre-packaged” bankruptcies, to accelerate and increase loss payments by insurers. In addition, some policyholders have asserted new classes of claims for coverages to which an aggregate limit of liability may not apply. Further uncertainties include insolvencies of other carriers and unanticipated developments pertaining to the Company’s ability to recover reinsurance for asbestos and environmental claims. Management believes these issues are not likely to be resolved in the near future.
A number of factors affect the variability of estimates for asbestos and environmental reserves including assumptions with respect to the frequency of claims, the average severity of those claims settled with payment, the dismissal rate of claims with no payment and the expense to indemnity ratio. The uncertainty with respect to the underlying reserve assumptions for asbestos and environmental adds a greater degree of variability to these reserve estimates than reserve estimates for more traditional exposures. While this variability is reflected in part in the size of the range of reserves developed by the Company, that range may still not be indicative of the potential variance between the ultimate outcome and the recorded reserves. The recorded net reserves as of December 31, 2005 of $2.7 billion ($2.3 billion and $360 for asbestos and environmental, respectively) is within an estimated range, unadjusted for covariance, of $2.0 billion to $3.1 billion. The process of estimating asbestos and environmental reserves remains subject to a wide variety of uncertainties, which are detailed in Note 12 of Notes to Consolidated Financial Statements. Due to these uncertainties, further developments could cause the Company to change its estimates and ranges of its asbestos and environmental reserves, and the effect of these changes could be material to the Company’s consolidated operating results, financial condition and liquidity.
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, 2005 represent the Company’s best estimate of its ultimate liability for claims and claim adjustment expenses related to losses covered by policies written by the Company. However, because of the significant uncertainties surrounding environmental, 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.
EGPs that are used as the basis for determining amortization of DAC are evaluated regularly to determine if actual experience or other evidence suggests that earlier estimates should be revised. Assumptions used to project account values and the related EGPs, are not revised unless the EGPs in the DAC amortization model fall outside of a reasonable range. In the event that the Company was to revise assumptions used for prior year cohorts, thereby changing its estimate of projected account value, and the related EGPs, in the DAC amortization model, the cumulative DAC amortization would be adjusted to reflect such changes, in the period the revision was determined to be necessary, a process known as “unlocking”.
To determine the reasonableness of the prior assumptions used and their impact on previously projected account values and the related EGPs, the Company evaluates, on a quarterly basis, its previously projected EGPs. The Company’s process to assess the reasonableness of its EGPs involves the use of internally developed models, which run a large number of stochastically determined scenarios of separate account fund performance. Incorporated in each scenario are the Company’s current best estimate assumptions with respect to separate account returns, lapse rates, mortality, and expenses. These scenarios are run for individual variable annuity business in the U.S. and independently for individual variable annuity business in Japan and are used to calculate statistically significant ranges of reasonable EGPs. The statistical ranges produced from the stochastic scenarios are compared to the present value of EGPs used in the respective DAC amortization models. If EGPs used in the DAC amortization model fall outside of the statistical ranges of reasonable EGPs, a revision to the assumptions in prior year cohorts used to project account value and the related EGPs, in the DAC amortization model would be necessary. A similar approach is used for variable universal life business.
However, significant favorable experience in the funds underlying the Japan variable annuities resulted in actual account values exceeding the account value in the DAC amortization model. Therefore, EGPs in the DAC amortization models for Japanese individual variable annuity business, based on previously projected account values that are lower than actual account values, were just inside the statistical range of reasonable EGPs as of December 31, 2005. Continued favorable experience on key assumptions for Japan variable annuities, which could include increasing fund return performance, decreasing lapses or decreasing mortality, could result in the DAC amortization model EGPs being outside of the statistical range of reasonableness and result in an unlock which would result in a decrease to DAC amortization and an increase to the DAC asset. If the Company assumed a separate account return assumption of 5.0% for all Japanese product cohorts and used its current best estimate assumptions for mortality and lapses to project account values forward from the current account values to reproject future EGPs, the estimated decrease to amortization for Japan variable annuities would be approximately $25-$30, after-tax. If, instead, the Company assumed a separate account return assumption of 6.0% in Japan or 4.0% in Japan, the estimated after-tax decrease in amortization for Japan variable annuities would be $30-$35 and $20-$25, respectively.
The overall recoverability of the DAC asset is dependent on the future profitability of the business. The Company tests the aggregate recoverability of the DAC asset by comparing the amounts deferred to the present value of total EGPs. In addition, the Company routinely stress tests its DAC asset for recoverability against severe declines in its separate account assets, which could occur if the equity markets experienced another significant sell-off, as the majority of policyholders’ funds in the separate accounts is invested in the
The Company offers certain variable annuity products with a guaranteed minimum withdrawal benefit (“GMWB”) rider. The fair value of the GMWB obligation is calculated based on actuarial and capital market assumptions related to the projected cash flows, including benefits and related contract charges, over the lives of the contracts, incorporating expectations concerning policyholder behavior. Because of the dynamic and complex nature of these cash flows, stochastic techniques under a variety of market return scenarios and other best estimate assumptions are used. Estimating these cash flows involves numerous estimates and subjective judgments including those regarding expected market rates of return, market volatility, correlations of market returns and discount rates. At each valuation date, the Company assumes expected returns based on risk-free rates as represented by the current LIBOR forward curve rates; market volatility assumptions for each underlying index based on a blend of observed market “implied volatility” data and annualized standard deviations of monthly returns using the most recent 20 years of observed market performance; correlations of market returns across underlying indices based on actual observed market returns and relationships over the ten years preceding the valuation date; and current risk-free spot rates as represented by the current LIBOR spot curve to determine the present value of expected future cash flows produced in the stochastic projection process. Changes in capital market assumptions can significantly change the value of the GMWB obligation. For example, independent decreases in equity market returns, decreases in interest rates and increases in equity index volatility will all have the effect of decreasing the GMWB asset resulting in a realized loss in net income. Furthermore, changes in policyholder behavior can also significantly change the value of the GMWB obligation. For example, independent increases in fund mix towards equity based funds vs. bond funds, increases in withdrawals, increasing mortality, increasing usage of the step-up feature and decreases in lapses will all have the effect of decreasing the GMWB asset resulting in a realized loss in net income. Independent changes in any one of these assumptions moving in the opposite direction will have the effect of increasing the GMWB asset resulting in a realized gain in net income. During the fourth quarter of 2005, the Company reflected a newly reliable market input for volatility on Standard and Poor’s (“S&P”) 500 index options. The impact of reflecting the newly reliable market input for the S&P 500 index volatility resulted in a decrease to the GMWB asset of $83. The impact to net income including other changes in assumptions, after DAC amortization and taxes was a loss of $18.
Securities not subject to Emerging Issues Task Force (“EITF”) Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets” (“non-EITF Issue No. 99-20 securities”) that are in an unrealized loss position, are reviewed at least quarterly to determine if an other-than-temporary impairment is present based on certain quantitative and qualitative factors. The primary factors considered in evaluating whether a decline in value for non-EITF Issue No. 99-20 securities is other-than-temporary include: (a) the length of time and the extent to which the fair value has been less than cost or amortized cost, (b) the financial condition, credit rating and near-term prospects of the issuer, (c) whether the debtor is current on contractually obligated interest and principal payments and (d) the intent and ability of the Company to retain the investment for a period of time sufficient to allow for recovery. Non-EITF Issue No. 99-20 securities depressed by twenty percent or more for six months are presumed to be other-than-temporarily impaired unless significant objective verifiable evidence supports that the security price is temporarily depressed and is expected to recover within a reasonable period of time. The evaluation of non-EITF Issue No. 99-20 securities depressed more than ten percent is documented and discussed quarterly by the committee.
For certain securitized financial assets with contractual cash flows including asset-backed securities, (“ABS”), EITF Issue No. 99-20 requires the Company to periodically update its best estimate of cash flows over the life of the security. If the fair value of a securitized financial asset is less than its cost or amortized cost and there has been a decrease in the present value of the estimated cash flows since the last revised estimate, considering both timing and amount, an other-than-temporary impairment charge is recognized. Estimating
future cash flows is a quantitative and qualitative process that incorporates information received from third party sources along with certain internal assumptions and judgments regarding the future performance of the underlying collateral. As a result, actual results may differ from current estimates. In addition, projections of expected future cash flows may change based upon new information regarding the performance of the underlying collateral.
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, currently available market and industry data and consultation with its plan actuaries. 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 5.50% was the appropriate discount rate as of December 31, 2005 to calculate the Company’s benefit liability. Accordingly, the 5.50% discount rate will also be used to determine the Company’s 2006 pension and other postretirement expense. At December 31, 2004, the discount rate was 5.75%.
For the year ended December 31, 2004, Life includes a $190 tax benefit recorded in its Other category and Property & Casualty’s Ongoing Operations includes a $26 tax benefit, which relate to agreement with the IRS on the resolution of matters pertaining to tax years prior to 2004. For further discussion of this benefit, see Note 12 of Notes to Consolidated Financial Statements.
An increase in net income for Retail of $119, principally driven by higher fee income from growth in the variable annuity and mutual fund businesses as a result of higher assets under management as compared to the prior year periods.
Total revenues increased $4.4 billion for the year ended December 31, 2005 compared with the prior year. The increase was primarily due to the following:
A decrease of $274 in net realized capital gains primarily due to lower net gains on the sale of fixed maturity securities, losses associated with GMWB derivatives, Japanese fixed annuity contract hedges and periodic net coupon settlements. These losses were offset in part by changes in the value of non-qualifying foreign currency swaps.
2004 Compared to 2003 - Net income increased $2.2 billion for the year ended December 31, 2004 compared with the prior year. The increase was primarily due to the following:
A $216 tax benefit in 2004, of which $190 was recorded in Life and $26 was recorded in Property & Casualty, primarily consisting of the benefit related to the separate account dividends-received deduction (“DRD”) and interest. For further discussion, see Note 12 of Notes to Consolidated Financial Statements.
Growth in all of Life’s segments and improved underwriting results, particularly in the Business Insurance segment.
Increased earned premiums for Group Benefits driven primarily by the acquisition of the group benefits business of CNA, sales growth and favorable persistency.
Increased earned premiums in the Business Insurance, Personal Lines and Specialty Commercial segments primarily due to earned pricing increases and growth in new business premiums out pacing non-renewals for Personal Lines and Business Insurance.
Increased fee income for Retail resulted from an increase in variable annuity average account values.
As a result of the net loss for the year ended December 31, 2003, SFAS No. 128, “Earnings Per Share”, requires the Company to use basic weighted average common shares outstanding in the calculation of the year ended December 31, 2003 diluted earnings (loss) per share, since the inclusion of options of 1.8 would have been antidilutive to the earnings per share calculation. In the absence of the net loss, weighted average common shares outstanding and dilutive potential common shares would have totaled 274.2.
In the Retail segment management believes the market for retirement products continues to expand as individuals increasingly save and plan for retirement. However, competition has increased substantially in the retail market with most major variable annuity writers now offering living benefits such as GMWB riders. As a result, sales may be lower than the level of sales attained in 2005 when considering the competitive environment, the risk of disruption on new sales from product offering changes, customer acceptance of new products and the effect on the distribution related to product offering changes. The success of the Company’s new living income benefit and any new products will ultimately be based on customer acceptance. With the increased competition in the variable annuity market causing lower sales levels from the level in 2004, combined with surrender activity on the aging block of business, net outflows are currently forecasted to be above levels experienced in 2005. This will be largely dependent on the Company’s ability to attract new customers and to retain contract holder’s account values in existing or new product offerings as they reach the end of the surrender charge period of their contract.
The future net income of the Institutional segment will depend on the Company’s ability to increase assets under management across all businesses and maintain its investment spread earnings on the products sold largely in the Institutional Investment Products (“IIP”) business. The IIP markets are highly competitive from a pricing perspective, and a small number of cases often account for a significant portion of sales, therefore the Company may not be able to sustain the level of assets under management growth attained in 2005. IIP will launch new products in 2006 to provide solutions that deal specifically with longevity risk. Longevity risk is defined as the likelihood of an individual outliving their assets. IIP is also designing innovative solutions to corporation’s defined benefit liabilities. The focus of the PPLI business is variable PPLI products to fund non-qualified benefits or other post employment benefit liabilities. The market served by PPLI is subject to extensive legal and regulatory review that could have an adverse effect on its business.
In Individual Life variable universal life sales and account values remain sensitive to equity market levels and returns. The Company continues to pursue new and enhanced products, as well as broader and deeper distribution opportunities to increase sales. Individual Life continues to face uncertainty surrounding estate tax legislation, aggressive competition from other life insurance providers, reduced availability and higher price of reinsurance, and the current regulatory environment regarding reserving practices for universal life products with no-lapse guarantees which may negatively affect Individual Life’s future earnings.
In the International segment management is optimistic about the growth potential of the retirement savings market in Japan. Several trends such as an aging population, longer life expectancies, declining birth rate leading to a smaller number of younger workers to support each retiree, and under funded pension systems have resulted in greater need for an individual to plan and adequately fund retirement savings. However, competition has increased substantially in the Japanese market with most major competitors offering guaranteed benefit riders and, as a result, the Company may not be able to sustain the level of sales attained in 2005. Continued growth depends on increasing the Company’s penetration in the Japanese market by securing new distribution outlets for our products and accessing more customers within existing distributors. In addition, the Company will be looking for ways to leverage our variable annuity capability into other investment product opportunities.
In 2006, management expects continued growth in written and earned premiums in Business Insurance and Personal Lines, partially offset by an expected decline in written and earned premium in Specialty Commercial. Within Business Insurance, in both small commercial and middle market, the Company plans to continue to broaden its relationships with key agencies to increase new business, maintain renewal retention and expand market share in targeted states. Management expects double-digit written premium growth in small commercial in 2006. The Personal Lines segment is expected to deliver written premium growth in the mid-single digits in 2006, including growth from both AARP and Agency. The Company expects new business growth in Agency business as well as strong renewal retention in AARP. Within Specialty Commercial, management expects written and earned premium to decline in 2006 given the non-renewal of a captive insurance program which represented $240 of written premium in 2005. Partially offsetting this decline is an expectation of growth in property written premium driven by new business growth and written pricing increases. Also, a decrease in the percentage of risks ceded to reinsurers will likely contribute to growth in professional liability written premium.
Life provides investment and retirement products such as variable and fixed annuities, mutual funds and retirement plan services and other institutional products; individual and PPLI; and, group benefit products, such as group life and group disability insurance.
Net investment income and interest credited on general account assets in Retail declined for the year ended December 31, 2005 due to lower assets under management from surrenders on market value adjusted (“MVA”) fixed annuity products at the end of their guarantee period. The increase for the year ended December 31, 2004 was largely due to the adoption of SOP 03-1.
The second major category is insurance operating costs and expenses, which is commonly expressed in a ratio of a revenue measure depending on the type of business. The third category is the amortization of deferred policy acquisition costs and the present value of future profits, which is typically expressed as a percentage of pre-tax income before the cost of this amortization. The individual annuity business within Retail accounts for the majority of the amortization of deferred policy acquisition costs and present value of future profits for Life.
Individual Life death benefits decreased for the year ended December 31, 2005 due to favorable mortality experience.
Amounts in 2003 are prior to the adoption of SOP 03-1.
Institutional offers institutional liability products, including stable value products, structured settlements and institutional annuities (primarily terminal funding cases), as well as variable PPLI owned by corporations and high net worth individuals.
International, which primarily has operations located in Japan, Brazil, Ireland and the United Kingdom, provides investments, retirement savings and other insurance and savings products to individuals and groups outside the United States and Canada.
Life includes in an Other category its leveraged PPLI product line of business; corporate items not directly allocated to any of its reportable operating segments; net realized capital gains and losses on fixed maturity sales generated from movements in interest rates, less amortization of those gains or losses back to the reportable segments; net realized capital gains and losses generated from credit related events, less a credit risk fee charged to the reportable segments; net realized capital gains and losses from non-qualifying derivative strategies (including embedded derivatives) other than the net periodic coupon settlements on credit derivatives and the net periodic coupon settlements on the cross currency swap used to economically hedge currency and interest rate risk generated from sales of the Company’s yen based fixed annuity, which are allocated to the reportable segments; the mark-to-market adjustment for the equity securities held for trading reported in net investment income and the related change in interest credited reported as a component of benefits, claims and claim adjustment expenses since these items are not considered by the Company’s chief operating decision maker in evaluating the International results of operations; and intersegment eliminations.
2005 Compared to 2004 - Life’s net income for the year ended December 31, 2005 decreased compared to the prior year due to higher income tax expense. Income tax expense increased for the year ended December 31, 2005 due to the absence of a tax benefit of $190 recorded in 2004 to reflect the impact of the Internal Revenue Service (“IRS”) audit settlement on tax years prior to 2004. Partially offsetting the increase in income tax expense compared to the prior year was an increase in the DRD benefit related to the 2005 tax year of $50. Additional contributing factors to the decrease in net income can be found below:
For the year ended December 31, 2005, Life experienced realized capital losses of $25 as compared to realized capital gains of $164 for the year ended December 31, 2004. See the Investments section for further discussion of investment results and related realized capital gains and losses.
Net income in Retail increased during 2005, principally driven by higher fee income from growth in the variable annuity and mutual fund businesses as a result of higher assets under management as compared to the prior year.
Net income in International increased during 2005, primarily driven by the increased fees from an increase in assets under management of the Japan annuity business. Japan’s assets under management have grown to $26.1 billion at December 31, 2005 from $14.6 billion at December 31, 2004.
2004 Compared to 2003 - Life’s net income increased in 2004 due primarily to business growth in virtually all segments as discussed below, a lower effective income tax rate, and higher net realized capital gains. (See the Investments section for further discussion of investment results and related realized capital gains). Life recorded in the third quarter of 2004 a tax benefit of $190, consisting primarily of a change in estimate of the dividends-received deduction (“DRD”) tax benefit reported during 2003 and prior years and interest, and changed the estimate of the after-tax benefit for the DRD benefit related to the 2004 tax year. Additional contributing factors to the increase in net income can be found below:
Net income in Retirement Plans increased primarily due to higher fee income related to the 401(k) business compared to the prior year.
The effective tax rate was 13% for Life operations in 2004 as compared to an effective tax rate of 21% for Life operations for the respective prior year period. The lower effective tax rate was attributed to tax related items, as discussed above, of $190 and a 2004 tax year DRD benefit of $132, as compared to tax related items of $30 and a 2003 tax year DRD benefit of $87 reported for the years ended December 31, 2004 and 2003, respectively.
2005 Compared to 2004 - Net income in Retail increased for the year ended December 31, 2005 primarily due to improved fee income driven by higher assets under management. Assets under management increased primarily as a result of market growth. A more expanded discussion of earnings growth can be found below:
Benefits and claims and claim adjustment expenses have decreased for the year ended December 31, 2005 due to an increase in reserves in the third quarter of 2004 related to the acquisition of a block of acquired business from London Pacific Life and Annuity Company in liquidation. The increase in reserves of $62 was offset by an equivalent increase in earned premium. Also contributing to the decrease in benefits expense is a decrease in interest credited as older fixed annuity MVA business with higher credited rates matures and either lapse or renews at lower credited rates.
2004 Compared to 2003 - Net income increased for the year ended December 31, 2004, principally driven by higher fee income from double digit growth in the assets under management in virtually all businesses of the segment and strong expense management:
Individual annuity sales of $11.5 billion in 2005 decreased 27% compared to prior year levels of $15.7 billion. Significantly contributing to the Company’s variable annuity sales during 2005 and 2004 was Principal First, a GMWB rider. In an effort to meet diverse customer needs, in the fourth quarter of 2005, Life introduced a new living withdrawal benefit, which guarantees a steady income stream for the life of the policyholder. The success of this and any new product will ultimately be based on customer acceptance. With the increased competition in the variable annuity market causing lower sales levels from the level in 2004, combined with surrender activity on the aging block of business, net outflows are currently forecasted to be above levels experienced in 2005. This will be largely dependent on the Company’s ability to attract new customers and to retain contract holder’s account values in existing or new product offerings as they reach the end of the surrender charge period of their contract.
The growth and profitability of the individual annuity and mutual fund businesses is dependent to a large degree on the performance of the equity markets. In periods of favorable equity market performance, Life may experience stronger sales and higher net flows, which will increase assets under management and thus increase fee income earned on those assets. In addition, higher equity market levels will generally reduce certain costs to Life of individual annuities, such as guaranteed minimum death benefit (“GMDB”) and GMWB benefits. Conversely, weak equity markets may dampen sales activity and increase surrender activity causing declines in assets under management and lower fee income. Such declines in the equity markets will also increase the cost to Life of GMDB and GMWB benefits associated with individual annuities. Life attempts to mitigate some of the volatility associated with the GMDB and GMWB benefits using reinsurance or other risk management strategies, such as hedging. Future net income for Life will be affected by the
effectiveness of the risk management strategies Life has implemented to mitigate the net income volatility associated with the GMDB and GMWB benefits of variable annuity contracts. For spread-based products sold in the Retail segment, the future growth will depend on the ability to earn targeted returns on new business given competition, retention of account values in the fixed annuity business when the contract holder’s rate guarantee expires and the future interest rate environment.
An increase in insurance operating costs and other expenses of $19 during 2005 was principally driven by the 401(k) business. The additional costs can be attributed to greater sales and assets under management, resulting in a 20% increase in asset-based commissions to third parties, technology expenditures, and marketing and servicing costs supporting the segment’s business. However, the increase in 401(k) sales has driven down the overall general insurance expense per case by over 4% compared to the prior year.
401(k) fee income increased 57% or $28 for year ended December 31, 2004 compared to the prior year. This increase is a result of positive net flows from the 401(k) business of $1.4 billion over the past four quarters driven by strong sales contributing to the
The Governmental business contributed significantly higher income in 2004. The 11% increase in net investment income in 2004 compared to 2003 as well as $9 of additional fee income was attributed to the growth in the average account values as a result of positive net flows of $230 and market appreciation of $767.
Insurance operating costs and other expenses for 401(k) increased for the year ended December 31, 2004 compared to the prior year mainly driven by greater sales and assets under management, resulting in a 50% increase in commissions over prior year, in addition to growth in investment technology services and sales and marketing costs.
The future profitability of this segment will depend on Life’s ability to increase assets under management across all businesses and maintain its investment spread earnings on the general account products sold largely in the Government business. 401(k) sales are expected to remain strong throughout 2006 primarily due to the continuing growth in the market for retirement products. As the “baby boom” generation approaches retirement, management believes these individuals will contribute more of their income to retirement plans due to the uncertainty of the Social Security system and the increase in average life expectancy. Assets under management are also expected to increase in 2006 due to both strong sales and the effects of increasing company wholesaling activities in 2005. Disciplined expense management will continue to be a focus; however, as Life looks to expand its reach in this market, additional investments in service and technology will occur. The Government market is highly competitive from a pricing perspective, and a small number of cases often account for a significant portion of sales, therefore the Company may not be able to sustain the level of sales growth attained in 2005.
2005 Compared to 2004 -Net income in Institutional increased for the year ended December 31, 2005 compared to the prior year driven by higher earnings in both the Institutional and PPLI businesses:
PPLI’s net income increased $3 or 17% compared to prior year primarily due to asset growth in the variable business combined with favorable mortality experience.
The decrease in other expenses was primarily attributed to a PPLI $40 after-tax charge, recorded in the third quarter ended September 30, 2003, associated with the settlement of a certain litigation matter.
Individual Life provides life insurance solutions to a wide array of partners to solve the wealth protection, accumulation and transfer needs of their affluent, emerging affluent and business insurance clients.
Fee income increased for the year ended December 31, 2004 as compared to the prior year primarily due to increased cost of insurance charges as life insurance inforce grew and aged and variable universal life account values increased driven by favorable equity markets and new sales. Account values and life insurance inforce grew 9% and 7% from 2003 to 2004, respectively.
Net investment income increased for the year ended December 31, 2004 as compared to the prior year primarily due to the adoption of SOP 03-1, growth in general account values and prepayments on bonds. The adoption of SOP 03-1 also resulted in
increases in benefits, claims and claim adjustment expenses and a decrease to fee income and other for the year ended December 31, 2004 as compared to the prior year period for the segment’s Modified Guarantee Life Insurance product, which was formerly classified as a separate account product.
Insurance operating costs and other expenses increased for the year ended December 31, 2004 as compared to the prior year as a result of business growth.
Additionally, income tax expense was higher for the year ended December 31, 2004 as compared to the prior year due primarily to earnings growth, as discussed above. Income tax expense includes a DRD tax benefit of $5 related to the 2004 tax year, whereas, income tax expense for 2003 includes a total DRD tax benefit of $6.
Individual Life sales grew to $250 in 2005 from $233 in 2004 and $196 in 2003 with the successful introduction of new universal life and variable universal life products. Variable universal life sales and account values remain sensitive to equity market levels and returns. The Company continues to pursue new and enhanced products, as well as broader and deeper distribution opportunities to increase sales. Individual Life continues to face uncertainty surrounding estate tax legislation, aggressive competition from other life insurance providers, reduced availability and higher price of reinsurance, and the current regulatory environment regarding reserving practices for universal life products with no-lapse guarantees which may negatively affect Individual Life’s future earnings.
Operating costs were higher for the year ended December 31, 2005 as compared to the prior year primarily due to higher operating expenses related to business growth.
The segment’s loss ratio was 74.0% for the year ended December 31, 2004 as compared to 78.5% for the prior year, which contributed favorably to net income. The improvement in loss ratio in 2004 was the result of improved mortality and morbidity experience. Excluding financial institutions, the loss ratio was 78.7%, down from 79.5% in the prior year.
The Company anticipates the increased scale of the group life and disability operations and the expanded distribution network for its products and services will generate strong sales growth in 2006. Sales, however, may be negatively affected by the competitive pricing environment in the marketplace. Management is committed to selling competitively priced products that meet the Company’s internal rate of return guidelines.
Despite the current market conditions, including low interest rates, rising medical costs, the changing regulatory environment and cost containment pressure on employers, the Group Benefits segment continues to leverage its strength in claim practices risk management, service and distribution, enabling the Company to capitalize on market opportunities. Additionally, employees continue to look to the workplace for a broader and ever expanding array of insurance products. As employers design benefit strategies to attract and retain employees, while attempting to control their benefit costs, management believes that the need for the Group Benefits segment’s products will continue to expand. This, combined with the significant number of employees who currently do not have coverage or adequate levels of coverage, creates unique opportunities for our products and services.
2005 Compared to 2004 - Net income increased significantly for the year ending December 31, 2005, principally driven by higher fee income and investment spread in Japan, derived from a 78% increase in the assets under management. A more expanded discussion of earnings growth can be found below:
The increase in operating costs in 2005 was primarily due to the significant growth in the Japan operation and the investment in our Ireland operation.
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. In addition, higher account values levels will generally reduce certain costs to the Company of individual annuities, such as guaranteed minimum death benefits (“GMDB”) and GMIB benefits. Expanse management is also an important component of product profitability.
Income tax benefit for the year ended December 31, 2004 included a $190 tax benefit.
Property & Casualty provides a number of coverages, as well as insurance related services, to businesses throughout the United States, including workers’ compensation, property, automobile, liability, umbrella, specialty casualty, marine, livestock, bond, professional liability and directors and officers’ liability coverages. Property & Casualty also provides automobile, homeowners and home-based business coverage to individuals throughout the United States as well as insurance-related services to businesses.
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.
target market and direct marketing programs to increase premium writings. The policy in force count is primarily a reflection of new business growth.
Premium renewal retention represents the ratio of net written premium in the current period that is not derived from new business divided by total net written premium of the prior period. Accordingly, premium renewal retention includes the effect of written pricing changes on renewed business. In addition, the renewal retention rate is affected by a number of other factors, including the percentage of renewal policy quotes accepted and decisions by the Company to non-renew policies because of specific policy underwriting concerns or because of a decision to reduce premium writings in certain lines of business or states. Premium renewal retention has decreased from 2004 to 2005 due to the effect of written pricing decreases in Business Insurance and lower written pricing increases in Personal Lines. Before the effect of written pricing changes, premium renewal retention in 2005 increased in Personal Lines auto and Business Insurance and decreased in Personal Lines homeowners. While Personal Lines premium retention continues to be strong, increased advertising and modest rate reductions by competitors contributed to the decrease in retention. Before the impacts of written pricing changes,premium renewal retention in Business Insurance increased for both small commercial and middle market accounts.
From 2004 to 2005, new business as a percentage of written premium has remained relatively flat for Business Insurance and Personal Lines homeowners and has decreased for Personal Lines auto. The decrease in Personal Lines auto new business premium as a percentage of written premium has been driven by companies in the industry, including The Hartford, concentrating on securing renewals and reducing rate shopping by customers.
Because the Company earns premiums over the 6 to 12 month term of the policies, earned pricing increases (decreases) lag written pricing increases (decreases) by 6 to 12 months. Written premiums are earned over the policy term, which is six months for certain Personal Lines auto business and 12 months for substantially all of the remainder of the Company’s business. In 2005, earned
In the latter half of 2005, claim frequency for property coverages became less favorable than it had been in 2003, 2004 and the first half of 2005. As a result, beginning in the latter half of 2005, increases in claim severity outpaced favorable claim frequency. Management expects the trend of increasing loss costs to continue in 2006, resulting in a higher current accident year loss and loss adjustment expense ratio, given that earned pricing is expected to decrease slightly in Business Insurance and become less positive in Personal Lines. Claim severity is expected to increase as a result of inflation in claim settlement costs, driven principally by medical cost inflation, property value increases and other indemnity cost increases. Reserve estimates, including reserves for catastrophe claims, are inherently uncertain. While the Company believes its recorded reserves are established at a level to meet the ultimate cost of unpaid claims, reserve estimates may change in the future based on information or trends that are not currently known. See “Reserves” below for a detailed discussion of prior accident year loss development and “Critical Accounting Estimates” for a discussion of current trends contributing to reserve uncertainty and the impact of changes in key assumptions on reserve volatility.
The combined ratio is the sum of the loss and loss adjustment expense ratio, the expense ratio and the policyholder dividend ratio. This ratio is a relative measurement that describes the related cost of losses and expense for every $100 of earned premiums. A combined ratio below 100.0 demonstrates underwriting profit; a combined ratio above 100.0 demonstrates underwriting losses. The combined ratio has decreased from 2004 to 2005, primarily because of a 2.0 point reduction in current accident year catastrophe losses.
Current accident year catastrophe loss and loss adjustment expenses in 2004 included $394 for Hurricanes Charley, Frances, Ivan and Jeanne.
The Other Operations segment is responsible for managing operations of The Hartford that have discontinued writing new or renewal business as well as managing the claims related to asbestos and environmental exposures. As such, neither earned premiums nor underwriting ratios are meaningful financial measures. Instead, management believes that net income (loss) is a more meaningful measure. Whether Other Operations reports net income or a net loss is largely a function of the amount of prior accident year development and the amount of investment income earned on assets held to meet claim liabilities. In 2005, Other Operations reported net income of $71 as net investment income earned exceeded unfavorable prior accident year loss development. In 2003 and 2004, the segment reported net losses as unfavorable prior accident year loss development exceeded net investment income. Unfavorable prior accident year development decreased from $409 in 2004 to $212 in 2005. The net loss in 2003 includes net asbestos reserve strengthening of $1.7 billion after-tax. Reserve estimates within Other Operations, including estimates for asbestos and environmental claims, are inherently uncertain. Refer to the Other Operations segment MD&A for further discussion of Other Operations prior accident year development and operating results.
Property & Casualty’s insurance business has been written by a number of writing companies that, under a pooling arrangement, participate in the Hartford Fire Insurance Pool, the lead company of which is the Hartford Fire Insurance Company (“Hartford Fire”). Property & Casualty maintains one portfolio of invested assets for all business written by the Hartford Fire Insurance Pool companies, including business reported in both the Ongoing Operations and Other Operations segments. Separate investment portfolios are maintained within Other Operations for the runoff of international assumed reinsurance claims and for the runoff business of Heritage Holdings, Inc., including its subsidiaries, Excess Insurance Company Ltd., First State Insurance Company and Heritage Reinsurance Company, Ltd. Within the Hartford Fire Insurance Pool, invested assets are attributed to Ongoing Operations and Other Operations pursuant to the Company’s capital attribution process.
the Company’s method of allocating net investment income for the Hartford Fire Insurance Pool and the net investment income earned by Other Operations on its separate investment portfolios, in 2005, the before-tax investment yield for Ongoing Operations was 5.5% and the before-tax investment yield for Other Operations was 5.7%.
Unless otherwise specified, the following discusses changes for the year ended December 31, 2005 compared to the year ended December 31, 2004 and the year ended December 31, 2004 compared to the year ended December 31, 2003.
Includes reinstatement premiums related to hurricanes of $73 recorded in the third and fourth quarter of 2005 and reinstatement premiums related to hurricanes of $17 recorded in the third quarter of 2004.
Net prior year incurred losses in 2005 includes an increase in reserves for assumed reinsurance of $85 and net reserve strengthening for workers’ compensation reserves of $45, partially offset by a net reserve release of $95, predominantly related to allocated loss adjustment expenses on auto liability claims.
An increase in underwriting profit derived from a $572 increase in earned premium, before considering the $90 retrospective earned premium adjustment in 2004. The earned premium growth was generated in Business Insurance and Personal Lines.
Net income increased $1.7 billion, from a net loss of ($745) in 2003, as a result of a $2,508 increase in income before income taxes. The increase in income before income taxes was driven primarily by the following:
A $120 decrease in net realized capital gains due to lower net realized gains on the sale of fixed maturity investments.
A $90 reduction in earned premium on retrospectively-rated policies recorded within Specialty Commercial in 2004.
A significant portion of the gross incurred loss and loss adjustment expenses are recoverable from reinsurers under the Company’s principal catastrophe reinsurance program in addition to other reinsurance programs. Reinsurance recoveries under the Company’s principal catastrophe reinsurance program, which covers multiple lines of business, are allocated to the segments in accordance with a pre-established methodology that is consistent with the method used to allocate the ceded premium to each segment. In addition to its retention, the Company has a co-participation in the losses ceded under the principal catastrophe reinsurance program, which varies by layer, and is recorded in Specialty Commercial. In the third and fourth quarters of 2005, the Company reinstated the limits under its reinsurance programs that were exhausted by Hurricane Katrina and Wilma, resulting in additional ceded premium of $73, which is reflected as a reduction in earned premium.
The Company’s estimates of net loss and loss expenses arising from Hurricanes Katrina, Rita and Wilma are based on information from reported claims and estimates of reinsurance recoverables on ceded losses. Estimating ultimate net losses for the 2005 hurricanes is challenging. Given the long time lag between Hurricane Katrina’s landfall and when many residents and business owners were able to return to their properties, the Company expects reported losses to emerge more slowly for Hurricane Katrina than for past hurricanes. Also, the extent of the damage caused by the hurricanes in the Gulf coast region potentially will increase loss costs due to increased demand for building materials and contractors needed to complete repair work. Given the inherent uncertainty in how reported claims will ultimately develop, ultimate loss and loss expenses paid after December 31, 2005 for Hurricanes Katrina, Rita and Wilma could vary significantly from the reserves recorded as of December 31, 2005.
Strengthened general liability reserves within Business Insurance by $40 for accident years 2000-2003 due to higher than anticipated loss payments beyond four years of development. The $40 reserve release represented 2% of the Company’s net reserves for general liability claims as of December 31, 2004.
Within the Specialty Commercial segment, there were other offsetting positive and negative adjustments to prior accident year reserves. The principal offsetting adjustments were a release of reserves for directors and officers insurance related to accident years 2003 and 2004 and strengthening of prior accident year reserves for contracts that provide auto financing gap coverage and auto lease residual value coverage; the release and offsetting strengthening were each approximately $80.
Released September 11 net reserves by $298 due to favorable developments in 2004, including the closure of primary insurance property cases, a high participation rate within the Victim’s Compensation Fund and the expiration of the deadline for filing a liability claim in March 2004.
Strengthened reserves for assumed casualty reinsurance by $170, primarily related to assumed casualty treaty reinsurance for the years 1997 through 2001. The $170 of strengthening represents 13% of the $1.3 billion of net Reinsurance reserves as of December 31, 2004. In recent years, the Company has seen an increase in reported assumed reinsurance claims above previous expectations and this increase in reported claims contributed to the reserve re-estimates.
As discussed in the Other Operations segment section, strengthened net asbestos reserves by $2.6 billion.
Strengthened assumed reinsurance reserves by $129, primarily related to accident years 1997 through 2000 and principally in the casualty line of HartRe assumed reinsurance.
Before the reserve strengthening for asbestos and environmental reserves over the past ten years, reserve re-estimates for total Property and Casualty ranged from (3.0%) to 1.6% .
In managing exposure, The Hartford’s risk 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 exposure limits and actively monitors the risk exposures as a percent of Property & Casualty surplus. For natural catastrophe perils, the Company generally limits its exposure to natural catastrophes from a single 250-year event to less than 30% of Property & Casualty statutory surplus for losses prior to reinsurance and to less than 15% of Property & Casualty statutory surplus for losses net of reinsurance. For terrorism, the Company manages its exposure in major metropolitan areas to single-site conventional terrorism attacks, such that the Company endeavors to limit its exposure, including exposures resulting from the Company’s Group Life operations, to less than 7% of the combined statutory surplus of the Life and Property and Casualty operations. The Company monitors exposures monthly and employs both internally developed and vendor-licensed loss modeling tools as part of its risk management discipline.
In managing risk, The Hartford utilizes reinsurance to transfer exposures to well-established and financially secure reinsurers. Reinsurance is used to manage aggregate exposures as well as specific risks based on accumulated property and casualty liabilities in certain geographic zones. All treaty purchases related to the Company’s property and casualty operations are administered by a
centralized function to support a consistent strategy and ensure that the reinsurance activities are fully integrated into the organization’s risk management processes.
A variety of traditional reinsurance products are used as part of the Company’s risk management strategy, including excess of loss occurrence-based products that protect aggregate property and workers’ compensation exposures, and individual risk or quota share products, that protect specific classes or lines of business. There are no significant finite risk contracts in place and the statutory surplus benefit from all such prior year contracts is immaterial. Facultative reinsurance is also used to manage policy-specific risk exposures based on established underwriting guidelines. The Hartford also participates in governmentally administered reinsurance facilities such as the Florida Hurricane Catastrophe Fund (“FHCF”), the Terrorism Risk Insurance Program established under The Terrorism Risk Insurance Act of 2002 and other reinsurance programs relating to particular risks or specific lines of business.
In addition, the Company has reinsurance from FHCF which covered, for the treaty year effective June 1, 2005, 90% of up to $312 of Personal Lines property losses incurred from a single catastrophe event in excess of an $83 retention. The Company has other treaties and facultative reinsurance agreements that cover property catastrophe losses on a per risk basis. Also, for the treaty year effective July 1, 2005, the Company reinsured 95% of up to $280 of workers’ compensation losses incurred from a single catastrophe event in excess of a $20 retention.
For catastrophe treaties that renewed on January 1, 2006, the terms of the treaties are substantially unchanged in 2006, except that the principal property catastrophe program provides coverage, on average, for 88% of up to $675 of property losses incurred from a single catastrophe event in excess of a $175 retention. Also, the Company’s retention on the specialty property treaty covering excess and surplus lines property business was increased from $10 to $20 and provides coverage on average for 95% of up to $330 of losses incurred on a single catastrophe event. In the aftermath of the 2004 and 2005 hurricane season, third-party catastrophe loss models for hurricane loss events are being updated to incorporate medium-term forecasts of increased hurricane frequency and severity. Given the losses sustained by reinsurers from the 2004 and 2005 hurricanes and the changes being made to the third-party catastrophe loss models for the peril of hurricane, reinsurance pricing has increased with the January 1, 2006 renewals. Like other property and casualty insurance companies, the Company has been reviewing its capacity to write business in catastrophe prone areas and will consider further changes to its reinsurance programs.
In February of 2006, the Company purchased $105 of additional four-year reinsurance protection from Foundation Re. This additional purchase provides coverage for 26% of $400 in losses in excess of an index loss trigger of $1.3 billion from Gulf and East Coast
Given the possibility that TRIA may not be extended beyond December 31, 2007 and the very limited private terrorism reinsurance capacity available, including reinsurance against losses from terrorism acts using weapons of mass destruction, the Company has been actively managing its exposures to the peril of terrorism, including adopting underwriting actions designed to reduce exposures in specific locations of the country. The Company has worked with various industry groups to develop policy exclusions related to the peril of terrorism, including those associated with nuclear, biological, chemical and radiological attacks. The Company may include such exclusions in policies in the future in those jurisdictions and classes of business where such exclusions are permitted, and take additional underwriting actions as deemed appropriate.
Where its contracts permit, the Company secures future claim obligations with various forms of collateral including irrevocable letters of credit, secured trusts, funds held accounts and group wide offsets. The allowance for uncollectible reinsurance was $413 and $374 as of December 31, 2005 and December 31, 2004, respectively. As part of its reinsurance recoverable review, the Company analyzes recent developments in commutation activity between reinsurers and cedants, recent trends in arbitration and litigation outcomes in disputes between cedants and reinsurers and the overall credit quality of the Company’s reinsurers. Due to the inherent uncertainties as to collection and the length of time before such amounts will be due, it is possible that future adjustments to the Company’s reinsurance recoverables, net of the allowance, could be required, which could have a material adverse effect on the Company’s consolidated results of operations or cash flows in a particular quarterly or annual period.
Annually, the Company completes an evaluation of the reinsurance recoverable asset associated with older, long-term casualty liabilities reported in the Other Operations segment. As a result of this evaluation, the Company reduced its net reinsurance recoverable by $20 in 2005 and $181 in 2004. The after-tax income effect of the $181 reduction in 2004 was $118. The $181 primarily related to a reduction of the amount of liabilities, principally asbestos, that the Company expected to cede to reinsurers and, to a lesser extent, an increase in the allowance for uncollectible reinsurance recoverables.
consistent with the statutory accounting practice followed for the rest of the Company’s business. This change had no effect on earned premium. For all periods presented, written premium for workers’ compensation business has been adjusted to reflect written premium in the period the policies incept. Reinstatement premium represents additional ceded premium paid for the reinstatement of the amount of reinsurance coverage that was reduced as a result of a reinsurance loss payment.
Unless otherwise specified, the following discussion speaks to changes for the year ended December 31, 2005 compared to the year ended December 31, 2004 and the year ended December 31, 2004 compared to the year ended December 31, 2003.
Total Ongoing Operations’ earned premiums grew $682, or 7%, due primarily to growth in Business Insurance and Personal Lines. Earned premiums are net of third and fourth quarter property catastrophe reinstatement premiums related to hurricanes totaling $73 in 2005 and $17 in 2004.
Specialty Commercial earned premiums increased by $31, primarily driven by a $90 reduction in earned premiums under retrospectively-rated policies during 2004 and increases in casualty, bond, professional liability and other premiums, partially offset by a $216 decrease in property earned premiums, primarily due to a decrease of $127 from exiting the multi-peril crop insurance business during 2004.
Total Ongoing Operations’ earned premiums grew $1.1 billion, or 13%, due to growth in all three segments. Earned premiums are net of third quarter property catastrophe reinstatement premium of $17 in 2004.
Specialty Commercial earned premiums increased by $168, primarily due to a $75 increase in earned premiums from a captive insurance program and increases in earned premium for property, bond, professional liability and other, partially offset by a $90 decrease in earned premiums under retrospectively rated-rated policies recorded in 2004.
A $179 increase in net investment income due, in part, to a larger investment base due to increased cash flows from underwriting, higher investment yields on fixed maturity investments and an increase in income from limited partnership investments. Also contributing to the increase, was the effect of allocating more invested assets to Ongoing Operations in 2005. Less invested assets were needed in Other Operations given the reduction in Other Operations’ loss reserves and the reduction in invested assets needed to support those reserves.
Underwriting results increased by $246, with a corresponding 2.1 point improvement in the combined ratio from 95.3 to 93.2, driven primarily by the following factors.
A $106 improvement in current accident year underwriting results before catastrophes, with a corresponding 0.3 point improvement in the combined ratio before catastrophes and prior accident year development,
A net reserve release of $95 in 2005, predominantly related to allocated loss adjustment expenses on Personal Lines auto liability claims,
Net unfavorable reserve development of $5 in 2004, including reserve increases of $303, partially offset by a reserve release of $298 for September 11. Reserve increases in 2004 included $190 for construction defects claims, $38 for small commercial package business and $25 for auto liability claims.
A $40 strengthening of general liability reserves within Business Insurance related to accident years 2000 to 2003, and
The $106 improvement in current accident year underwriting results before catastrophes is primarily due to earned premium growth and a slight improvement in current accident year non-catastrophe loss costs, partially offset by $64 of hurricane-related assessments in 2005. Earned premiums grew $682, primarily due to growth in Business Insurance and Personal Lines and the effect of a $90 decrease in earned premium on retrospectively rated policies recorded in 2004, partially offset by a decrease in specialty property earned premium and a $56 increase in catastrophe treaty reinstatement premiums.
The combined ratio before catastrophes and prior accident year development decreased from 2004 to 2005 due to the effect of the $90 decrease in earned premium on retrospectively-rated policies in 2004. Before the effect of the $90 earned premium reduction in 2004, the combined ratio before catastrophes and prior accident year development increased 0.5 points, to 89.4 in 2005, principally due to an increase in the expense ratio, partially offset by a slight improvement in current accident year loss and loss adjustment expense ratio. In 2005, the Company recognized improved current accident year performance for auto bodily injury and workers’ compensation claims, partially offset by the effect of an increase in non-catastrophe property loss costs. Non-catastrophe property loss costs increased primarily due to increasing claim severity and, in specialty property, increasing claim frequency as well.
The expense ratio increased 0.6 points during 2005, to 26.5, primarily due to $64 of hurricane related assessments incurred in 2005 related to the 2004 and 2005 hurricanes. Apart from the impact of hurricane related assessments, the favorable effects on the expense ratio of an increase in earned premiums, a reduction in contingent commissions and a shift to lower commission workers’ compensation business were offset by the unfavorable effects of an increase in catastrophe treaty reinstatement premiums and reduced catastrophe treaty profit commissions. The reduction in contingent commissions was due, in part, to a decision made by some agents and brokers not to accept contingent commissions after the third quarter of 2004. The hurricane-related assessments were predominantly from the Citizens Property Insurance Corporation (Citizens) in Florida. Citizens is a company established by the State of Florida to provide personal and commercial insurance to individuals and businesses in Florida who are in high risk areas of the state and are unable to obtain insurance through the private insurance markets. The third quarter 2004 hurricanes caused a deficit in Citizens’ “high risk” account, which triggered an assessment to the Company of $15. In addition, the Company recorded an estimated Citizens’ assessment of $46 based on losses sustained by Citizens as a result of hurricane Wilma in the fourth quarter of 2005. Assessments recorded related to the 2004 and 2005 hurricanes could be adjusted in future periods as catastrophe losses develop. While the Company may recoup these assessments from Florida policyholders through surcharges that it will bill on new and renewal premium written in the future, the surcharges are not recognized until the period in which the future premium is earned.
Net income increased $172, or 22%, driven primarily by the following:
An $85 increase in income tax expense reflecting the increase in income before income taxes.
Underwriting results increased by $147, with a corresponding 1.2 point improvement in the combined ratio from 96.5 to 95.3, driven primarily by the factors described below.
A $250 increase in current accident year catastrophe losses, due to losses from Hurricanes Charley, Frances, Ivan and Jeanne in the third quarter of 2004.
For the year ended December 31, 2005, earned pricing increased 3% for small commercial and decreased 3% for middle market. As substantially all premiums in the segment are earned over a 12 month policy period, earned pricing changes for the year ended December 31, 2005 primarily reflect written pricing changes during the last six months of 2004 and the year ended December 31, 2005.
Earned premiums for the segment increased $603, or 16%, in 2004, primarily due to earned pricing increases and new business premium outpacing non-renewals.
Growth in middle market earned premiums was driven primarily by growth in workers’ compensation premium. New business premium decreased by $61 due largely to written pricing decreases.
A $67 improvement resulting from earned premium growth at a combined ratio less than 100.0 and from a decrease in the combined ratio before catastrophes and prior accident year development of 0.3 points, from 89.7 to 89.4
A $75 release of workers’ compensation reserves during 2005 related to accident years 2003 and 2004, and
A $25 release of prior accident year reserves for allocated loss adjustment expenses during 2005.
Partially offsetting the improvements in underwriting results were the following factors:
Net favorable reserve development of $67 in 2004 included a $175 release of September 11 reserves, partially offset by a $38 strengthening of reserves for small commercial package business, a $25 strengthening of automobile liability reserves and a $23 strengthening of reserves for construction defects claims,
A $20 strengthening of third quarter 2004 hurricane reserves during 2005.
The combined ratio before catastrophes and prior accident year development decreased 0.3 points to 89.4, due primarily to earned pricing increases in small commercial, improved current accident year underwriting results for workers’ compensation business and a 0.6 point decrease in the expense ratio, partially offset by earned pricing decreases in middle market and increasing non-catastrophe property claim costs. The improved current accident year performance for workers’ compensation business was consistent with the favorable prior accident year development recorded in 2005 related to accident years 2003 and 2004.
Underwriting results increased by $202, with a corresponding 4.1 point decrease in the combined ratio to 91.6. The net increase in underwriting results was principally driven by the following factors:
A $181 improvement resulting from earned premium growth at a combined ratio less than 100.0 and from a decrease in the combined ratio before catastrophes and prior accident year development of 3.3 points, from 93.0 to 89.7, and
The combined ratio before catastrophes and prior accident year development decreased 3.3 points, to 89.7, due primarily to earned pricing increases in excess of loss cost increases in both small commercial and middle market and a 1.7 point decrease in the expense ratio. Improved claim frequency was partially offset by increased claim severity. The 1.7 point improvement in the expense ratio was primarily due to earned premium growth a shift to more workers’ compensation business which has lower commissions.
In small commercial, the Company expects double-digit written premium growth to be generated, in part, through the use of customized pricing, more sophisticated pricing models and automated underwriting decision making tools and increasing its underwriting appetite within certain industries and risks. Also, the Company increased the number of small commercial sales representatives by 20% in 2005 and expects to increase the sales staff further in 2006. Within middle market, the Company expects to focus on growing its property book of business as well as protecting its renewals.
Omni earned premium decreased by $55, or 22%, because of a strategic decision by management to focus on more profitable non-standard auto business.
The earned premium growth in AARP and Agency during 2005 was primarily due to new business written premium outpacing non-renewals for auto business in 2004 and 2005 and to earned pricing increases in homeowners’ business.
Earned pricing increases for automobile of 1% in 2005 were down from 5% in 2004. Likewise, earned pricing increases for homeowners of 7% in 2005 were down from 11% in 2004. The moderation in earned pricing increases during 2005 is a reflection of written pricing changes from 2004 to 2005.
Written pricing for homeowners increased 7% in the last six months of 2004 and 6% in 2005.
The written price declines are reflective of the company’s response in different states and different auto segments to the current levels of price adequacy. Written pricing for homeowners has increased primarily due to increased insurance to value.
AARP earned premium grew $190, or 10%, reflecting growth in the size of the AARP target market and the effect of direct marketing programs to increase premium writings, in both auto and homeowners.
Omni earned premium was flat during 2004 because of a strategic decision by management to focus on more profitable non-standard auto business.
The earned premium growth in AARP and Agency is primarily because new business growth over the prior 6 to 12 months exceeded non-renewals in both auto and homeowners.
The number of policies in force at year end increased in auto and homeowners from 2,058,825 and 1,319,629, respectively, as of December 31, 2003, to 2,166,922 and 1,348,573, respectively, as of December 31, 2004. The growth in policies in force does not correspond directly with the growth in earned premium due to the impact of earned pricing increases and because policy in force counts are as of a point in time rather than over a period of time. Most of the growth in homeowners policies in force was generated by Agency while for auto policies in force, growth in both AARP and Agency is partially offset by a decline in Omni.
Earned pricing increases for automobile of 5% for the year ended December 31, 2004 were down from 9% during the year ended December 31, 2003. Likewise, earned pricing increases for homeowners of 11% for the year ended December 31, 2004 were down from 14% during the year ended December 31, 2003. The moderation in earned pricing increases during 2004 is a reflection of a decline in written pricing increases from 2003 to 2004.
Written pricing for automobile increased 8% in the last six months of 2003 and 3% in 2004.
In addition to earned pricing increases, homeowners earned premiums included the effect of automatic increases in the amount of insurance coverage to adjust for construction cost inflation.
A $166 decrease in current accident year catastrophe losses. Catastrophe losses in 2005 included losses for Hurricanes Katrina, Rita and Wilma of $50 whereas catastrophe losses in 2004 included losses for Hurricanes Charley, Frances, Ivan and Jeanne of $215,
plans, expansion of its product breadth, an increase in the number of new agency appointments and the use of value pricing to long-time customers. The Company expects new business growth in Agency business as well as strong renewal retention in AARP.
Strong underwriting profitability within the past couple of years has intensified the level of competition, putting downward pressure on rates, particularly in auto. For auto, written pricing in 2006 is expected to be flat to slightly negative. For homeowners, management expects written pricing increases in the mid-single digits. Regulatory requirements applying to premium rates vary from state to state, and, in most states, rates are subject to prior regulatory approval. State regulatory constraints may prevent companies from obtaining the necessary rates to achieve an underwriting profit. Industry rates may remain inadequate in certain states in 2006. Loss costs in 2006 are expected to increase in the mid-single digits as increasing claim severity is expected to slightly outpace favorable claim frequency. While earned pricing is expected to keep pace with loss cost increases in homeowners, margins will likely be reduced for auto.
Bond earned premium grew $22, or 12%, due to new business growth in commercial and contract surety business, an increase in earned pricing, a decrease in the portion of risks ceded to outside reinsurers and a decrease in the price of reinsurance with outside reinsurers.
Within the “other” category, earned premium increased by $63, or 59%, primarily due to increased premiums on inter-segment reinsurance programs.
Earned premiums for the Specialty Commercial segment grew $168, or 11%, due primarily to earned premium growth in all lines of business, partially offset by a $90 reduction in premiums receivable under retrospectively-rated policies, reflecting a decrease in estimated earned premium under the terms of these policies.
Property earned premium increased $32, or 7%, primarily due to an increase of $43 in the portion of property business derived from multi-peril crop insurance premiums. In the fourth quarter of 2004, the Company transferred its entire book of multi-peril crop insurance (MPCI) to Rural Community Insurance Company (RCIC), a subsidiary of Wells Fargo & Company. The agreement transferred in bulk all 2005 crop year policies to RCIC in exchange for an initial payment and renewal fees based upon retention of the transferred business over a three year period. The Company retained responsibility for the MPCI business written for the 2004 and prior crop years. Earned premium for MPCI business for the year ended December 31, 2004 was $127. Before considering the increase in MPCI premiums, earned premiums for property declined by 6%, reflecting a business decision to write less new business and renew less premium as a result of the decline in written pricing.
Professional liability earned premiums grew $39, or 13%, primarily due to a decrease in the portion of risks ceded to outside reinsurers and earned pricing increases, partially offset by a decrease in renewal retention and new business growth. Earned pricing increases in professional liability were due entirely to written pricing increases in 2003 as prices declined in 2004.
Within the “other” category, earned premiums increased $41, or 62%, primarily due to increased premiums on inter-segment reinsurance programs.
A $53 increase in current accident year catastrophe losses. Catastrophe losses in 2005 for Hurricanes Katrina, Rita and Wilma were $145 compared to catastrophe losses in 2004 for Hurricanes Charley, Frances, Ivan and Jeanne of $81. Catastrophe losses in 2005 and 2004 include $70 and $19, respectively, of catastrophe losses assumed under inter-segment reinsurance programs and
Contributing to the $109 decrease in current accident year underwriting results were higher non-catastrophe losses in property and a $22 increase in net catastrophe treaty reinstatement premiums, partially offset by improvement in professional liability. The expense ratio increased by 3.2 points, to 24.3, primarily due to a reduction in ceding commissions on professional liability business, a reduction in profit commissions due to increased catastrophe losses and a shift to more casualty business which has a higher expense ratio, partially offset by the impact on the expense ratio of the $90 earned premium adjustment in 2004.
An $86 increase in current accident year catastrophe losses, principally due to losses incurred for hurricanes Charley, Frances, Ivan and Jeanne in the third quarter of 2004 and
Current accident year non-catastrophe underwriting results improved in all lines of business. The improvement in casualty, bond and professional liability was due to earned pricing increases exceeding loss costs. The improvement in property was due to low non-catastrophe property losses, despite a decline in earned pricing. The expense ratio for the year ended December 31, 2004 decreased over the prior year expense ratio due primarily to earned premium growth.
Beginning in the fourth quarter of 2005, specialty property written pricing has been increasing in catastrophe prone areas and management expects rates to continue to increase in 2006. The written price increases reflect, in part, a medium-term forecast of increased hurricane frequency and severity as well as an increase in the cost of reinsurance. Although written pricing increases are expected for property and bond, written pricing decreases are expected for casualty and professional liability,
In 2006, management expects that the written pricing increases in property will yield a lower loss and loss adjustment expense ratio, provided that catastrophe property claim experience returns to expected levels. The level of catastrophe losses can have a significant impact on Specialty Commercial’s underwriting results, however, due to specialty property exposures in hurricane-prone areas. Specialty Commercial’s expense ratio will likely continue to vary significantly from period to period depending, in part, on the level of profit commissions and reinstatement premium recognized related to catastrophe activity and changes in business mix.
A $62 decrease in net investment income, primarily as a result of a decrease in invested assets resulting from net claims and claim adjustment expenses paid in 2004 and 2005. Other Operations net investment income includes income earned on the separate portfolios of Heritage Holdings and its subsidiaries, and on the Hartford Fire invested asset portfolio, which is allocated between Ongoing Operations and Other Operations. The Company attributes capital and invested assets to each segment using an internally developed, risk-based capital attribution methodology.
The reporting pattern for assumed reinsurance claims, including those related to asbestos and environmental claims, is much longer than for direct claims. In many instances, it takes months or years to determine that the policyholder’s own obligations have been met and how the reinsurance in question may apply to such claims. The delay in reporting reinsurance claims and exposures adds to the uncertainty of estimating the related reserves.
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, 2005, 2004 and 2003.
Excludes asbestos and environmental net liabilities reported in Ongoing Operations of $10 and $6, respectively, as of December 31, 2005, $13 and $9, respectively, as of December 31, 2004, and $11 and $8, respectively, as of December 31, 2003. Total net claim and claim adjustment expenses incurred in Ongoing Operations for the twelve months ended December 31, 2005, 2004, and 2003 includes $11, $13, and $13, respectively, related to asbestos and environmental claims. Total net claim and claim adjustment expenses paid in Ongoing Operations for the twelve months ended December 31, 2005, 2004, and 2003 includes $17, $11, and $12, respectively, related to asbestos and environmental claims.
the first and second quarters, respectively. The majority of the reserve strengthening of $85 was for assumed casualty reinsurance for the years 1997 through 2001. With the transfer of the HartRe assumed reinsurance business into Other Operations, the segment has exposure related to more recent assumed casualty reinsurance reserves, particularly for the underwriting years 1997 through 2001. Assumed reinsurance exposures are inherently less predictable than direct insurance exposures because the Company may not receive notice of a reinsurance claim until the underlying direct insurance claim is mature. This causes a delay in the receipt of information from the ceding companies. In recent years, the Company has seen an increase in reported losses above previous expectations and this increase in reported losses contributed to the reserve re-estimates. The Company completed an updated evaluation of HartRe’s assumed reinsurance reserves in the fourth quarter of 2005. The evaluation indicated no change in assumed reinsurance reserves. The Company currently expects to perform a review of its HartRe assumed reinsurance liabilities at least annually.
During the third quarters of 2005 and 2004, the Company completed its annual environmental reserve evaluations. In each of these evaluations, the Company reviewed all of its domestic direct and assumed reinsurance accounts exposed to environmental liability. The Company also examined its London Market exposures for both direct insurance and assumed reinsurance. In both years, the Company found estimates for individual cases changed based upon the particular circumstances of each account, although the reviews found no apparent underlying cause or change in the claim environment. The net effect of these changes resulted in $37 and $75 increases in net environmental liabilities in 2005 and 2004, respectively.
As of December 31, 2005, the allowance for uncollectible reinsurance totals $335. The Company currently expects to perform its regular comprehensive review of Other Operations reinsurance recoverables in the second quarter of 2006. The Company is engaged in pending litigation in Connecticut Superior Court against certain of its upper-layer reinsurers under its Blanket Casualty Treaty (“BCT”). For discussion of the Company’s BCT litigation and the potential effect on the Company’s net reinsurance recoverables, see Note 12 of Notes to Consolidated Financial Statements. Uncertainties regarding the factors that affect the allowance for uncollectible reinsurance could cause the Company to change its estimates, and the effect of these changes could be material to the Company’s consolidated results of operations or cash flows.
During the first quarter of 2004, the Company completed an updated gross asbestos reserve evaluation. As part of this evaluation, the Company also reviewed all of its open direct domestic insurance accounts exposed to asbestos liability as well as assumed reinsurance accounts and certain closed accounts. The Company also examined its London Market exposures for both direct insurance and assumed reinsurance. The evaluation indicated no change in the overall gross asbestos reserves.
The Company classifies its asbestos and environmental reserves into three categories: direct insurance, assumed reinsurance and London Market. Direct insurance includes primary and excess coverage. Assumed reinsurance includes both “treaty” reinsurance (covering broad categories of claims or blocks of business) and “facultative” reinsurance (covering specific risks or individual policies of primary or excess insurance companies). London Market business includes the business written by one or more of the Company’s subsidiaries in the United Kingdom, which are no longer active in the insurance or reinsurance business. Such business includes both direct insurance and assumed reinsurance.
Of the three categories of claims (direct, assumed reinsurance and London Market), direct policies tend to have the greatest factual development from which to estimate the Company’s exposures.
The following table sets forth, for the years ended December 31, 2005, 2004 and 2003, paid and incurred loss activity by the three categories of claims for asbestos and environmental.
Consistent with the Company’s long-standing reserving practices, the Company will continue to review and monitor its reserves in the Other Operations segment regularly and, where future developments indicate, make appropriate adjustments to the reserves. For a discussion of the Company’s reserving practices, please see the “Critical Accounting Estimates-Property & Casualty Reserves, Net of Reinsurance” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations. The loss reserving assumptions, drawn from both industry data and the Company’s experience, have been applied over time to all of this business and have resulted in reserve strengthening or reserve releases at various times over the past decade. The Company believes that its current asbestos and environmental reserves are reasonable and appropriate. However, analyses of future developments could cause the Company to change its estimates and ranges of its asbestos and environmental reserves, and the effect of these changes could be material to the Company’s consolidated operating results, financial condition and liquidity.
The Company expects to perform its regular reviews of asbestos liabilities in the second quarter of 2006 and environmental liabilities in the third quarter of 2006. If there are significant developments that affect particular exposures, reinsurance arrangements or the financial condition of particular reinsurers, the Company will make adjustments to its reserves, or the portion of liabilities it expects to cede to reinsurers.
The Other Operations segment will continue to manage the discontinued operations of The Hartford as well as claims (and associated reserves) related to asbestos, environmental and other exposures. The Hartford will continue to review various components of all of its reserves on a regular basis.
Return on general account invested assets is an important element of The Hartford’s financial results. Significant fluctuations in the fixed income or equity markets could weaken the Company’s financial condition or its results of operations. Additionally, changes in market interest rates may impact the period of time over which certain investments, such as mortgage-backed securities (“MBS”), are repaid and whether certain investments are called by the issuers. Such changes may, in turn, impact the yield on these investments and also may result in re-investment of funds received from calls and prepayments at rates below the average portfolio yield. Net investment income and net realized capital gains accounted for approximately 30%, 23% and 19% of the Company’s consolidated revenues for the years ended December 31, 2005, 2004 and 2003, respectively. The increase in the percentage of consolidated revenues for 2005, as compared to the prior years, is primarily due to an increase in the value of equity securities held for trading.
The Hartford’s investments in fixed maturities, which include bonds, redeemable preferred stock and commercial paper; and certain equity securities, which include common and non-redeemable preferred stocks, are classified as “available-for-sale” and accordingly are carried at fair value with the after-tax difference from cost or amortized cost, as adjusted 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, reflected in stockholders’ equity as a component of AOCI. 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, which approximates fair value. Other investments primarily consist of mortgage loans, limited partnership interests and derivatives. Mortgage loans on real estate are recorded at the outstanding principal balance adjusted for amortization of premiums or discounts and net of valuation allowances, if any. Limited partnerships are accounted for under the equity method and accordingly the Company’s share of partnership earnings are included in net investment income. Derivatives are carried at fair value.
Prices from independent pricing services are often unavailable for securities that are rarely traded or are traded only in privately negotiated transactions. As a result, certain of the Company’s ABS and commercial mortgage-backed securities (“CMBS”) are priced via broker quotations. A pricing matrix is used to price securities for which the Company is unable to obtain either a price from an independent third party service or an independent broker quotation. The pricing matrix begins with current treasury rates and uses credit spreads and issuer-specific yield adjustments received from an independent third party source to determine the market price for the security. The credit spreads, as assigned by a nationally recognized rating agency, incorporate the issuer’s credit rating and a risk premium, if warranted, due to the issuer’s industry and the security’s time to maturity. The issuer-specific yield adjustments, which can be positive or negative, are updated twice annually, as of June 30 and December 31, by an independent third party source and are intended to adjust security prices for issuer-specific factors. The matrix-priced securities at December 31, 2005 and 2004, primarily consisted of non-144A private placements and have an average duration of 5.0 and 4.8 years, respectively.
Net investment income on equity securities held for trading for 2005 was primarily generated by positive performance of the underlying investment funds supporting the Japanese variable annuity product, partially offset by foreign currency depreciation in comparison to the U.S. dollar. Net investment income on equity securities held for trading for 2004 was primarily generated by positive performance of the underlying investment funds supporting the Japanese variable annuity product as well as foreign currency appreciation in comparison to the U.S. dollar. The change in net investment income as compared to the prior year is primarily due to the performance of the underlying funds on a higher asset base.
The lower net gains on fixed maturity sales in 2005 were primarily the result of rising interest rates and losses associated with a major automotive manufacturer. See additional discussion of the gross gains and losses on sales below. If interest rates remain at current levels or rise during 2006, or credit spreads widen, net realized capital gains on fixed maturity sales for 2006 will likely be lower than the 2005 levels. The losses associated with the GMWB derivatives were primarily driven by changes in the GMWB rider valuation assumptions in the fourth quarter of 2005. For further discussion of the GMWB rider valuation assumption, see the Capital Markets Risk Management section of the MD&A under “Market Risk-Life”.
In 2005, gross losses on sales were primarily within the corporate sector. Gross losses for 2005 included $27 of losses on sales of securities related to a major automotive manufacturer, that primarily occurred during the second quarter. Sales related to actions taken to reduce issuer exposure in light of a downward adjustment in earnings and cash flows of the issuer primarily due to sluggish sales, rising employee and retiree benefit costs and an increased debt service interest burden, and to reposition the portfolio into higher quality securities. For 2005, excluding sales related to the automotive manufacturer noted above, there was no single security sold at a loss in excess of $6 and the average loss as a percentage of the fixed maturity’s amortized cost was less than 2%, which under the Company’s impairment policy was deemed to be depressed only to a minor extent.
2004 Compared to 2003 - Net investment income, excluding income on policy loans and equity securities held for trading, increased $859, or 47%, compared to the prior year. The increase in net investment income was primarily due to income earned on a higher average invested assets base, as compared to the prior year, and an increase in income from prepayment penalties primarily associated with CMBS and yield adjustments related to changes in prepayment speeds associated with MBS held at a premium or discount. These increases were partially offset by a decrease in the average new invested assets yield and the repositioning of the portfolio into higher quality assets as described below.
The increase in the average invested assets base, as compared to the prior year, was primarily the result of separate account assets reclassified to the general account pursuant to the adoption of SOP 03-1 and, to a lesser extent, assets acquired in the CNA acquisition and operating cash flows. Income earned on separate account assets reclassified to the general account, excluding equity securities held for trading, was $619 for 2004. Income earned on assets acquired in the CNA transaction was $116 for 2004.
During 2004, the yield on average invested assets decreased from the prior year as a result of new investment purchases at rates below the average portfolio yield due to the continued low interest rate environment and decreased policy loan income. Since the Company invests primarily in long-term fixed rate debt securities, changes in long-term interest rates impact the yield on new asset purchases
In 2004, gross gains were realized as fixed maturity credit spreads tightened and portions of the Life investment portfolios were repositioned into higher quality assets where the Company believed greater relative value existed. Credit spreads tightened primarily due to improved credit quality, market liquidity and demand for higher yielding assets, as well as the relatively low interest rate environment. It is expected that the higher quality assets will provide greater liquidity if the credit environment and issuer default rates return to historical norms. In addition, foreign government securities were sold, primarily in the first and fourth quarters of 2004, to reduce the portfolios’ exposure to foreign holdings and realize gains associated with the decline in value of the U.S. dollar against foreign currencies.
Separate account products are those for which a separate investment and liability account is maintained on behalf of the policyholder. The Company’s separate accounts reflect two categories of risk assumption: non-guaranteed separate accounts wherein the policyholder assumes substantially all the risk and reward; and guaranteed separate accounts wherein the Company contractually guarantees either a minimum return or the account value to the policyholder.
The primary investment objective for Property & Casualty’s Ongoing Operations segment is to maximize economic value while generating sufficient after-tax income to meet policyholder and corporate obligations. For Property & Casualty’s Other Operations segment, the investment objective is to ensure the full and timely payment of all liabilities. Property & Casualty’s investment strategies are developed based on a variety of factors including business needs, regulatory requirements and tax considerations.
The following table identifies the invested assets by type held as of December 31, 2005 and 2004.
During 2005, fixed maturities increased $920, or 4%, primarily due to positive operating cash flow and a decrease in long-term interest rates, partially offset by an increase in short-term to intermediate-term interest rates, credit spread widening and foreign currency depreciation in comparison to the U.S. dollar for foreign denominated securities.
2005 Compared to 2004 - Before-tax net investment income increased $117, or 9%, and after-tax net investment income increased $84, or 9%, compared to the prior year. The increases in net investment income were primarily due to income earned on a higher average invested assets base as well as higher partnership income. The increase in the average invested assets base, as compared to the prior year, was primarily due to positive operating cash flows. The higher partnership income was due to certain of the Company’s partnerships reporting higher market values and the result of certain partnerships liquidating their underlying investment holdings in the favorable market environment.
Net realized capital gains for 2005 decreased $89 as compared to the prior year primarily due to lower net realized gains on fixed maturity securities, lower periodic net coupon settlements on credit derivatives, as well as net losses on non-qualifying derivatives in 2005 compared to net gains in 2004. If interest rates remain at current levels or increase during 2006, or credit spreads widen, net realized capital gains would likely be lower than the 2005 levels.
In 2005, gross gains on sales were primarily within fixed maturities and were concentrated in the corporate and foreign government sectors and were the result of decisions to reposition the portfolio due to credit spread tightening in certain sectors and changes in foreign currency exchange rates. Certain lower quality corporate securities that had appreciated in value as a result of an improved corporate credit environment were sold to reposition the corporate holdings into higher quality securities. Foreign securities were sold to reduce the foreign currency exposure in the portfolio due to the expected near term volatility in foreign exchange rates. Also, certain foreign government securities appreciated in price and were sold to capture gains resulting from credit spread tightening since the date of purchase.
In 2005, gross losses were primarily within corporate and foreign government securities. Included in the corporate gross losses for 2005 are losses on sales of securities related to a major automotive manufacturer of $10 that primarily occurred during the second quarter. Sales related to actions taken to reduce issuer exposure in light of a downward adjustment in earnings and cash flows of the issuer primarily due to sluggish sales, rising employee and retiree benefit costs and an increased debt service interest burden, and to reposition the portfolio into higher quality securities. For 2005, excluding sales related to the automotive manufacturer noted above, there was no single security sold at a loss in excess of $3 and the average loss as a percentage of the fixed maturity’s amortized cost was less than 2%, which under the Company’s impairment policy, was deemed to be depressed only to a minor extent.
2004 Compared to 2003 - Before-tax net investment income increased $76, or 6%, and after-tax net investment income increased $43, or 5%, compared to the prior year. The increases in net investment income were primarily due to income earned on a higher average invested assets base in 2004, as compared to prior year, partially offset by a decrease in the average new invested assets yield and the repositioning of the portfolio into higher quality assets as described below.
In 2004, gross gains were realized as fixed maturity credit spreads tightened and portions of the Property & Casualty portfolios were repositioned into higher quality assets where HIMCO believed greater relative value existed. Credit spreads tightened primarily due to improved credit quality, market liquidity and demand for higher yielding assets, as well as the relatively low interest rate environment. It is expected that the higher quality assets will provide greater liquidity if the credit environment and issuer default rates return to historical norms. In addition, foreign government securities were sold, primarily in the first and fourth quarters of 2004, to reduce the portfolios’ exposure to foreign holdings and realize gains associated with the decline in value of the U.S. dollar against foreign currencies.
In 2004, securities sold at a loss were predominantly corporate securities, U.S. government securities, certain ABS and CMBS with no single security sold at a loss in excess of $5 and an average loss as a percentage of the fixed maturity’s amortized cost of less than 5%, which under the Company’s impairment policy were deemed to be depressed only to a minor extent. In 2003, no Property & Casualty security was sold at a loss in excess of $10.
HIMCO serves as collateral manager for four synthetic collateralized loan obligation trusts and a recently issued continuously offered ERISA-eligible institutional fund (collectively, “synthetic CLOs”) that invests in senior secured bank loans through total return swaps (“referenced bank loan portfolios”). HIMCO assumed collateral manager responsibilities for two of the synthetic CLOs in 2004 and subsequently sponsored and issued three additional synthetic CLOs (one in 2004 and two in 2005). The outstanding notional value of the referenced bank loan portfolios from the five synthetic CLOs was $1.7 billion and $1.1 billion as of December 31, 2005 and 2004, respectively.
As of December 31, 2005 and 2004, the synthetic CLOs had issued approximately $290 and $185 of notes and preferred shares (“CLO issuances”), respectively. The proceeds from the CLO issuances are invested in collateral accounts consisting of high credit quality securities and/or bank loans that are pledged to the referenced bank loan portfolios’ swap counterparties. Investors in the CLO issuances receive the net proceeds from the referenced bank loan portfolios. Any principal losses incurred by the swap counterparties associated with the referenced bank loan portfolios are borne by the CLO issuances investors through the total return swaps. Approximately $240 and $170 of the CLO issuances were held by third party investors as of December 31, 2005 and 2004, respectively. The third party investors in the synthetic CLOs have recourse only to the synthetic CLOs’ assets and not to the general credit of the Company. Accordingly, the Company’s financial exposure to these synthetic CLOs is limited to its direct investment in certain notes and preferred shares issued by the synthetic CLOs and loss of management fees.
Under FIN 46R, the Company is not deemed to be the primary beneficiary of the other three synthetic CLOs managed by HIMCO, one of which was issued in 2005. As a result, these synthetic CLOs are not consolidated by the Company. The Company’s maximum exposure to loss from the non-consolidated synthetic CLOs (consisting of the Company’s investments and accrued management fees) was approximately $21 and $3 as of December 31, 2005 and 2004. The collateral management fees earned by HIMCO for the three non-consolidated synthetic CLOs totaled $6 and $3 for the years ended December 31, 2005 and 2004, respectively, and are reported in other income in the consolidated statements of operations.
Future other-than-temporary impairment levels will depend primarily on economic fundamentals, political stability, issuer and/or collateral performance and future movements in interest rates. If interest rates continue to increase during 2006 or credit spreads widen, other-than-temporary impairments for 2006 may be higher than the 2005 levels. For further discussion of risk factors associated with sectors with significant unrealized loss positions, see the sector risk factor commentary under the Consolidated Total Available-for-Sale Securities with Unrealized Loss Greater than Six Months by Type table in the Investment Credit Risk section of the MD&A.
During 2004 there were no significant other-than-temporary impairments (e.g. $15 or greater) recorded on any single security or issuer. In aggregate, other-than-temporary impairments recorded on ABS primarily related to the decline in market values of certain previously impaired securities. Other-than-temporary impairments recorded on equity securities primarily related to variable rate perpetual preferred securities issued by two highly rated financial services companies. These securities are variable rate securities with unique structural interest rate reset characteristics that have sustained a decline in market value for an extended period of time primarily as a result of the increase in short-term interest rates after the security’s interest rate reset period. As of December 31, 2004, the Company did not hold other perpetual preferred securities in an unrealized loss position with similar interest rate reset characteristics.
Within ABS other-than-temporary impairments, there were approximately $31 of collateralized debt obligations (“CDOs”) and $29 of aircraft lease receivables. The CDO impairments consisted of approximately ten securities, the majority of which were interests in the lower tranches of securities backed by high yield corporate debt and were primarily the result of continued high default rates in 2003 and lower recovery rates on the CDOs’ underlying collateral. The aircraft lease receivable impairments primarily consisted of investments in lower tranches of five transactions. These securities are supported by aircraft leases and enhanced equipment trust certificates issued by multiple airlines that had sustained a steep decline in market value and adverse change in expected cash flows due to continued lower aircraft lease rates, airline bankruptcies and the prolonged decline in airline travel.
The Company’s derivative counterparty exposure policy establishes market-based credit limits, favors long-term financial stability and creditworthiness and typically requires credit enhancement/credit risk reducing agreements. Credit risk is measured as the amount owed to the Company based on current market conditions and potential payment obligations between the Company and its counterparties. Credit exposures are generally quantified daily, netted by counterparty for each legal entity of the Company, and collateral is pledged to and held by, or on behalf of, the Company to the extent the current value of derivatives exceeds the exposure policy thresholds which do not exceed $10. The Company also minimizes the credit risk in derivative instruments by entering into transactions with high quality counterparties rated Aa/A or better, which are monitored by the Company’s internal compliance unit and reviewed frequently by senior management. In addition, the compliance unit 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 all
Credit default swaps involve a transfer of credit risk from one party to another in exchange for periodic payments. One party to the contract will make a payment based on an agreed upon rate and a notional amount. The second party, who assumes credit exposure, will only make a payment when there is a credit event and such payment will be equal to the notional value of the swap contract less the value of the referenced security issuer debt obligation. A credit event is generally defined as default on contractually obligated interest or principal payments or bankruptcy. As of December 31, 2005 and 2004, the notional value of these credit default swaps, which exposed the Company to credit risk, totaled $700 and $447, respectively, and the swap fair value totaled $(4) and $3, respectively. As of December 31, 2005, the average S&P rating for these referenced security issuer debt obligations is A-.
The Company also uses credit default swaps to reduce its credit exposure by entering into agreements in which the Company pays a derivative counterparty a periodic fee in exchange for compensation from the counterparty should a credit event occur on the part of the referenced security issuer. Alternatively, the derivative counterparty may be required to purchase the referenced security at a predetermined value. The Company enters into these agreements as an efficient means to reduce credit exposure to the specified issuers. As of December 31, 2005 and 2004, the notional value of these credit default swaps totaled $254 and $215, respectively, and the swap fair value totaled $2 and $(1), respectively. As of December 31, 2005, the average S&P rating for these referenced securities issuers is BBB.
The following table identifies fixed maturity securities by type on a consolidated basis as of December 31, 2005 and 2004.
The Company’s fixed maturity portfolio gross unrealized gains and losses as of December 31, 2005, in comparison to December 31, 2004, were primarily impacted by changes in interest rates as well as credit spread movements, changes in foreign currency exchange rates and security sales. The Company’s fixed maturity gross unrealized gains decreased $1.6 billion and gross unrealized losses increased $498 from December 31, 2004 to December 31, 2005, primarily due to an increase in short-term through intermediate-term interest rates as well as credit spread widening and foreign currency depreciation in comparison to the U.S. dollar for foreign denominated securities, offset in part by a decrease in long-term interest rates and other-than-temporary impairments taken during the year. Gross unrealized gains and losses were reduced by securities sold in a gain or loss position, respectively.
Investment sector allocations as a percentage of total fixed maturities have changed since December 31, 2004, with a shift from certain corporate and short-term securities to CMBS due to their attractive yields relative to credit quality and MBS due to their relatively low risk profile and attractive spreads. The shift from corporate securities was primarily a result of capturing gains within the technology and communications sector due to credit spreads tightening as well as divesting securities that could be adversely impacted by issuers recapitalizing, pushing the Company’s interest lower in the repayment priority (e.g. leveraged buy-outs) or issuer capital uses that would not benefit the Company’s debt holders position (e.g. share repurchases). Also, HIMCO continues to overweight, in comparison to the Lehman Aggregate Index, ABS supported by diversified pools of consumer loans (e.g. home equity and auto loans and credit card receivables) and CMBS due to the securities’ attractive spread levels and underlying asset diversification and quality. In general, CMBS have lower prepayment risk than MBS due to contractual fees.
As of December 31, 2005 and 2004, 22% and 19%, respectively, of the fixed maturities were invested in private placement securities, including 15% and 12%, respectively, in Rule 144A offerings to qualified institutional buyers. Private placement securities are generally less liquid than public securities. Most of the private placement securities are rated by nationally recognized rating agencies.
The following table identifies fixed maturities by credit quality on a consolidated basis as of December 31, 2005 and 2004. The ratings referenced below are based on the ratings of a nationally recognized rating organization or, if not rated, assigned based on the Company’s internal analysis of such securities.
As of December 31, 2005 and 2004, 96% and 95%, respectively, or greater of the fixed maturity portfolio was invested in short-term securities or securities rated investment grade (BBB and above).
The following table presents the BIG fixed maturities by type as of December 31, 2005 and 2004.
The total securities classified as available-for-sale in an unrealized loss position for longer than six months by type as of December 31, 2005 and 2004 are presented in the following table.
The increase in total unrealized loss greater than six months since December 31, 2004, was primarily driven by an increase in short-term through intermediate-term interest rates as well as credit spread widening and foreign currency depreciation in comparison to the U.S. dollar for foreign denominated securities, offset in part by security sales, a decrease in long-term interest rates and other-than-temporary impairments taken during the year. With the exception of ABS security types, the majority of the securities in an unrealized loss position for six months or more as of December 31, 2005, were depressed primarily due to interest rate changes from the date of purchase. The sectors with the most significant concentration of unrealized losses at December 31, 2005 were CMBS, ABS supported by aircraft lease receivables and corporate fixed maturities primarily within the financial services sector. The Company’s current view of risk factors relative to these fixed maturity types is as follows:
CMBS - The CMBS in an unrealized loss position as of December 31, 2005, were primarily the result of an increase in interest rates from the security’s purchase date. Substantially all of these securities are investment grade securities priced at or greater than 90% of amortized cost as of December 31, 2005. Additional changes in fair value of these securities are primarily dependent on future changes in interest rates.
Financial services - As of December 31, 2005, the Company held approximately 200 different securities in the financial services sector that had been in an unrealized loss position for greater than six months. Substantially all of these securities are investment grade securities priced at or greater than 90% of amortized cost as of December 31, 2005. These positions are a mixture of fixed and variable rate securities with extended maturity dates, which have been adversely impacted by changes in interest rates after the purchase date. Additional changes in fair value of these securities are primarily dependent on future changes in interest rates.
collateral. As of December 31, 2005 and 2004, management’s expectation of the discounted future cash flows on these securities was in excess of the associated securities’ amortized cost. For a further discussion, see “Evaluation of Other-Than-Temporary Impairments on Available-for-Sale Securities” included in the Critical Accounting Estimates section of the MD&A and Note 1 of Notes to Consolidated Financial Statements.
The following table presents the Company’s unrealized loss aging for BIG and equity securities on a consolidated basis as of December 31, 2005 and 2004.
The increase in the BIG and equity security unrealized loss amount for securities classified as available-for-sale from December 31, 2004 to December 31, 2005, was primarily the result of the increase in short-term through intermediate-term interest rates as well as credit spread widening and foreign currency depreciation in comparison to the U.S. dollar for foreign denominated securities, offset in part by asset sales, a decrease in long-term interest rates and other-than-temporary impairments taken during the year. For further discussion, see the economic commentary under the Consolidated Fixed Maturities by Type table in this section of the MD&A.
The BIG and equity securities classified as available-for-sale in an unrealized loss position for longer than six months by type as of December 31, 2005 and 2004 are presented in the following table.
The decrease in the consolidated available-for-sale BIG and equity securities greater than six months unrealized loss amount since December 31, 2004, was primarily the result of other-than-temporary impairments taken during the year, asset sales and a decrease in long-term interest rates partially offset by the increase in short-term through intermediate-term interest rates as well as credit spread widening and foreign currency depreciation in comparison to the U.S. dollar for foreign denominated securities. For further discussion of risk factors associated with sectors with significant unrealized loss positions, see the sector risk factor commentary under the Consolidated Total Available-for-Sale Securities with Unrealized Loss Greater than Six Months by Type table in this section of the MD&A.
To calculate duration, projections of asset and liability cash flows are discounted to a present value using interest rate assumptions. These cash flows are then revalued at alternative interest rate levels to determine the percentage change in fair value due to an incremental change in rates. Cash flows from corporate obligations are assumed to be consistent with the contractual payment streams on a yield to worst basis. The primary assumptions used in calculating cash flow projections include expected asset payment streams taking into account prepayment speeds, issuer call options and contract holder behavior. ABS, CMOs and MBS are modeled based on estimates of the rate of future prepayments of principal over the remaining life of the securities. These estimates are developed using prepayment speeds provided in broker consensus data. Such estimates are derived from prepayment speeds previously experienced at the interest rate levels projected for the underlying collateral. Actual prepayment experience may vary from these estimates.
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 Aa with maturities between zero and thirty years. Declines in long-term interest rates have had a negative impact on the funded status of the plans. For a further discussion of interest rate risk associated with the plans, see the Critical Accounting Estimates section of the MD&A under “Pension and Other Postretirement Benefit Obligations” and Note 17 of Notes to Consolidated Financial Statements.
The Company’s currency exchange risk is related to non-U.S. dollar denominated investments, which primarily consist of fixed maturity investments, the investment in the Japanese Life operation, its GMDB and GMIB benefits associated with its Japanese variable annuities, and a yen denominated individual fixed annuity product. A significant portion of the Company’s foreign currency exposure is mitigated through the use of derivatives.
Financial futures are standardized commitments to either purchase or sell designated financial instruments, at a future date, for a specified price and may be settled in cash or through delivery of the underlying instrument. Futures contracts trade on organized exchanges. Margin requirements for futures are met by pledging securities, and changes in the futures’ contract values are settled daily in cash.
Derivative activities are monitored by an internal compliance unit and reviewed frequently by senior management. The notional amounts of derivative contracts represent the basis upon which pay or receive amounts are calculated and are not reflective of credit risk. Notional amounts pertaining to derivative instruments used in the management of market risk at December 31, 2005 and 2004, were $62.9 billion and $54.1 billion, respectively. The increase in the derivative notional amount during 2005 was primarily due to the embedded derivatives associated with the GMWB product feature. For further information, see Note 4 of Notes to Consolidated Financial Statements.
While interest rate risk associated with many of these products has been reduced through the use of market value adjustment features and surrender charges, the primary risk associated with these products is that the spread between investment return and credited rate may not be sufficient to earn targeted returns.
Interest rate caps and floors, swaptions and option contracts are primarily used to hedge against the risk of liability contract holder disintermediation in a rising interest rate environment, and to offset the changes in fair value of corresponding derivatives embedded in certain of the Company’s fixed maturity investments.
The after-tax change in the net economic value of investment contracts (e.g. guaranteed investment contracts) and certain other insurance product liabilities (e.g. short-term and long-term disability contracts), for which the payment rates are fixed at contract issuance and the investment experience is substantially absorbed by Life, are included in the following table along with the corresponding invested assets. Also included in this analysis are the interest rate sensitive derivatives used by Life to hedge its exposure to interest rate risk. Certain financial instruments, such as limited partnerships, have been omitted from the analysis due to the fact that the investments are accounted for under the equity method and generally lack sensitivity to interest rate changes. Non-guaranteed separate account assets and liabilities and equity securities held for trading and the corresponding liabilities associated with the variable annuity products sold in Japan are excluded from the analysis because gains and losses in separate accounts accrue to policyholders. The hypothetical calculation of the estimated change in net economic value below assumes a 100 basis point upward and downward parallel shift in the yield curve.
The Company identifies the most appropriate investment strategy based upon the expected policyholder behavior and liability crediting needs. The hypothetical calculation of the estimated change in fair value below assumes a 100 basis point upward and downward parallel shift in the yield curve.
The Company sells variable annuity contracts that offer one or more benefit guarantees, the value of which, generally increases with declines in equity markets. As is described in more detail below, the Company manages the equity market risks embedded in these guarantees through reinsurance, product design and hedging programs. The Company believes its ability to manage these equity market risks by these means gives it a competitive advantage; and, in particular, its ability to create innovative product designs that allow the Company to meet identified customer needs while generating manageable amounts of equity market risk. The Company’s relative sales and variable annuity market share have generally increased during periods when it has recently introduced new products to the market. In contrast, the Company’s relative sales and market share have generally decreased when competitors introduce products that cause an issuer to assume larger amounts of equity and other market risk than the Company is confident it can prudently manage. The Company believes its long-term success in the variable annuity market will continue to be aided by successful innovation in both product design and in equity market risk management and that, in the absence of this innovation, its market share could decline. Currently, the Company is experiencing lower levels of U.S. variable annuity sales as competitors continue to introduce equity guarantees of increasing risk and complexity. New product development is an ongoing process and during the fourth quarter of 2005, the Company introduced a new living income benefit, which guarantees a steady income stream for the life of the policyholder. Depending on customer acceptance and competitor reaction to the Company’s product innovations, the Company’s future level of sales is subject to a high level of uncertainty.
The accounting for various benefit guarantees offered with variable annuity contracts can be significantly different. Those accounted for under SFAS No. 133 (such as GMWBs) are subject to significant fluctuation in value, which is reflected in net income, due to changes in interest rates, equity markets and equity market volatility as use of those capital market rates are required in determining the liability’s fair value at each reporting date. Benefit guarantee liabilities accounted for under SOP 03-1 (such as GMIBs and GMDBs) may also change in value; however, the change in value is not immediately reflected in net income. Under SOP 03-1, the income statement reflects the current period increase in the liability due to the deferral of a percentage of current period revenues. The percentage is determined by dividing the present value of claims by the present value of revenues using best estimate assumptions over a range of market scenarios. Current period revenues are impacted by actual increases or decreases in account value. Claims recorded against the liability have no immediate impact on the income statement unless those claims exceed the liability. As a result of these significant accounting differences the liability for guarantees recorded under SOP 03-1 may be significantly different if it was recorded under SFAS No. 133 and vice versa. In addition, the conditions in the capital markets in Japan vs. those in the U.S. are sufficiently different that if the Company’s GMWB product currently offered in the U.S. were offered in Japan, the capital market conditions in Japan would have a significant impact on the valuation of the GMWB, irrespective of the accounting model. The same would hold true if the Company’s GMIB product currently offered in Japan were to be offered in the U.S. Capital market conditions in the U.S. would
have a significant impact on the valuation of the GMIB. Many benefit guarantees meet the definition of an embedded derivative, under SFAS No. 133 (GMWB), and as such are recorded at fair value with changes in fair value recorded in net income. However, certain contract features that define how the contract holder can access the value of the guaranteed benefit change the accounting from SFAS No. 133 to SOP 03-1. For contracts where the contract holder can only obtain the value of the guaranteed benefit upon the occurrence of an insurable event such as death (GMDB) or by making a significant initial net investment (GMIB), such as when one invests in an annuity, the accounting for the benefit is prescribed by SOP 03-1.
During 2005, the Company periodically entered into forward starting Standard and Poor’s (“S&P”) 500 put options, as well as S&P index futures and interest rate swap contracts (“anticipated future sales hedges”) to economically hedge the equity volatility risk exposure associated with anticipated future sales of the GMWB rider. As of December 31, 2005, there were no open anticipated future sales hedges and the net after-tax gain related to this hedge strategy was $8.
The Company purchases one and two year S&P 500 Index put option contracts to economically hedge certain liabilities that could increase if the equity markets decline. As of December 31, 2005 and 2004, the notional value related to this strategy was $1.1 billion and $1.9 billion, respectively, while the fair value related to this strategy was $14 and $32, respectively. Because this strategy is intended to partially hedge certain equity-market sensitive liabilities calculated under statutory accounting (see Capital Resources and Liquidity), changes in the value of the put options may not be closely aligned to changes in liabilities determined in accordance with Generally Accepted Accounting Principles (“GAAP”), causing volatility in GAAP net income. The Company anticipates employing similar strategies in the future, which could further increase volatility in GAAP net income.
Foreign currency exchange risk exists with respect to investments in non-U.S. dollar denominated fixed maturities, primarily denominated in euro, sterling, yen and Canadian dollars, as well as Life’s investment in foreign operations, primarily Japan, and the yen based individual fixed annuity product and its GMDB and GMIB benefits associated with its Japanese variable annuities.
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 at December 31, 2005 and 2004, were approximately $1.9 billion and $2.5 billion, respectively. In order to manage its currency exposures, Life enters into foreign currency swaps and forwards to hedge the variability in cash flow associated with certain foreign denominated fixed maturities. These foreign currency swap agreements are structured to match the foreign currency cash flows of the hedged foreign denominated securities. At December 31, 2005 and 2004, the derivatives used to hedge currency exchange risk related to non-U.S. dollar denominated fixed maturities had a total notional value of $2.0 billion and $1.7 billion, respectively, and total fair value of $(232) and $(503), respectively.
2005 and 2004, respectively. The fair value of these and Property & Casualty’s other invested assets fluctuates depending on the interest rate environment and other general economic conditions. During periods of declining interest rates, embedded call features within securities are exercised with greater frequency and paydowns on MBS and CMOs increase as the underlying mortgages are prepaid. During such periods, the Company generally will not be able to re-invest the proceeds of any such prepayments at comparable yields. Conversely, during periods of rising interest rates, the rate of prepayments generally decline. Derivative instruments such as swaps, caps and options are used to manage interest rate risk and had a total notional amount as of December 31, 2005 and 2004 of $1.5 billion and fair value of $(9) and $7, respectively.
One of the measures Property & Casualty uses to quantify its exposure to interest rate risk inherent in its invested assets is duration. The weighted average duration of the fixed maturity portfolio was 4.6 years as of December 31, 2005 and 2004. In 2005, the duration of the Property & Casualty portfolios were modestly shortened in anticipation of higher future interest rates.
Foreign currency exchange risk exists with respect to investments in non-U.S. dollar denominated fixed maturities, primarily euro, sterling and Canadian dollar denominated securities. The risk associated with these securities relates to potential decreases in value resulting from unfavorable changes in foreign exchange rates. The fair value of these fixed maturity securities at December 31, 2005 and 2004 was $1.1 billion and $1.4 billion, respectively.
In order to manage its currency exposures, Property & Casualty enters into foreign currency swaps and forward contracts to hedge the variability in cash flow associated with certain foreign denominated securities. These foreign currency swap agreements are structured to match the foreign currency cash flows of the hedged foreign denominated securities. At December 31, 2005 and 2004, the derivatives used to hedge currency exchange risk had a total notional value of $515 and $370, respectively, and total fair value of $(19) and $(70), respectively.
The liquidity requirements of The Hartford have been and will continue to be met by funds from operations as well as the issuance of commercial paper, common stock, debt securities and borrowings from its credit facilities. Current and expected patterns of claim frequency and severity may change from period to period but continue to be within historical norms and, therefore, the Company’s current liquidity position is considered to be sufficient to meet anticipated demands. However, if an unanticipated demand was placed on the Company it is likely that the Company would either sell certain of its investments to fund claims which could result in larger
As previously disclosed, the Company has been in the process of evaluating alternative capital structures related to its Japanese life insurance operations that it believes in the long term could result in improved financial flexibility. The Company’s Japanese life insurance operations are conducted through Hartford Life Insurance K.K. (“HLIKK”), which, prior to September 1, 2005, was a wholly owned subsidiary of Hartford Life and Accident Insurance Company (“HLA”), one of the Company’s principal statutorily regulated operating subsidiaries. Prior to September 1, 2005, the Company funded the capital needs of its Japanese operations through investments in the common stock of HLIKK by HLA. This arrangement generally allowed some portion of the Company’s investment
During the second quarter of 2005, the Company sought and secured approval of a proposed plan to change the ownership structure of HLIKK. The proposed plan provided for a change in the ownership of HLIKK whereby the stock of HLIKK, an insurance operating company, would be transferred to Hartford Life, Inc., HLA’s parent company. The proposed plan was approved by both the State of Connecticut Insurance Department, HLA’s primary regulator, as well as the FSA, HLIKK’s primary regulator. On September 1, 2005 this plan was executed and the stock of HLIKK was transferred from HLA to Hartford Life, Inc. The transfer of the stock has been treated as a return of capital for GAAP and statutory accounting purposes for the respective entities. This transaction had no effect on the Company’s consolidated financial statements. The primary financial effect of the transaction was to reduce the statutory capital of HLA by the amount of the carrying value of HLIKK, which was $963 as of September 1, 2005. In addition, for certain capital adequacy ratios, a corresponding reduction in required capital will occur, which will result in an improved capital adequacy ratio. However, as previously disclosed, this action could potentially reduce certain other capital adequacy ratios employed by regulators and rating agencies to assess the capital growth of The Hartford’s life insurance operations. At the current time, taking into consideration the effects of the transaction, the Company believes it has sufficient capital resources to maintain capital solvency ratios consistent with all of its objectives.
The Company’s Board of Directors has authorized the repurchase of outstanding shares of its common stock and equity units from time to time, in an aggregate amount not to exceed $1 billion. For additional information regarding the Company’s authorization to repurchase its securities, please see the “Stockholders’ Equity” section below.
limitations on the payment of dividends. The Company’s insurance subsidiaries are permitted to pay up to a maximum of approximately $1.9 billion in dividends to HFSG in 2006 without prior approval from the applicable insurance commissioner. However, through August 31, 2006 HLA, comprising $667 of the $1.9 billion, will need prior approval from the insurance commissioner to pay dividends. In 2005, HFSG and HLI received a combined total of $1.9 billion from their insurance subsidiaries, which includes a $963 dividend of HLIKK to HLI.
The principal sources of operating funds are premium, fees and investment income, while investing cash flows originate from maturities and sales of invested assets. The primary uses of funds are to pay claims, policy benefits, operating expenses and commissions and to purchase new investments. In addition, The Hartford has a policy of carrying a significant short-term investment position and accordingly does not anticipate selling intermediate- and long-term fixed maturity investments to meet any liquidity needs. (For a discussion of the Company’s investment objectives and strategies, see the Investments and Capital Markets Risk Management sections.)
On September 7, 2005, The Hartford and HLI entered into a $1.6 billion Five-Year Competitive Advance and Revolving Credit Facility Agreement (the “Credit Agreement”) with a syndicate of financial institutions. The Credit Agreement replaced (i) The Hartford’s $1.0 billion Second Amended and Restated Five-Year Competitive Advance and Revolving Credit Facility Agreement dated as of February 26, 2003, as amended, and (ii) The Hartford’s and HLI’s $490 Three-Year Competitive Advance and Revolving Credit Facility Agreement, dated as of December 31, 2002, as amended.
Under the revolving credit facility, the Company must maintain a minimum level of consolidated statutory surplus. In addition, the Company must not exceed a maximum ratio of debt to capitalization. Quarterly, the Company certifies compliance with the financial covenants for its banks. As of December 31, 2005, the Company was in compliance with all such covenants.
The Company does not have any off-balance sheet arrangements that are reasonably likely to have a material effect on the financial condition, results of operations, liquidity, or capital resources of the Company, except for the following:
• The Company has unfunded commitments to purchase investments in limited partnerships and mortgage loans totaling $754 as disclosed in Note 12 of Notes to Consolidated Financial Statements.
• Under generally accepted accounting principles, the Company is only permitted to discount reserves for claim and claim adjustment expenses in cases where the payment pattern and ultimate loss costs are fixed and reliably determinable on an individual claim basis. For the Company, these include claim settlements with permanently disabled claimants and certain structured settlement contracts that fund loss runoffs for unrelated parties. As of December 31, 2005, the total property and casualty reserves in the above table of $22,874 are gross of the reserve discount of $608.
[4] Includes $1.3 billion in commitments to purchase investments including $366 of limited partnerships and $388 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 estimated. The remaining $520 relates to payables for securities purchased which are reflected on the Company’s consolidated balance sheet.
[6] Includes $42 in collateralized loan obligations (“CLOs”) issued to third-party investors by consolidated investment management entities sponsored by the Company in connection with synthetic CLO transactions. The CLO investors have no recourse to the Company’s assets other than the dedicated assets collateralizing the CLOs. Refer to Note 4 of Notes to Consolidated Financial Statements for additional discussion of CLOs.
[7] Does not include estimated voluntary contribution of $200 to the Company’s pension plan in 2006.
The Company made contributions to its pension plans of $504, $317 and $306 in 2005, 2004 and 2003, respectively. The Company’s 2005 required minimum funding contribution was immaterial. The Company presently anticipates contributing approximately $200 to its pension plans in 2006, 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’s 2006 required minimum funding contribution is expected to be immaterial.
The capital structure of The Hartford as of December 31, 2005 and 2004 consisted of debt and equity, summarized as follows:
Includes junior subordinated debentures of $691 and $704 and debt associated with equity units of $1,020 and $1,020 as of December 31, 2005 and 2004, respectively.
On June 15, 2005, HLI repaid $250 of 7.75% senior notes at maturity.
Dividends - On February 16, 2006, The Hartford’s Board of Directors declared a quarterly dividend of $0.40 per share payable on April 3, 2006 to shareholders of record as of March 1, 2006.
On October 20, 2005, The Hartford declared a dividend on its common stock of $0.30 per share payable on January 3, 2006 to shareholders of record as of December 1, 2005.
Rights Agreement - Pursuant to the terms of the Rights Agreement dated as of November 1, 1995 between The Hartford and The Bank of New York as Rights Agent, the shareholders’ rights associated with The Hartford’s common stock expired on November 1, 2005.
The following table summarizes The Hartford’s significant member companies’ financial ratings from the major independent rating organizations as of February 22, 2006.
The National Association of Insurance Commissioners (“NAIC”) has regulations establishing minimum capitalization requirements based on risk-based capital (“RBC”) formulas for both life and property and casualty companies. The requirements consist of formulas, which identify companies that are undercapitalized and require specific regulatory actions. The RBC formula for life companies establishes capital requirements relating to insurance, business, asset and interest rate risks. RBC is calculated for property and casualty companies after adjusting capital for certain underwriting, asset, credit and off-balance sheet risks. As of December 31, 2005, each of The Hartford’s insurance subsidiaries within Life and Ongoing Property & Casualty had more than sufficient capital to meet the NAIC’s minimum RBC requirements.
The C-3 Phase II Capital project addresses the equity, interest rate and expense recovery risks associated with variable annuities and group annuities that contain death benefits or certain living benefit guarantees including GMWBs. The capital requirements under C-3 Phase II are principle-based, which represents a change from the current factor-based approach. Under the new methodology, capital requirements are determined at a point in time using stochastic scenario testing and give credit for risk management strategies employed such as hedging and reinsurance. The Company expects the capital requirements to fluctuate primarily with changes in market levels and returns.
Dependence on Certain Third Party Relationships - The Company distributes its annuity, life and certain property and casualty insurance products through a variety of distribution channels, including broker-dealers, banks, wholesalers, its own internal sales force and other third party organizations. The Company periodically negotiates provisions and renewals of these relationships and there can be no assurance that such terms will remain acceptable to the Company or such third parties. An interruption in the Company’s continuing relationship with certain of these third parties could materially affect the Company’s ability to market its products.
TRIA is scheduled to expire on December 31, 2007. In the event terrorism reinsurance legislation is not extended or renewed after December 2007, the Company may attempt to limit certain of its writings or obtain supplemental reinsurance protection, if available. For a discussion of The Hartford’s Risk Management processes as they relate to terrorism reinsurance legislation, please see the “Property & Casualty-Risk Management Strategy” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.
On May 26, 2005, the Senate Judiciary Committee approved legislation that provides for the creation of a Federal asbestos trust fund in place of the current tort system for determining asbestos liabilities. On February 6, 2006, the Senate began consideration of S. 852, “The Fairness in Asbestos Injury Resolution Act of 2005”. However, the proponents were unable to secure the sixty votes necessary to overcome a procedural budget objection. The prospects for enactment and the ultimate details of any legislation creating a Federal asbestos trust fund remain very uncertain. Depending on the provisions of any legislation which is ultimately enacted, the legislation may have a material adverse effect on the Company.
In all states, insurers licensed to transact certain classes of insurance are required to become members of a guaranty fund. In most states, in the event of the insolvency of an insurer writing any such class of insurance in the state, members of the funds are assessed to
The Hartford accounts for guaranty fund and other insurance assessments in accordance with Statement of Position No. 97-3, “Accounting by Insurance and Other Enterprises for Insurance-Related Assessments”. Liabilities for guaranty fund and other insurance-related assessments are accrued when an assessment is probable, when it can be reasonably estimated, and when the event obligating the Company to pay an imposed or probable assessment has occurred. Liabilities for guaranty funds and other insurance-related assessments are not discounted and are included as part of other liabilities in the Consolidated Balance Sheets. As of December 31, 2005 and 2004, the liability balance was $223 and $215, respectively. As of December 31, 2005 and 2004, $20 and $14, respectively, related to premium tax offsets were included in other assets.