2004 includes a $23 after-tax charge related to the cumulative effect of accounting change for the Company’s adoption of the AICPA issued Statement of Position 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts”.
As a result of the net loss for the year ended December 31, 2003, Statement of Financial Accounting Standards 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.
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, 2006, compared with December 31, 2005, and its results of operations for each of the three years in the period ended December 31, 2006. 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.
Life is organized into six reportable operating segments: Retail Products Group (“Retail”), Retirement Plans, Institutional Solutions Group (“Institutional”), Individual Life, Group Benefits and International. Through Life the Company provides retail and institutional investment products such as variable and fixed annuities, mutual funds, private placement life insurance and retirement plan services, individual life insurance products including variable universal life, universal life, interest sensitive whole life and term life; and group benefit products, such as group life and group disability insurance.
Property & Casualty is organized into four reportable operating segments: the underwriting segments of Business Insurance, Personal Lines and Specialty Commercial (collectively “Ongoing Operations”), and the Other Operations segment. Through Property & Casualty the Company provides a number of coverages, as well as insurance-related services, to businesses throughout the United States, including workers’ compensation, property, automobile, liability, umbrella, specialty casualty, marine, livestock, fidelity and surety, professional liability and director’s and officer’s liability coverages. Property & Casualty also provides automobile, homeowners, and home-based business coverage to individuals throughout the United States, as well as insurance-related services to businesses.
As the Company has disclosed previously, the Company pays brokers and independent agents commissions and other forms of incentive compensation in connection with the sale of many of the Company’s insurance products. Since the New York Attorney General’s Office filed a civil complaint against Marsh on October 14, 2004, several of the largest national insurance brokers, including Marsh, Aon Corporation and Willis Group Holdings Limited, have announced that they have discontinued the use of contingent compensation arrangements. Other industry participants may make similar, or different, determinations in the future. In addition, legal, legislative, regulatory, business or other developments may require changes to industry practices relating to incentive compensation.
reported loss cost trends and other factors that could affect the reserve estimates. The output of the reserve reviews are reserve estimates that are referred to herein as the “actuarial indication”.
The actuarial techniques or methods used include paid and reported loss development, frequency / severity, expected loss ratio and Bornhuetter-Ferguson techniques. Within any one line of business, a variety of techniques are used. Within any one line of business, certain methods are generally given more influence in determining the actuarial indication. The methods that are given more influence vary within a line of business based primarily on the maturity of the accident year, the mix of business and the particular internal and external influences impacting the claims experience or the methods. The following is a discussion of the most common methods used; these methods are not used for every line of business or every accident year within a line of business.
Paid Development method. Historical data, organized by accident period and calendar period, is used to develop paid loss development patterns, which are then applied to current paid losses by accident period to estimate ultimate losses. The paid development method is also used to estimate reserves for allocated loss adjustments expenses (ALAE).
For all lines of business, variations of the above methods are used. Examples of variation within the paid and reported development methods include:
For each line of business, certain methods are given more influence than other methods. The discussion below gives a general indication of which methods are preferred by line of business. Because the actuarial estimates are generated at a much finer level of detail than line of business (e.g., by distribution channel, coverage, accident period), this description should not be assumed to apply to each coverage and accident year within a line of business. Also, as circumstances change, the methods that are given more influence will change. For example, for Personal Lines auto liability claims, reported development techniques are currently not given significant influence in making estimates for recent accident years because case reserving practices have been changing in the recent past. If case reserving practices become more stable, reported development techniques may be given more weight.
Long-Tailed General Liability, Fidelity and Surety and Large Deductible Workers’ Compensation. For these very long-tailed lines of business, the Company generally relies on the expected loss ratio, Bornhuetter-Ferguson and reported development techniques. Management generally weights these techniques together, relying more heavily on the expected loss ratio method at early ages of development and more on the reported development method as an accident year matures.
Workers’ Compensation. Workers’ compensation is the Company’s single largest reserve line of business and management does the largest amount of actuarial analysis on this line of business. Methods performed include paid and reported development, variations on expected loss ratio methods, and an in-depth analysis on the largest states. Paid development patterns are historically very stable in the Company’s workers’ compensation business, so paid techniques are preferred for older accident periods. For more recent periods, paid techniques are less predictive of the ultimate liability since such a low percentage of ultimate losses are paid in early periods of development. Accordingly, for more recent accident periods, the Company generally relies more heavily on a state-by-state analysis and the expected loss ratio approach.
The final step in the reserve review process involves a comprehensive review by senior reserving actuaries who apply their judgment and, in concert with senior management, determine the appropriate level of reserves based on the various information that has been accumulated. 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 2006, total recorded net reserves excluding asbestos and environmental and excluding the allowance for uncollectible reinsurance were 2.2% 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.
During 2006, there were numerous changes to non-A&E reserve estimates. Among other loss developments in 2006, these changes included an $83 reduction in catastrophe reserves related to the 2005 and 2004 hurricanes, a $58 release of Business Insurance allocated
In Personal Lines, reserving estimates are generally less variable than for the Company’s other property and casualty segments. This is largely due to the coverages having relatively shorter periods of loss emergence. Estimates, however, can still vary due to a number of factors, including interpretations of frequency and severity trends and their impact on recorded reserve levels. Severity trends can be impacted by changes in internal claim handling and case reserving practices in addition to changes in the external environment. These changes in claim practices increase the uncertainty in the interpretation of case reserve data, which increases the uncertainty in recorded reserve levels. In addition, the success of the Company’s new Dimensions class plan for automobile first introduced in 2004 has lead to a different mix of business by type of insured than the Company experienced in the past. In general, the Company now has a lower proportion of preferred risks than in the past. Such a change in mix increases the uncertainty of the reserve projections, since historical data and reporting patterns may not be applicable to the new business.
In the Specialty Commercial segment, many lines of insurance, such as excess insurance and large deductible workers’ compensation insurance are “long-tail” lines of insurance. For long-tail lines, the period of time between the incidence of the insured loss and either the reporting of the claim to the insurer, the settlement of the claim, or the payment of the claim can be substantial, and in some cases, several years. As a result of this extended period of time for losses to emerge, reserve estimates for these lines are more uncertain (i.e. more variable) than reserve estimates for shorter-tail lines of insurance. Estimating required reserve levels for large deductible workers’ compensation insurance is further complicated by the uncertainty of whether losses that are attributable to the deductible amount can be paid by the insured; if such losses are not paid by the insured due to financial difficulties, the Company would be contractually liable. Another example of reserve variability relates to reserves for directors and officers insurance. There is uncertainty in the required level of reserves due to the impact of recent allegations within the financial services industry, including those in the mutual fund, investment banking and insurance industries.
in key assumptions is a reasonable estimate of possible variation that may occur in the future, likely over a period of several calendar years. It is important to note that the variation discussed is not meant to be a worst-case scenario, and therefore, it is possible that future variation may be more than the amounts discussed below.
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 HartRe assumed reinsurance business, excluding asbestos and environmental liabilities, within Other Operations were $813 as of December 31, 2006. If the reported loss development patterns underlying the Company’s net reserves for HartRe assumed casualty reinsurance change by 10%, the estimated net reserve need would change by $254, in either direction. A 10% change in reported loss development patterns is within historical variation, as measured by the variation around the average development factors as reported in statutory accident year reports.
respective shares of liability of potentially responsible parties at each site, the appropriateness and cost of remediation at each site, the nature of governmental enforcement activities at each site, and potential bankruptcy impact.
For both asbestos and environmental reserves, the Company also compares its historical direct net loss and expense paid and incurred experience, and net loss and expense paid and incurred experience year by year, to assess any emerging trends, fluctuations or characteristics suggested by the aggregate paid and incurred activity.
In the case of the reserves for environmental exposures, factors contributing to the high degree of uncertainty include expanding theories of liability and damages; the risks inherent in major litigation; inconsistent decisions concerning the existence and scope of coverage for environmental claims; and uncertainty as to the monetary amount being sought by the claimant from the insured.
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, 2006 represent the Company’s best estimate of its ultimate liability for losses and loss adjustment expenses related to losses covered by policies written by the Company. However, because of the significant uncertainties surrounding reserves, and particularly asbestos exposures, it is possible that management’s estimate of the ultimate liabilities for these claims may change and that the required adjustment to recorded reserves could exceed the currently recorded reserves by an amount that could be material to the Company’s results of operations, financial condition and liquidity.
The Company amortizes DAC related to investment contracts and universal life-type contracts (including individual variable annuities) using the retrospective deposit method. Under the retrospective deposit method, acquisition costs are amortized in proportion to the present value of estimated gross profits (“EGPs”). EGPs are also used to amortize other assets and liabilities on the Company’s balance sheet, such as sales inducement assets and unearned revenue reserves. Components of EGPs are used to determine reserves for guaranteed minimum death and income benefits. For most contracts, the Company evaluates EGPs over a 20 year horizon as estimated profits emerging subsequent to year 20 are immaterial. The Company uses other measures for amortizing DAC, such as gross costs (net of reinsurance), as a replacement for EGPs when EGPs are expected to be negative for multiple years of the contract’s life. The Company also adjusts the DAC balance, through other comprehensive income, by an amount that represents the amortization of DAC that would have been required as a charge or credit to operations had unrealized gains and losses on investments been realized. Actual gross profits, in a given reporting period, that vary from management’s initial estimates result in increases or decreases in the rate of amortization, commonly referred to as a “true-up”, which are recorded in the current period. The true-up recorded for the years ended December 31, 2006, 2005 and 2004 was an increase to amortization of $41, $18 and $16, respectively.
Estimating future gross profits is a complex process requiring considerable judgment and the forecasting of events well into the future. Estimating future gross profits is important not only for determining the amortization of DAC but also in the accounting and valuation of sales inducement assets, unearned revenue reserves and guaranteed minimum death and income benefit reserves. The estimation process, the underlying assumptions and the resulting EGPs, are evaluated regularly.
In addition to when a comprehensive assumption study is completed, revisions to best estimate assumptions used to estimate future gross profits are necessary when the EGPs in the Company’s models fall outside of a reasonable range of EGPs. The Company performs a quantitative process each quarter to determine the reasonable range of EGPs. This process 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 assumptions with respect to lapse rates, mortality, and expenses, based on the Company’s most recent assumption study. 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 Company’s models. If EGPs used in the Company’s models fall outside of the statistical ranges of reasonable EGPs, an “unlock” would be necessary. A similar approach is used for variable universal life business.
As described above, during the fourth quarter of 2006, the Company completed a comprehensive study of assumptions underlying EGPs, resulting in an “unlock”. The study covered all assumptions, including mortality, lapses, expenses and separate account returns, in substantially all product lines. The new best estimate assumptions were applied to the current in-force to project future gross profits. The impact on the Company’s assets and liabilities as a result of the unlock during the fourth quarter was as follows:
As a result of the unlock in the fourth quarter of 2006, the Company expects total Company DAC amortization to be lower than it would have been in 2007 if the unlock had not occurred. This effect of the lower DAC amortization in 2007 is expected to result in an increase to net income of approximately $12, after-tax, of which approximately $6 relates to Retail Products Group. The impact on amortization in 2007 for other segments is immaterial.
The Company offers certain variable annuity products with a guaranteed minimum withdrawal benefit (“GMWB”) rider. The fair value of the GMWB 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, best estimate assumptions and stochastic techniques under a variety of market return scenarios 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. For example, independent future decreases in equity market returns, future decreases in interest rates and future increases in equity index volatility will all have the effect of decreasing the GMWB asset as of December 31, 2006 resulting in a realized loss in net income. Furthermore, changes in policyholder behavior can also significantly change the value of the GMWB. For example, independent future increases in fund mix towards equity based funds vs. bond funds, future increases in withdrawals, future increasing mortality, future increasing usage of the step-up feature and decreases in lapses will all have the effect of decreasing the GMWB asset as of December 31, 2006 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 as of December 31, 2006 resulting in a realized gain in net
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 accumulated other comprehensive income (“AOCI”).
One of the significant estimates related to available-for-sale securities is the evaluation of investments for other-than-temporary impairments. If a decline in the fair value of an available-for-sale security is judged to be other-than-temporary, a charge is recorded in net realized capital losses equal to the difference between the fair value and cost or amortized cost basis of the security. In addition, for securities expected to be sold, an other-than-temporary impairment charge is recognized if the Company does not expect the fair value of a security to recover to cost or amortized cost prior to the expected date of sale. The fair value of the other-than-temporarily impaired investment becomes its new cost basis. For fixed maturities, the Company amortizes the new cost basis to par or to estimated future value over the remaining life of the security based on future estimated cash flows.
Securities not subject to Emerging Issues Task Force (“EITF”) Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continued to Be Held by a Transferor 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.
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 5.75% was the appropriate discount rate as of December 31, 2006 to calculate the Company’s benefit liability. Accordingly, the 5.75% discount rate will also be used to determine the Company’s 2007 pension and other postretirement expense. At December 31, 2005, the discount rate was 5.50%.
For the year ended December 31, 2004, represents the cumulative impact of the Company’s adoption of the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position (“SOP”) 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts” (“SOP 03-1”).
Property & Casualty net income increased $283, as a result of a $389 increase in Ongoing Operations’ net income, partially offset by a decrease in Other Operations’ results from net income of $71 in 2005 to a net loss of $35 in 2006. Ongoing Operations’ net income increased due to increases in underwriting results and net investment income, partially offset by a decrease in net realized capital gains. The increase in Ongoing Operations’ underwriting results was principally due to lower current accident year catastrophe losses, lower insurance operating costs and expenses due to a change in estimated Florida Citizens assessments, a change to net favorable prior accident year loss development and the effect of catastrophe treaty reinstatement premium recorded as a reduction of earned premium in 2005. The net loss in Other Operations was primarily a result of prior year reserve development of $243, pre-tax, recorded in 2006, resulting from the agreement with Equitas and the Company’s evaluation of the reinsurance recoverables and allowance for uncollectible reinsurance associated with older, long-term casualty liabilities.
During 2006, the Company achieved favorable settlements in several cases brought against the Company by policyholders regarding their purchase of broad-based leveraged corporate owned life insurance policies in the early to mid-1990s. The Company reduced its estimate of the ultimate cost of these cases in 2006. This reserve reduction resulted in an after-tax benefit of $34.
A charge of $102, after-tax, recorded in 2005 in Life to reserve for investigations related to market timing by the SEC and New York Attorney General’s Office, directed brokerage by the SEC and single premium group annuities by the New York Attorney General’s Office and the Connecticut Attorney General’s Office.
Partially offsetting the increase in Life’s net income was a $63, after-tax, charge related to the DAC unlock. See the Critical Accounting Estimates section of the MD&A for further information on the DAC unlock.
Net realized capital losses occurred in 2006 as compared to gains in 2005, primarily as a result of a higher interest rate environment. The components that drove the increase in net losses during the year ended December 31, 2006 included net losses on sales of fixed maturity securities and other-than-temporary impairments.
Fee income increased $727 as a result of increases in the Life operation’s Retail and International segments. The increase in fee income occurred primarily as the result of growth in average account values.
Earned premium increased $664 as a result of $387 from Life operations and $277 from Property & Casualty operations. The increase in Life earned premiums was primarily related to Group Benefits where the increase was driven by year-to-date sales (excluding buyouts) growth, particularly in group life insurance. Contributing to the growth in Property & Casualty earned premium was a $73 reduction of earned premium in 2005 due to catastrophe treaty reinstatement premium payable to reinsurers as a result of losses from the 2005 hurricanes. Apart from the effect of the reinstatement premium in 2005, the growth was primarily driven by new business premium outpacing non-renewals over the last six months of 2005 and the full year of 2006 and the effect of earned pricing increases in homeowners, partially offset by an increase in reinsurance costs. Growth in Business Insurance and Personal Lines earned premium was partially offset by a decrease in Specialty Commercial earned premium.
An increase in net income for the Group Benefits segment of $43, driven primarily by higher earned premiums and net investment income as well as a favorable loss ratio.
A $216 tax benefit recorded in 2004 to reflect the effect of the IRS audit settlement on tax years prior to 2004.
An increase of $793 in earned premiums. Earned premium growth of $486 in Business Insurance was primarily driven by new business premium growth outpacing non-renewals in the prior 12 months. Earned premium growth of $165 in Personal Lines was primarily driven by new business growth outpacing non-renewals in auto and the effect of earned pricing increases in homeowners. Earned premiums and other increased $158 in Group Benefits primarily due to increased sales, particularly in group disability, and continued strong persistency.
An increase of $541 in fee income primarily driven by increased individual annuity assets under management in the United States and Japan.
Partially offsetting these increases was 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.
The effective tax rate for 2006, 2005 and 2004 was 24%, 24% and 15%, respectively. The principal causes of the difference between the effective rate and the U.S. statutory rate of 35% for 2006 and 2005 were tax-exempt interest earned on invested assets and the separate account dividends received deduction (“DRD”). For 2004, the principal causes were tax exempt interest earned on invested assets, the separate account DRD and the tax benefit associated with the settlement of the 1998-2001 IRS audit. Income taxes paid in 2006, 2005 and 2004 were $179, $447 and $32, respectively. For additional information, see Note 13 of Notes to Consolidated Financial Statements.
The Company receives a foreign tax credit (“FTC”) against its U.S. tax liability for foreign taxes paid by the Company including payments from its separate account assets. The separate account FTC is estimated for the current year using information from the most recent filed return, adjusted for the change in the allocation of separate account investments to the international equity markets during the current year. The actual current year FTC can vary from the estimates due to the actual FTC’s passed through by the mutual funds.
The Hartford provides projections and other forward-looking information in the “Outlook” sections within MD&A. The “Outlook” sections contain many forward-looking statements, particularly relating to the Company’s future financial performance. These forward-looking statements are estimates based on information currently available to the Company, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and are subject to the precautionary statements set forth in the introduction to MD&A above. Actual results are likely to differ materially from those forecast by the Company, depending on the outcome of various factors, including, but not limited to, those set forth in each “Outlook” section and in Item 1A, Risk Factors.
The Institutional Investment Products (“IIP”) markets are highly competitive from a pricing perspective, and a small number of cases often account for a significant portion of deposits, therefore the Company may not be able to sustain the level of assets under management growth attained in 2006. The Company’s success depends in part on the level of credited interest rates and the Company’s credit rating.
The increased scale of the group life and disability operations and the expanded distribution network for its products and services has generated strong premium and sales growth in 2006. Management is committed to selling competitively priced products that meet the
Company’s internal rate of return guidelines and sales may be negatively affected by the competitive pricing environment in the marketplace. Although sales may fluctuate from year to year, the Company has experienced consistent premium growth over the past few years which results from the combination of sales, renewal pricing and persistency.
The Company will adopt Statement of Position 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications of Exchanges of Insurance Contracts” (“SOP 05-1”) on January 1, 2007. The Company expects the cumulative effect upon adoption of SOP 05-1 to be $50 to $65, after-tax, which will be recorded as a reduction in retained earnings as of January 1, 2007. In addition, the Company expects an after-tax reduction in net income, in 2007, of $15 to $25 assuming the level of internal replacement activity in 2007 is consistent with prior years.
The Personal Lines segment is expected to deliver written premium growth of 4% to 7% in 2007, including growth from both AARP and Agency. The Company expects personal auto written premium to increase 3% to 6% and homeowners’ written premium to increase 7% to 10% as management expects that growth from Agency business will be largely driven by an increase in the number of agency appointments and growth in AARP business will be largely driven an increase in marketing to AARP members.
Lines of business within Business Insurance and Personal Lines experienced either lower written price increases or a continuation of written price declines in 2006. Despite the downward pressure on rates, the Company expects market pricing to remain largely rational in 2007, although underwriting margins will likely lessen as loss costs outpace earned pricing increases. Management believes that 2006 represented the peak year of profitability in the underwriting cycle. Across Business Insurance and Personal Lines, management expects that loss costs will increase in 2007 as claim frequency is expected to be less favorable than in 2006 and claim severity is expected to increase. Due to the earned pricing and loss cost trends, management expects that, in 2007, the current accident year loss and loss adjustment expense ratio before catastrophes will increase in Business Insurance. While Personal Lines earned pricing and loss cost trends are expected to be less favorable in 2007, the current accident year loss and loss adjustment expense ratio before catastrophes is expected to remain relatively unchanged as underwriting results will benefit from the sale of Omni, which generated an underwriting loss of $52 in 2006. Within Specialty Commercial, management expects that current accident year underwriting results before catastrophes in 2007 will be relatively consistent with results in 2006.
$200 for a second or subsequent event. With the January 1 renewal, the cost of the company’s principal property catastrophe reinsurance program increased by approximately 28%.
The expense ratio is expected to increase slightly in 2007 since the 2006 expense ratio benefited from a $41 reduction in Florida Citizens assessments. In addition, the expense ratio in 2007 will likely reflect an increase in spending for AARP marketing initiatives and investments in technology. As a result of less favorable or unfavorable earned pricing changes and increases in loss costs and underwriting expenses, the Company expects an Ongoing Operations’ combined ratio before catastrophes and prior accident year development of between 87.5 and 90.5 in 2007, compared to 88.0 in 2006. Likewise, P&C operating cash flow is expected to be less favorable than in 2006, although still very positive. Management expects a mid-single digit increase in net investment income in 2007, driven by net underwriting cash inflows and a change in asset mix. Based upon current market forward interest rate expectations and an expectation of moderating partnership income, management expects the after-tax investment yield for Property & Casualty to be about 4.0% in 2007, consistent with an after-tax yield of 4.1% in 2006.
The Other Operations segment will continue to manage the discontinued operations of the Company as well as claims (and associated reserves) related to asbestos, environmental and other exposures. The Company will continue to review various components of all of its reserves on a regular basis.
Life provides retail and institutional investment products such as variable and fixed annuities, mutual funds, PPLI, and retirement plan services, individual life insurance and group benefit products, such as group life and group disability insurance.
Retail offers individual variable and fixed market value adjusted (“MVA”) annuities, retail mutual funds, 529 college savings plans, Canadian and offshore investment products.
Institutional primarily offers institutional liability products, including stable value products and institutional annuities (primarily terminal funding cases), as well as variable Private Placement Life Insurance (“PPLI”) owned by corporations and high net worth individuals. Within stable value, Institutional has an investor note program that offers both institutional and retail investor notes. Institutional and Retail notes are sold as funding agreement backed notes through trusts and may also be issued directly from the Company to investors. Institutional also offers mutual funds to institutional investors. Furthermore, Institutional offers additional individual products including structured settlements, consumer notes and single premium immediate annuities and longevity assurance.
Individual Life sells a variety of life insurance products, including variable universal life, universal life, interest sensitive whole life and term life.
Life’s expenses essentially consist of interest credited to policyholders on general account liabilities, insurance benefits provided, amortization of deferred policy acquisition costs, expenses related to selling and servicing the various products offered by the Company, dividends to policyholders, and other general business expenses.
Net flows for the U.S. variable annuity business were negative and have worsened from prior year levels resulting from higher surrenders outpacing increased deposits.
Mutual Fund net sales increased substantially over the prior year as a result of focused wholesaling efforts and favorable fund and equity market performance.
The increase in Retirement Plans’ account values is due to positive net flows over the past year due to higher deposits and market appreciation.
Individual Life variable universal life account value increased due primarily to premiums, deposits and market appreciation. Life insurance inforce increased from December 31, 2005 due to business growth.
Japan annuity account values as of December 31, 2006 were higher as a result of positive net flows and fund performance, offset by the effects of currency translation. Japan net flows have decreased from the prior year due to increased competition.
Changes in market value were based on market conditions and investment management performance in 2006.
The increase in U.S. variable annuity account values can be attributed to market growth during 2005.
Net flows and net deposits for the U.S. variable annuity and retail mutual fund businesses decreased in particular, as variable annuity net flows and mutual fund net sales were negatively affected due to lower sales levels and higher surrenders due to increased competition.
In addition to interest credited on general account assets, Institutional also had other contract benefits for limited payment contracts of $345 and $212 for the years ended December 31, 2006 and 2005, respectively. These amounts need to be deducted from net investment income to understand the net interest spread on these businesses because these contracts are accounted for as traditional insurance products.
Net investment income and interest credited in Other increased due to $3.8 billion increase in the mark-to-market effects of trading account securities supporting the Japanese variable annuity business.
Net investment income and interest credited on general account assets in Institutional increased as a result of the Company’s funding agreement backed Investor Notes program, partially offset by surrenders in the PPLI business.
There are three major categories for expenses. The first major category of expenses is benefits and losses. These include the costs of mortality and morbidity, particularly in the group benefits business, and mortality in the individual life businesses, as well as other contractholder benefits to policyholders. In addition, traditional insurance type products generally use a loss ratio which is expressed as the amount of benefits incurred during a particular period divided by total premiums and other considerations, as a key indicator of underwriting performance. Since Group Benefits occasionally buys a block of claims for a stated premium amount, the Company excludes this buyout from the loss ratio used for evaluating the underwriting results of the business as buyouts may distort the loss ratio.
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 annuity’s asset growth in 2006 and 2005 decreased individual annuity’s expense ratio to a level lower than prior years.
International’s expense ratio continued to decline in 2006 as Japan further leveraged the existing infrastructure as it attains economies of scale.
Management evaluates the rates of return various businesses can provide as an input in determining where additional capital should be invested to increase net income and shareholder returns. Specifically, because of the importance of its individual annuity products, the Company uses the return on assets for the individual annuity business for evaluating profitability. In Group Benefits, after tax margin is a key indicator of overall profitability.
Individual annuity’s ROA decreased primarily due to the DAC unlock in 2006. Excluding the DAC unlock, ROA was 53.6 bps in 2006. Contributing to the decline was an increase in trail commissions. Individual annuity’s ROA increased for 2005, compared to the prior year. In particular, variable annuity fees and fixed annuity general account spreads each increased for 2005 compared to the prior year. The increase in the ROA can be attributed to the increase in account values and resulting increased fees including GMWB rider fees without a corresponding increase in expenses, while the increase in fixed annuity general account spread resulted
from fixed annuity contracts that were repriced upon the contract reaching maturity. Also, contributing to a higher ROA in 2005 is an increase in the separate account dividends received deduction (“DRD”) tax benefit compared to 2004.
The improvement in the Group Benefits after-tax margin for 2006 was primarily due to an improvement in the loss and expense ratios partially offset by a lower net investment income rate and higher income tax expense. The improvement in the Group Benefits after tax margin for 2005 as compared to 2004 was primarily due to the favorable loss ratios and higher net investment income.
International’s ROA increased significantly in 2006 primarily due to the DAC unlock and the leveraging of its existing infrastructure through disciplined expense management. Excluding the DAC unlock, ROA was 74 bps in 2006.
Life recorded an after-tax expense of $46 in 2005, which related to the termination of a provision of an agreement with a mutual fund distribution partner.
Net income increased due to growth in assets under management resulting from sales as well as higher premium and favorable loss ratios in Group Benefits.
Insurance operating costs and other expenses increased for the year ended December 31, 2006 primarily due to an increase in mutual fund commissions due to significant growth in deposits. In addition, variable annuity asset based commissions increased due to 9% growth in assets under management, as well as an increase in the number of contracts reaching anniversaries when trail commission payments begin. During 2005, the Company recorded an after-tax expense of $46, for the termination of a provision of an agreement with a distribution partner of the Company’s retail mutual funds.
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:
The increase in fee income in the variable annuity business for the year ended December 31, 2005 was mainly a result of growth in average account values. The year-over-year increase in average account values of 10% can be attributed to market appreciation of $6.6 billion during 2005. Variable annuities had net outflows of $881 for the year ended December 31, 2005 compared to net inflows of $5.5 billion for the year ended December 31, 2004. The net outflows in 2005 were due to increased surrender activity and increased competition for deposits particularly from competitors that offered guaranteed living benefits riders with their variable annuity products.
Management believes the market for retirement products continues to expand as individuals increasingly save and plan for retirement. Demographic trends suggest that as the “baby boom” generation matures, a significant portion of the United States population will allocate a greater percentage of their disposable incomes to saving for their retirement years due to uncertainty surrounding the Social Security system and increases in average life expectancy. Competition has increased substantially in the variable annuities market with most major variable annuity writers now offering living benefits such as GMWB riders. The Company’s strategy in 2007 revolves around introducing new products and continually evaluating the portfolio of products currently offered. As a result, deposits may be lower than the level of deposits attained in 2006 due to the increasingly competitive environment, the risk of disruption on new deposits from product offering changes, customer acceptance of new products and the effect on the distribution related to product offering changes.
deposits and revenues 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 contracts.
Government Mutual Fund assets declined to zero due to a large case surrender in 2005 and the remaining business being transferred to the Institutional segment.
General account spread remained stable for the year ended December 31, 2006 compared to the prior year. Overall, net investment income and the associated interest credited within benefits, losses and loss adjustment expenses each increased as a result of the growth in general account assets under management. Additionally, benefits, losses and loss adjustment expenses increased for the year ended December 31, 2006 compared to the prior year due to a large case annuitization in the 401(k) business which also resulted in a corresponding increase in earned premiums of $12.
Net income in the Retirement Plans segment increased for the year ended December 31, 2005 compared to the prior year end primarily due to higher earnings in the 401(k) business while net income for the Government business was relatively stable as positive market appreciation was largely offset by negative net flows resulting in little growth in assets under management. A more expanded discussion of earnings growth can be found below.
Fee income for 401(k) increased 39% or $30 for year ended December 31, 2005 compared to the prior year. This increase is a result of positive net flows from the 401(k) business of $1.8 billion over the prior year driven by strong deposits and increasing ongoing deposits contributing to the growth in 401(k) assets under management of 34% to $9.7 billion. Total 401(k) deposits and net flows increased substantially by 32% and 26%, respectively, over the prior year primarily due to the full year impact of 2004’s expansion of wholesaling capabilities and new product offerings.
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. 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. In 2007, Life will begin selling mutual fund based products in the 401(k) market that will increase Life’s ability to grow assets under management in the medium size 401(k) market. Life will also be selling mutual fund based products in the 403(b) market as they look to grow assets in a highly competitive environment. Disciplined expense management will continue to be a focus; however, as Life looks to expand its reach in these markets, additional investments in service and technology will occur.
Mutual fund assets under management include transfers from the Retirement Plan segment of $178 during 2006.
Institutional primarily offers customized wealth creation and financial protection for institutions, corporate and high net worth individuals through its two business units: Institutional Investment Products (“IIP”) and PPLI.
Net income in Institutional increased for the year ended December 31, 2006 compared to the prior year driven by higher earnings in both the IIP and PPLI businesses. A more expanded discussion of earnings can be found below:
General account spread is one of the main drivers of net income for the Institutional line of business. The increase in spread income in 2006 was driven by higher assets under management as noted above, combined with improved partnership income. For the year ended December 31, 2006 and 2005, income from partnership investments were $15 and $6 after-tax, respectively.
Net income in Institutional increased for the year ended December 31, 2005 compared to the prior year driven by higher earnings in both the IIP and PPLI businesses. A more expanded discussion of earnings can be found below:
The future net income of this segment will depend on Institutional’s ability to increase assets under management across all businesses and maintain its investment spread earnings on the products sold largely in the IIP business. The IIP markets are highly competitive from a pricing perspective, and a small number of cases often account for a significant portion of deposits, therefore the Company may not be able to sustain the level of assets under management growth attained in 2006. In 2004, IIP introduced the Hartford Income Notes which is a product that provides the Company with opportunity for future growth. This product provides access to both a multi-billion dollar retail market, and a nearly trillion dollar institutional market. These markets are highly competitive and the Company’s success depends in part on the level of credited interest rates and the Company’s credit rating.
As the “baby boom” generation approaches retirement, management believes these individuals will seek investment and insurance vehicles that will give them steady streams of income throughout retirement. IIP has launched new products in 2006 to provide solutions that deal specifically with longevity risk, and will continue to introduce products in 2007. Longevity risk is defined as the likelihood of an individual outliving their assets. IIP is also designing innovative solutions to corporations’ 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.
Cost of insurance charges, the largest component of fee income, increased $30 for the year ended December 31, 2006, driven by growth in the variable universal and universal life insurance inforce. Variable fee income increased, consistent with the growth in the variable universal life insurance account value. Other fee income, another component of total fee income, increased primarily due to additional amortization of deferred revenues of $48 associated with the DAC unlock.
Earned premiums, which include premiums for ceded reinsurance, decreased primarily due to increased ceded reinsurance premiums for the year ended December 31, 2006.
Benefits, losses and loss adjustment expenses increased for 2006 consistent with the growth in account values and life insurance inforce, and also reflect favorable mortality experience in 2006 compared to 2005.
Insurance operating costs and other expenses increased for the year ended December 31, 2006 consistent with the growth of life insurance inforce.
Amortization of DAC for the year ended December 31, 2006 increased $76 related to the DAC unlock, partially offset by revisions to prior year estimates. Excluding the impacts of the DAC unlock and revisions, the amortization of DAC decreased for the year ended December 31, 2006, consistent with the mix of products and the level and mix of product profitability.
Net income increased for the year ended December 31, 2005 compared to 2004, primarily due to increases in both life insurance inforce and account values. The following factors contributed to the earnings results:
Amortization of DAC increased for the year ended December 31, 2005 compared to 2004 primarily as a result of product mix and higher gross margins within variable universal and interest-sensitive whole life insurance products.
Insurance operating costs and other expenses increased for the year ended December 31, 2005 compared to 2004 as a result of business growth.
The Japan MVA fixed annuity business contributed $13 of higher investment spread income, including net periodic coupon settlements included in realized losses, in 2005 compared to 2004. This increase in investment spread was driven by higher assets under management. As of December 31, 2005, Japan’s MVA assets under management increased to $1.5 billion compared to $502 in the prior year. The increase in fixed annuity assets under management can be attributed to deposits of $1.2 billion for the year ending December 31, 2005 as compared to $521 for the prior year.
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 value levels will generally reduce certain costs for individual annuities to the Company, such as guaranteed minimum death benefits (“GMDB”) and guaranteed minimum income benefits (“GMIB”). Expense management is also an important component of product profitability.
Competition has continued to increase in the Japanese market with the most significant competition the result of the strengthening of domestic competitors. This competition has resulted in changes to key distribution relationships that have negatively impacted current year deposits and could potentially impact future deposits. The Company continues to focus its efforts on strengthening our distribution relationships and improving our wholesaling and servicing efforts. In addition, the Company continues to evaluate product designs that meet customers’ needs while maintaining prudent risk management. In the first quarter 2007, the company is launching a new variable annuity product to complement its existing variable annuity product offerings. The success of the Company’s enhanced product offering will ultimately be based on customer acceptance in an increasingly competitive environment. International continues to invest in its operations outside of Japan. In the short term, the Company expects losses in these operations outside of Japan to be relatively consistent with 2006.
Variable annuity deposits of ¥530 billion to ¥825 billion ($4.5 billion to $7.0 billion)
Net investment income includes the mark-to-market adjustment for equity securities held for trading which decreased primarily due to decreased fund performance in International. This decrease in net investment income is offset by a decrease in benefit, losses and loss adjustment expenses which reflects the interest credited on the Japan account balance liability.
Life recorded an after-tax charge of $102 for the year ended December 31, 2005 to establish reserves for regulatory matters for investigations related to market timing by the SEC and New York Attorney General’s Office, directed brokerage by the SEC, and single premium group annuities by the New York Attorney General’s Office and the Connecticut Attorney General’s Office.
Also contributing to the insurance operating costs and other expenses decreases for the year ended December 31, 2006 was a lower level of dividends to leveraged COLI policyholders.
The increase in the DAC amortization in 2006 was due to the DAC unlock of $46, after-tax.
Other than the impact of Japan interest credited, benefits, losses, and loss adjustment expenses increased for the year ended December 31, 2005 primarily due to the establishment of a $102 after-tax reserve for investigations related to market timing by the SEC and the New York Attorney General’s Office, directed brokerage by the SEC and single premium group annuities by the New York Attorney General’s Office and the Connecticut Attorney General’s Office.
Partially offsetting these favorable drivers were factors that decreased earned premium:
Year ended December 31, 2005 compared to the year ended December 31, 2004
A $651 increase in Business Insurance and Personal Lines earned premium before considering catastrophe treaty reinstatement premium, primarily driven by new business outpacing non-renewals,
Partially offsetting these favorable drivers was a $56 increase in catastrophe treaty reinstatement premium as a result of the 2005 hurricanes.
$73 of catastrophe treaty reinstatement premium recorded as a reduction of earned premium in 2005, and
A $51 increase in underwriting results from earned premium growth in Business Insurance and Personal Lines before considering catastrophe treaty reinstatement premium.
A $35 decrease in net realized capital gains, primarily due to a $24, pre-tax, realized capital loss from the sale of Omni, and
A $20 increase in other expenses, primarily due to lower bad debt expense in 2005.
Ongoing Operations was primarily due to an $83 release of prior accident year hurricane reserves and a $58 release of allocated loss adjustment expense reserves for workers’ compensation and package business, partially offset by reserve strengthenings in Specialty Commercial. See the “Reserves” section for a discussion of prior accident year reserve development.
A $32 decrease in other expenses, primarily due to lower bad debt expense in 2005, and
A $76 increase in underwriting results from earned premium growth in Business Insurance and Personal Lines at a combined ratio less than 100.0.
A $56 increase in catastrophe treaty reinstatement premium recorded as a reduction of earned premium, and
A $209 increase in income tax expense, reflecting an increase in income before income taxes.
The $172 decrease in current accident year catastrophe losses was primarily due to $264 of losses from Hurricanes Katrina, Rita and Wilma in 2005 compared to $394 of losses from Hurricanes Charley, Frances, Ivan and Jeanne in 2004. The $166 decrease in net unfavorable prior accident year development was primarily due to $181 of unfavorable development in 2004 related to a reduction in the reinsurance recoverable asset associated with older, long-term casualty liabilities, including asbestos liabilities.
The $89 decrease in net realized capital gains was primarily due to lower net realized gains on the sale of fixed maturity investments and net losses on non-qualifying derivatives during 2005 compared to net gains during 2004.
Included in the prior year catastrophe ratio is the net reserve release of (3.1) points related to September 11 in 2004.
The lower growth rate in Business Insurance was primarily attributable to a decrease in new business written premium, lower earned pricing increases in small commercial, larger earned pricing decreases in middle market and higher property catastrophe treaty reinsurance costs.
The lower growth in Personal Lines was primarily due to unfavorable changes in earned pricing and the effect of higher property catastrophe treaty reinsurance costs. Partially offsetting the lower growth rate was the effect of $31 of catastrophe treaty reinstatement premium recorded as a reduction of earned premium in 2005 and an increase in new business written premium in auto and homeowners. During 2006, there was a decline in earned pricing increases in homeowners and a change from slight earned pricing increases for auto in 2005 to flat earned pricing for auto in 2006.
The decline in Specialty Commercial earned premium primarily resulted from the non-renewal of a single captive insurance program within specialty casualty that accounted for $241 of earned premium in 2005 and a decrease in specialty property earned premium, partially offset by the effect of $26 of catastrophe treaty reinstatement recorded as a reduction of earned premium in 2005 and a higher growth rate in professional liability, fidelity and surety business.
For 2006, the combined ratio before catastrophes and prior accident year development decreased by 1.4 points, to 88.0, driven largely by the effect of $73 of catastrophe treaty reinstatement premium recorded as a reduction of earned premium in 2005 and an improvement in the expense ratio. Before the effect of reinstatement premium in 2005, the combined ratio before catastrophes and prior accident year development decreased by 0.7 points, primarily due to a 0.8 point decrease in the expense ratio and a lower current accident year loss and loss adjustment expense ratio for workers’ compensation business in small commercial, partially offset by an increase in non-catastrophe property loss costs in middle market and Personal Lines homeowners. The decrease in the expense ratio was primarily driven by a reduction of $41 for Citizens’ assessments in 2006 and a charge of $64 for Citizens assessments in 2005.
The decrease in the current accident year catastrophe ratio for 2006 was primarily due to $264 of net losses incurred in 2005 for hurricanes Katrina, Rita and Wilma, partially offset by an increase in non-hurricane catastrophe losses. Catastrophe losses for 2006 included tornadoes and hail storms in the Midwest and windstorms in Texas and on the East coast.
The after-tax investment yield remained flat at 4.1% from 2005 to 2006. An increase in the yield on investments in fixed maturities was offset by a decrease in the yield on limited partnerships.
The average annual invested assets at cost increased as a result of net underwriting cash inflows and investment income.
Contributing to the decrease in the earned premium growth rate for Business Insurance were lower earned pricing increases in small commercial, earned pricing decreases in middle market and a decrease in new business growth, partially offset by increased renewal retention.
primarily due to lower invested assets as a result of loss and loss adjustment expense payments and the reallocation of capital from Other Operations to Ongoing Operations.
The after-tax investment yield of 4.1% for 2005 was consistent with the after-tax yield in 2004.
Net income is the measure of profit or loss used in evaluating the performance of Total Property & Casualty and the Ongoing Operations and Other Operations segments. Within Ongoing Operations, the underwriting segments of Business Insurance, Personal Lines and Specialty Commercial are evaluated by The Hartford’s management primarily based upon underwriting results. Underwriting results within Ongoing Operations are influenced significantly by earned premium growth and the adequacy of the Company’s pricing. Underwriting profitability over time is also greatly influenced by the Company’s underwriting discipline, which seeks to manage exposure to loss through favorable risk selection and diversification, its management of claims, its use of reinsurance and its ability to manage its expense ratio which it accomplishes through economies of scale and its management of acquisition costs and other underwriting expenses.
The investment yield, or return, on the Company’s invested assets primarily includes interest income on fixed maturity investments. Based upon the fair value of Property & Casualty’s investments as of December 31, 2006 and 2005, approximately 93% and 94%, respectively, of invested assets were held in fixed maturities. A number of factors affect the yield on fixed maturity investments, including fluctuations in interest rates and the level of prepayments. The Company also invests in equity securities, mortgage loans and limited partnership arrangements.
When fixed maturity or equity investments are sold, any gain or loss is reported in net realized capital gains (losses). Individual securities may be sold for a variety of reasons, including a decision to change the Company’s asset allocation in response to market conditions and the need to liquidate funds to meet large claim settlements. Accordingly, net realized capital gains (losses) for any particular period are not predictable and can vary significantly. In addition, net realized capital gains (losses) include the pre-tax loss from the sale of Omni (see Ongoing Operations segment MD&A for further discussion). Refer to the Investment section of MD&A for further discussion of net investment income and net realized capital gains (losses).
Reserving for property and casualty losses is an estimation process. As additional experience and other relevant claim data become available, reserve levels are adjusted accordingly. Such adjustments of reserves related to claims incurred in prior years are a natural occurrence in the loss reserving process and are referred to as “reserve development”. Reserve development that increases previous estimates of ultimate cost is called “reserve strengthening”. Reserve development that decreases previous estimates of ultimate cost is called “reserve releases”. Reserve development can influence the comparability of year over year underwriting results and is set forth in the paragraphs and tables that follow. The “prior accident year development” in the following table represents the ratio of reserve development to earned premiums. For a detailed discussion of the Company’s reserve policies, see Notes 1, 11 and 12 of Notes to Consolidated Financial Statements and the discussion in Critical Accounting Estimates.
Based on the results of the quarterly reserve review process, the Company determines the appropriate reserve adjustments, if any, to record. Recorded reserve estimates are changed after consideration of numerous factors, including but not limited to, the magnitude of the difference between the actuarial indication and the recorded reserves, improvement or deterioration of actuarial indications in the period, the maturity of the accident year, trends observed over the recent past and the level of volatility within a particular line of business. In general, changes are made more quickly to more mature accident years and less volatile lines of business. For information regarding reserving for asbestos and environmental claims within Other Operations, refer to the Other Operations segment discussion.
As part of its quarterly reserve review process, the Company is closely monitoring reported loss development in certain lines where the recent emergence of paid losses and case reserves could indicate a trend that may eventually lead the Company to change its estimate of ultimate losses in those lines. If, and when, the emergence of reported losses is determined to be a trend that changes the Company’s estimate of ultimate losses, prior accident year reserves would be adjusted in the period the change in estimate is made. For example, for both Personal Lines homeowners’ claims and Business Insurance workers’ compensation claims, during the latter half of 2006 there was an increase in severity in reported losses for recent accident years. While it is too early to tell whether this increase in severity constitutes a reliable trend, if reported losses continue to emerge unfavorably in 2007, prior accident year reserves may be strengthened. For Personal Lines auto liability claims, the Company’s estimates of ultimate losses include assumptions about frequency and severity trends. These assumptions are updated each quarter as the Company’s actuaries complete a review of reserves. During 2005 and 2006, these updates resulted in improvements in estimates of both frequency and severity trends and, as a result, the Company released reserves in the first, second, and fourth quarters of 2006. If, during 2007, frequency and severity trends continue to improve and the development of reported losses indicates that the assumptions made in the prior reserve review are too high, prior accident years may develop favorably.
During the year ended December 31, 2006, the Company’s reestimates of prior accident year reserves included the following significant reserve changes.
Strengthened reserves for personal auto liability claims by $30 due to an increase in estimated severity on claims where the Company is exposed to losses in excess of policy limits. From the Company’s reserve review during the first quarter of 2006, the Company determined that the facts and circumstances necessitated an increase in the reserve estimate. The $30 of reserve strengthening represented 2% of the Company’s net reserves for Personal Lines auto liability claims as of December 31, 2005.
Strengthened Specialty Commercial construction defect claim reserves by $45 for accident years 1997 and prior as a result of an increase in claim severity trends. In 2004, two large construction defects claims were reported, but these were not viewed as an indication of an increase in the severity trend for all claims. In 2005, two additional large cases were reported. Management performed an expanded review of construction defects claims in the second quarter of 2006. Based on the expanded review and additional reported claim experience, management concluded that reported losses would likely continue at a higher level in the future and this resulted in strengthening the recorded reserves. The $45 of reserve strengthening represented 16% of the Company’s net reserves for Specialty Commercial property claims as of December 31, 2005.
Includes reserve discount accretion of $30, including $13 in Business Insurance, $10 in Specialty Commercial and $7 in Other Operations.
Released reserves for workers’ compensation losses in Business Insurance on accident years 2003 and 2004 by $75. The state of California instituted reforms to its workers’ compensation laws that began in 2003 and continued through 2005. In addition, in this same time frame, the Company was taking underwriting actions to improve workers’ compensation underwriting performance. Management recognized that the combination of the Company’s underwriting initiatives and the state of California changes could,
over time, improve the Company’s workers’ compensation experience. Verification of this improvement as a probable outcome, however, would require sufficient supporting evidence. While there appeared to be some favorable trends emerging in late 2004 with respect to accident year 2003 and while early indications on accident year 2004 were favorable, senior reserving actuaries and senior management were uncertain that these favorable trends were real and would be sustained. In the third quarter of 2005, management concluded that sufficient evidence existed in the actuarial data and methods to support a release of reserves. The actuarial work was further supported by a review of underwriting metrics, supporting the effectiveness of the actions taken, and by discussions with claim handlers involved with the California workers’ compensation business. The $75 reserve release represented a change in estimate which was 2% of the Company’s net reserves for workers’ compensation claims as of December 31, 2004.
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 strengthening represented 2% of the Company’s net reserves for general liability claims as of December 31, 2004.
Strengthened assumed reinsurance reserves by $85, principally for accident years 1997 through 2001. In recent years, the Company has seen an increase in reported losses above previous expectations and this increase in reported losses contributed to the reserve re-estimates. Assumed reinsurance exposures are inherently less predictable than direct insurance exposures because the Company may not receive notice of a reinsurance claim until the underlying direct insurance claim is mature. The reserve strengthening of $85 represents 6% of the $1.3 billion of net Reinsurance reserves within Other Operations as of December 31, 2004.
The Company’s estimates of net loss and loss expenses arising from hurricanes Charley, Frances, Ivan and Jeanne were based on information from reported claims and estimates of reinsurance recoverables on ceded losses. In the third quarter of 2004, the Company reinstated the limits under its reinsurance programs that were exhausted by the 2004 hurricanes, resulting in additional ceded premium of $17, which was reflected as a reduction in earned premium.
Includes reserve discount accretion of $29, including $13 in Business Insurance, $10 in Specialty Commercial and $6 in Other Operations.
Strengthened reserves for construction defects claims by $190, representing 11% of the Company’s $1.8 billion of net reserves for general liability claims as of December 31, 2004. The Company’s construction defects claims, which relate primarily to accident years prior to 2000, experienced increasing severity, particularly due to losses from contractors in California.
Strengthened auto liability reserves by $25 and package business reserves by $38 related to accident years 1998 to 2002 as actual reported losses were above previous expectations. In particular, the Company observed a higher frequency of large claims (generally those greater than $100,000) than had been anticipated in prior estimates. The auto liability reserve strengthening of $25 represented 1% of the Company’s net reserves for auto liability claims as of December 31, 2004 and the package business reserve strengthening of $38 represented 3% of the Company’s net reserves for package business as of December 31, 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 represented 13% of the $1.3 billion of net Reinsurance reserves as of December 31, 2004. In recent years, the Company had seen an increase in reported assumed reinsurance claims above previous expectations and this increase in reported claims contributed to the reserve re-estimates.
As explained in connection with the Company’s discussion of Critical Accounting Estimates, the establishment of Property and Casualty reserves is an estimation process, using a variety of methods, assumptions and data elements. Ultimate losses may vary significantly from the current estimates. Many factors can contribute to these variations and the need to change the previous estimate
Range of prior accident year development for the six years ended December 31, 2006 [1] [2]
Before the reserve strengthening for asbestos and environmental reserves over the past ten years, reserve re-estimates for total Property & Casualty ranged from (3.0%) to 1.6% .
The potential variability of the Company’s Property & Casualty reserves would normally be expected to vary by segment and the types of loss exposures insured by those segments. Illustrative factors influencing the potential reserve variability for each of the segments are discussed under Critical Accounting Estimates. In general, over the long term, the Company would expect the variability of its Personal Lines reserve estimates to be relatively less than the variability of the reserve estimates for its other property and casualty segments. The Company would expect the degree of variability of the remaining segments’ reserve estimates, from lower variability to higher variability, to be generally Business Insurance, Specialty Commercial, and Other Operations. The actual relative variability could prove to be different than anticipated.
Terrorism Risk Insurance Extension Act of 2005 and other reinsurance programs relating to particular risks or specific lines of business.
The Company has several catastrophe reinsurance programs, including reinsurance treaties that cover property and workers’ compensation losses aggregating from single catastrophe events. The following table summarizes the primary catastrophe treaty reinsurance coverages that the Company has in place as of January 1, 2007:
Under certain conditions, the Company’s loss retention from a single event could be reduced to $200 for a second or subsequent event.
As of December 31, 2006, there have been no events that are expected to trigger a recovery under any of the reinsurance programs with Foundation Re or Foundation Re II and, accordingly, the Company has not recorded any recoveries from the associated reinsurance treaties.
The Company uses third party models to estimate the potential loss resulting from various catastrophe events and the potential financial impact those events would have on the Company’s financial position and results of operations. The following table shows modeled loss estimates before expected reinsurance recoveries and after expected reinsurance recoveries. The loss estimates represent total property losses for hurricane events and property and workers compensation losses for earthquake events resulting from a single event. The estimates provided are based on 250-year return period loss estimates, which have a 0.4% likelihood of being exceeded in any single year. The net loss estimates assume that the Company would be able to recover all losses ceded to reinsurers under its reinsurance programs. There are various methodologies used in the industry to estimate the potential property and workers’ compensation losses that would arise from various catastrophe events and companies may use different models and assumptions in their estimates. Therefore, the Company’s estimates of gross and net losses arising from a 250-year hurricane or earthquake event may not be comparable to estimates provided by other companies. Furthermore, the Company’s estimates are subject to significant uncertainty and could vary materially from the actual losses that would arise from these events.
For terrorism, private sector catastrophe reinsurance capacity is limited and generally unavailable for terrorism losses caused by nuclear, biological, chemical or radiological weapons attacks. As such, the Company’s principal reinsurance protection against large-scale terrorist attacks is the coverage currently provided through the Terrorism Risk Insurance Extension Act of 2005 (TRIEA). On December 22, 2005, the President signed TRIEA extending the Terrorism Risk Insurance Act of 2002 (“TRIA”) through the end of 2007. TRIA provides a backstop for insurance-related losses resulting from any “act of terrorism” certified by the Secretary of the Treasury, in concurrence with the Secretary of State and Attorney General, that results in industry losses in excess of $100 in 2007. Under the program, the federal government would pay 85% of covered losses from a certified act of terrorism in 2007 after an insurer’s losses exceed 20% of the Company’s eligible direct commercial earned premiums in 2006, up to a combined annual aggregate limit for the federal government and all insurers of $100 billion. If an act of terrorism or acts of terrorism result in covered losses exceeding the $100 billion annual limit, Congress will be responsible for determining how additional losses in excess of $100 billion will be paid.
Among other items, TRIEA required that the President’s Working Group on Financial Markets (PWG) perform an analysis regarding the long-term availability and affordability of insurance for terrorism risk. Among the findings detailed in the PWG’s report, released October 2, 2006, were that the high level of uncertainty associated with predicting the frequency of terrorist attacks, coupled with the unwillingness of some insurance policyholders to purchase insurance coverage, makes predicting long term development of the terrorism risk market difficult, and that there is likely little potential for future market development for nuclear, biological, chemical and radiological (NBCR) coverage. A September 2006 study by the U.S. Government Accountability Office on insuring NBCR terrorism risk similarly concluded that any market-driven expansion of coverage is highly unlikely in the foreseeable future.
It is uncertain whether a federal terrorism risk insurance program similar to TRIEA will be enacted to cover events occurring after December 31, 2007. Given the possibility that TRIEA may not be extended beyond December 31, 2007 and the 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.
Citizens Property Insurance Corporation in Florida (“Citizens”) provides property insurance to Florida homeowners and businesses that are unable to obtain insurance from other carriers, including for properties deemed to be “high risk”. Citizens maintains a Personal Lines account, a Commercial Lines account and a High Risk account. If Citizens incurs a deficit in any of these accounts, Citizens may impose a “regular assessment” on other insurance carriers in the state to fund the deficits, subject to certain restrictions and subject to approval by the Florida Office of Insurance Regulation. Carriers are then permitted to surcharge policyholders to recover the assessments over the next few years. Citizens may also opt to finance a portion of the deficits through issuing bonds and may impose “emergency assessments” on other insurance carriers to fund the bond repayments. Unlike with regular assessments, however, insurance carriers only serve as a collection agent for emergency assessments and are not required to remit surcharges for emergency assessments to Citizens until they collect surcharges from policyholders. Under generally accepted accounting principles, the Company is required to accrue for regular assessments in the period the assessments become probable and estimable and the obligating event has
Based on A.M. Best ratings as of December 31, 2006 and 2005, respectively.
Includes reinstatement premiums related to hurricanes of $73 in 2005 and reinstatement premiums related to hurricanes of $17 in 2004.
Includes 2006 catastrophes of $129, 2005 catastrophes of $365 and 2004 catastrophes of $507, before the net reserve release of $395 related to September 11.
Includes net realized capital gains, after tax, of $46, $29 and $87 for the years ended December 31, 2006, 2005 and 2004, respectively.
Net income increased by $326, or 36%, as a result of a $210 increase in Ongoing Operations’ net income and a $116 increase in Other Operations’ net income. See the Ongoing Operations and Other Operations segment MD&A discussions for an analysis of the underwriting results and investment performance driving the change in net income.
Ongoing Operations includes the three underwriting segments of Business Insurance, Personal Lines and Specialty Commercial.
Total Ongoing Operations’ earned premiums grew $276, or 3%, due primarily to growth in Business Insurance and Personal Lines, partially offset by a decrease in Specialty Commercial. Contributing to the growth in earned premium was a $73 reduction of earned premium in 2005 due to catastrophe treaty reinstatement premium payable to reinsurers as a result of losses from hurricanes Katrina, Rita and Wilma, including $16 in Business Insurance, $31 in Personal Lines and $26 in Specialty Commercial. Before catastrophe treaty reinstatement premium, Ongoing Operations’ earned premium grew $203, or 2%, for 2006.
For the year ended December 31, 2006, earned premiums grew $333, or 7%, in Business Insurance and grew $150, or 4%, in Personal Lines. Apart from the effect of catastrophe treaty reinstatement premium in 2005, the growth was primarily driven by new business premium outpacing non-renewals over the last six months of 2005 and the full year of 2006 and the effect of earned pricing increases in homeowners, partially offset by the effect of higher property catastrophe treaty reinsurance costs and earned pricing decreases in middle market.
Specialty Commercial earned premiums decreased by $207, or 12%, primarily driven by a decrease in casualty, property and other earned premiums, partially offset by an increase in professional liability, fidelity and surety. Casualty earned premiums decreased by $220, primarily because of the non-renewal of a single captive insurance program. The decrease in property earned premium is primarily due to a decline in new business, an increase in catastrophe treaty reinsurance costs and a strategic decision not to renew certain accounts with properties in catastrophe-prone areas.
The $168 improvement in current accident year underwriting results before catastrophes was primarily due to:
Before reinstatement premium, a lower combined ratio before catastrophes and prior accident year development improved current accident year underwriting results before catastrophes by $72. The 1.4 point decrease in the combined ratio before catastrophes and prior accident year development, to 88.0, was primarily driven by:
A 0.3 point decrease in the current accident year loss and loss adjustment expense ratio before catastrophes, to 62.4, largely due to the effect that catastrophe treaty reinstatement premium had on the ratio in 2005. Apart from the effect of catastrophe treaty reinstatement premium, the current accident year loss and loss adjustment expense ratio before catastrophes increased slightly due to a slight increase in the ratio for both Business Insurance and Personal Lines. The slight deterioration in Business Insurance was primarily due to an increase in non-catastrophe property loss costs in middle market, the effect of earned pricing decreases in middle market and the effect of a shift to more workers’ compensation premium which has a higher loss and loss adjustment expense ratio than other business in the segment. Partially offsetting the deterioration in Business Insurance was a lower loss and loss adjustment expense ratio on small commercial workers’ compensation business. The deterioration in Personal Lines was principally due to an increase in non-catastrophe property loss costs for homeowners and an increase in the loss and loss adjustment expense ratio for auto liability claims due to a shift to more Dimensions product business within Agency.
Current accident year catastrophe losses decreased by $152, from $351 in 2005 to $199 in 2006. The decrease in current accident year catastrophe losses was primarily due to $264 of net losses incurred for hurricanes Katrina, Rita and Wilma in 2005, partially offset by an increase in non-hurricane related catastrophes in 2006. Catastrophe losses in 2006 included tornadoes and hail storms in the Midwest and windstorms in Texas and on the East coast.
a change in asset mix (i.e., a greater share of investments in mortgage loans and limited partnerships). The $17 in net realized capital losses during 2006 included a $24 pre-tax realized capital loss from the sale of Omni, an increase in other-than-temporary-impairments and losses on the sale of fixed maturity investments, partially offset by an increase in income from other sources. (See the Other-Than-Temporary Impairments discussion within Investment Results for more information on the increase in impairments).
Net income increased $210, or 22%, driven primarily by the following:
A $139 increase in income tax expense, reflecting an increase in income before income taxes.
The $106 improvement in current accident year underwriting results before catastrophes was primarily due to:
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 Citizens. 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.
Also contributing to the increase, was an increase in capital and invested assets attributed 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.
Business Insurance provides standard commercial insurance coverage to small and middle market commercial businesses, primarily throughout the United States. This segment offers workers’ compensation, property, automobile, liability, umbrella and marine coverages. The Business Insurance segment also provides commercial risk management products and services.
Growth in middle market earned premium was driven primarily by growth in workers’ compensation and marine, partially offset by a decrease in property and commercial auto. New business written premium for middle market increased by $22, or 4%, for the year ended December 31, 2005, mostly related to workers’ compensation business. Premium renewal retention for middle market decreased from 83% to 81%, primarily due to the effect of larger written pricing decreases and a decrease in retention on larger accounts.
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 reflected written pricing changes during the last six months of 2004 and the year ended December 31, 2005.
Underwriting results increased by $222, or 56%, with a corresponding 3.8 point decrease in the combined ratio, to 87.9. The net increase in underwriting results was principally driven by the following factors:
Before reinstatement premium, a lower combined ratio before catastrophes and prior accident year development improved current accident year underwriting results before catastrophes by $70. The 1.7 point decrease in the combined ratio before catastrophes and prior accident year development, to 87.7, was primarily driven by an improvement in the expense ratio.
The expense ratio decreased by 1.8 points, primarily due to the impact in 2006 and 2005 of changes in the expected assessments from Citizens and a continued shift to lower commission workers’ compensation business. The year ended December 31, 2006 benefited from a $22 reduction in estimated Citizens’ assessments related to the 2005 Florida hurricanes and the year ended December 31, 2005 included a charge of $33 for assessments related to the 2004 and 2005 Florida hurricanes.
Before catastrophes, the current accident year loss and loss adjustment expense ratio decreased slightly, to 59.7, primarily due to a lower loss and loss adjustment expense ratio on small commercial workers’ compensation business, a decrease in non-catastrophe property loss costs in small commercial and the effect on the ratio of catastrophe treaty reinstatement premium in 2005. Largely offsetting the improvement was, an increase in non-catastrophe property loss costs in middle market, the effect of earned pricing decreases in middle market and the effect of a shift to more workers’ compensation premium which has a higher loss and loss adjustment expense ratio than other business in the segment. The increase in non-catastrophe property loss costs in middle market was primarily due to increasing claim severity. In small commercial, non-catastrophe property loss costs were favorable due to favorable claim frequency.
Current accident year catastrophe losses decreased by $18, from $89 in 2005 to $71 in 2006. Catastrophe losses in 2005 included $68 of catastrophe losses from Hurricanes Katrina, Rita and Wilma. While hurricane losses were significantly lower in 2006, non-hurricane catastrophe losses increased significantly due, in large part, to tornadoes and hail storms in the Midwest and windstorms in Texas and on the East coast.
Contributing to the 0.6 point decrease in the expense ratio was earned premium growth, a shift to more workers’ compensation business which has lower commissions and a $16 reduction in contingent commissions, partially offset by $20 of hurricane related assessments in 2005. The $16 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 0.5 point increase in the current accident year loss and loss adjustment expense ratio before catastrophes, to 59.8, was primarily due to earned pricing decreases in middle market and increasing non-catastrophe property claim costs, partially offset by earned pricing increases in small commercial and improved current accident year underwriting results for workers’ compensation business. 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.
Written pricing trends in 2006 were affected by increased competition as evidenced by 1% written pricing increases in small commercial and 4% written pricing decreases in middle market. During 2006, non-catastrophe property loss costs increased, driven by increasing claim severity in middle market, partially offset by favorable claim frequency and severity in small commercial. In 2007, management expects claim severity to increase and claim frequency to be less favorable. Based on anticipated trends in earned pricing and loss costs, the combined ratio before catastrophes and prior accident year development is expected to be in the range of 88.5 to 91.5 in 2007. The combined ratio before catastrophes and prior accident year development was 87.7 in 2006.
To summarize, management’s outlook in Business Insurance for the 2007 full year is:
Other earned premium decreased by $91, or 29%, because of a strategic decision to reduce other affinity business and limit non-standard writings to fewer geographic areas. On November 30, 2006, the Company sold Omni and exited the non-standard auto business. Refer to Note 20 of the Notes to Consolidated Financial Statements for further discussion.
The earned premium growth in AARP and Agency was primarily due to new business written premium outpacing non-renewals over the last six months of 2005 and the full year of 2006 and to earned pricing increases in homeowners for both AARP and Agency.
Auto earned premium grew $64, or 2% primarily from new business outpacing non-renewals in both AARP and Agency over the last six months of 2005 and the year ended December 31, 2006, partially offset by a decline in other auto business. Before considering the decline in other auto business, auto earned premium grew $154, or 6%. Homeowners’ earned premium grew $86, or 10%, primarily due to new business outpacing non-renewals in both AARP and Agency business over the last six months of 2005 and the year ended December 31, 2006 and due to earned pricing increases. Consistent with the growth in earned premium, the number of policies in force has increased in auto and homeowners. The growth in policies in force does not correspond directly with the growth in earned premiums due to the effect of earned pricing changes and because policy in force counts are as of a point in time rather than over a period of time.
AARP earned premium grew $150, or 7%, reflecting growth in the size of the AARP target market and the effect of direct marketing programs to increase premium writings, particularly in auto.
Agency earned premium grew $90, or 10%, as a result of continued growth of the Dimensions class plans first introduced in 2004. Dimensions, which had been rolled out to 41 states for auto and 37 states for homeowners as of December 31, 2005, allows Personal Lines to write a broader class of risks.
Auto new business written premium decreased by $43, or 9%, to $426 in 2005, due primarily to a $52 decline in Omni new business and, to a lesser extent, a decline in Agency and Other Affinity new business, partially offset by an increase in AARP new business. Homeowners’ new business written premium increased by $16, or 14%, to $131 in 2005, primarily due to an increase in Agency new business written premium.
Premium renewal retention decreased in 2005 for both auto and for homeowners, from 89% to 87% for auto, and from 100% to 94% for homeowners. Premium renewal retention for automobile decreased primarily due to lower written pricing increases and a decrease in retention in Agency business, partially offset by an increase in retention to AARP business. Premium renewal retention for homeowners decreased primarily due to a decrease in retention of Agency business and lower written pricing increases.
The moderation in earned pricing increases during 2005 is a reflection of written pricing changes in the last six months of 2004 and the year ended December 31, 2005. The written pricing 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.
Net favorable prior accident year reserve development of $38 in 2006 included a $53 reduction in auto liability reserves and a $23 reduction in hurricane catastrophe reserves, including $10 related to Hurricane Katrina in 2005 and $7 related to Hurricane Charley in 2004, partially offset by a $30 increase in reserves for personal auto liability claims due to an increase in estimated severity on claims where the company is exposed to losses in excess of policy limits. The $53 reduction in auto liability reserves in 2006 included a $31 reduction in reserves for auto liability claims related to accident year 2005 as a result of better than expected frequency trends and a $22 reduction of reserves for AARP and other affinity auto liability claims related to accident years 2003 to 2005 as a result of better than expected severity trends. Net favorable prior accident year reserve development of $95 in 2005 included a $95 reduction in reserves for allocated loss adjustment expenses.
The $48 improvement in current accident year underwriting results before catastrophes was primarily due to:
The combined ratio before catastrophes and prior year development decreased by 0.8 points, to 86.4, due to the effect of $31 of catastrophe treaty reinstatement premiums recorded as a reduction of earned premium in 2005. Before the effect of catastrophe treaty reinstatement premium, the combined ratio before catastrophes and prior accident year development was relatively flat, improving current accident year underwriting results before catastrophes by only $1.
The 1.0 point improvement in the expense ratio was primarily due to the impact in 2006 and 2005 of changes in the expected assessments from Citizens. The year ended December 31, 2006 benefited from a $19 reduction of estimated Citizens’ assessments related to the 2005 Florida hurricanes whereas the year ended December 31, 2005 included a charge of $30 for assessments related to the 2004 Florida hurricanes.
Underwriting results increased by $322, with a corresponding 8.7 point decrease in the combined ratio, from 96.0 to 87.3. The net increase in underwriting results was principally driven by the following factors:
There was a change from $3 of net unfavorable prior accident year reserve development in 2004 to $95 of net favorable prior accident year reserve development in 2005. Net favorable reserve development of $95 in 2005 represented a $95 reduction in prior accident year reserves for allocated loss adjustment expenses, predominantly related to auto liability claims.
The expense ratio increased by 0.6 points, to 23.7, primarily due to $31 of hurricane-related assessments in 2005.
Management expects the Personal Lines segment to deliver 4% to 7% written premium growth in 2007, compared to written premium growth of 5% in 2006. Written premium growth of 3% to 6% in auto and 7% to 10% in homeowners is expected to come from growth in both AARP and Agency. For AARP business, management expects to achieve its targeted written premium growth primarily through an increase in marketing to AARP members. In addition to marketing through mail, magazines and other traditional channels, the Company plans to attract new customers by continuing to help AARP build its membership, using internet advertisements and placing more direct response television advertisements.
loss cost trends are expected to be less favorable in 2007, underwriting results in 2007 will benefit from the sale of Omni which generated an underwriting loss of $52 in 2006. The Company expects a 2007 combined ratio before catastrophes and prior accident year development in the range of 84.5 to 87.5. The combined ratio before catastrophes and prior accident year development was 86.4 in 2006.
To summarize, management’s outlook in Personal Lines for the 2007 full year is:
A combined ratio before catastrophes and prior accident year development of 84.5 to 87.5
Specialty Commercial offers a variety of customized insurance products and risk management services. The segment provides standard commercial insurance products including workers’ compensation, automobile and liability coverages to large-sized companies. Specialty Commercial also provides professional liability, fidelity and surety, specialty casualty and livestock coverages, as well as core property and excess and surplus lines coverages not normally written by standard lines insurers. Specialty Commercial provides other insurance products and services primarily to captive insurance companies, pools and self-insurance groups. In addition, Specialty Commercial provides third-party administrator services for claims administration, integrated benefits, loss control and performance measurement through Specialty Risk Services.
Earned premiums for the Specialty Commercial segment decreased by $207, or 12%, primarily due to decreases in casualty, property and other earned premiums, partially offset by an increase in professional liability, fidelity and surety earned premiums and the effect of $26 of catastrophe treaty reinstatement premium payable to reinsurers recorded as a reduction of earned premium in 2005.
Casualty earned premiums decreased by $220, or 28%, primarily because of the non-renewal of a single captive insurance program and a decline in new business written premium growth. Partially offsetting the decrease was an increase in premium retention and the effect of renewing a single large deductible policy as a retrospectively rated policy which bears a higher premium. The single captive insurance program accounted for earned premium of $241 for the year ended December 31, 2005.
Earned premiums for the Specialty Commercial segment increased by $31, or 2%, due to an increase in casualty, professional liability, fidelity and surety and other earned premiums, partially offset by a decrease in property earned premiums.
Underwriting results increased by $229, with a corresponding 13.5 point decrease in the combined ratio, to 95.9. The increase in underwriting results was principally driven by the following factors:
Net unfavorable prior accident year reserve development increased by $40, from $69 in 2004, to $109 in 2005. Net unfavorable prior accident year reserve development of $109 in 2005 included a $70 strengthening of workers’ compensation reserves for claim payments expected to emerge after 20 years of development and a $20 strengthening of reserves for large deductible workers’ compensation policies related to accident years 1999 to 2001. Reserve development in 2005 also included a release of reserves for directors and officers insurance related to accident years 2003 and 2004 and strengthening of prior accident year reserves for contracts that provide auto financing gap coverage and auto lease residual value coverage; the release and offsetting strengthening were each approximately $80. Net unfavorable prior accident year reserve development of $69 in 2004 included $167 of reserve strengthening for construction defect claims, a release of $116 in September 11 reserves and strengthening in large deductible workers’ compensation reserves and a release in other liability reserves, each approximately $150.
The ($19) decrease in current accident year underwriting results before catastrophes was primarily due to:
Contributing to the lower current accident year underwriting results in property were higher non-catastrophe losses and a reduction in profit commissions due to increased catastrophe losses. Contributing to the improvement in current accident year underwriting results for professional liability was a reduction in the current accident year loss and loss adjustment expense ratio, partially offset by a reduction in ceding commissions.
While casualty written premium declined during 2006 due largely to the non-renewal of a single captive insurance program, management expects a modest increase in casualty written premium in 2007. To grow specialty casualty business, the Company will focus on increasing its share of business with larger brokers and will continue to improve sales execution at regional offices. Within professional liability, fidelity and surety, management expects growth in professional liability and fidelity written premium, partially offset by a decline in surety bond written premium. Despite declining written pricing, management expects to grow professional liability written premium in 2007 by, among other things, expanding sales to small and middle market companies and larger private companies and writing more public employment practices liability insurance. Written premium growth could be lower than planned in any one or all of the Specialty Commercial businesses if written pricing is less favorable than anticipated and management determines that new and renewal business is not adequately priced.
The Other Operations segment includes operations that are under a single management structure, Heritage Holdings, which is responsible for two related activities. The first activity is the management of certain subsidiaries and operations of the Company that have discontinued writing new business. The second is the management of claims (and the associated reserves) related to asbestos, environmental and other exposures. The Other Operations book of business contains policies written from approximately the 1940s to 2003. The Company’s experience has been that this book of runoff business has, over time, produced significantly higher claims and losses than were contemplated at inception.
A change from an income tax expense of $10 in 2005 to an income tax benefit of $45 in 2006, as a result of a pre-tax loss in 2006.
A $62 decrease in net investment income, primarily as a result of a decrease in invested assets resulting from net losses and loss adjustment expenses paid.
With regard to both environmental and particularly asbestos claims, significant uncertainty limits the ability of insurers and reinsurers to estimate the ultimate reserves necessary for unpaid losses and related expenses. Traditional actuarial reserving techniques cannot reasonably estimate the ultimate cost of these claims, particularly during periods where theories of law are in flux. The degree of variability of reserve estimates for these exposures is significantly greater than for other more traditional exposures. In particular, the Company believes there is a high degree of uncertainty inherent in the estimation of asbestos loss reserves.
Reserves and reserve activity in the Other Operations segment are categorized and reported as asbestos, environmental, or “all other”. The “all other” category of reserves covers a wide range of insurance and assumed reinsurance coverages, including, but not limited to, potential liability for construction defects, lead paint, silica, pharmaceutical products, molestation and other long-tail liabilities.
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, 2006, 2005 and 2004.
As a result of the unfavorable trends observed in assumed casualty reinsurance, for the years ended December 31, 2005 and December 31, 2004, the Company booked unfavorable reserve development of $85 and $170, respectively, related to assumed reinsurance. In the second quarter 2006, the Company completed an updated evaluation of its assumed reinsurance reserves. As a result, the Company increased its domestic assumed reinsurance reserves by $12, primarily due to a reduction in amounts retroceded. In connection with the assumed reinsurance evaluation, the Company also recognized $8 of profit sharing commission income based on favorable loss performance of certain retroceded contracts. In the fourth quarter 2006, the Company completed an updated evaluation of its HartRe
assumed reinsurance reserves. The evaluation indicated no change in the Company’s assumed reinsurance reserves. The Company currently expects to perform a review of its HartRe assumed reinsurance liabilities annually.
During the third quarters of 2006, 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 all three years, the Company found estimates for individual cases changed based upon the particular circumstances of each account, although the reviews found no underlying cause or change in the claim environment. The net effect of these changes resulted in $43, $37 and $75 increases in net environmental liabilities in 2006, 2005 and 2004, respectively. The Company currently expects to continue to perform an evaluation of its environmental liabilities annually.
The Company divides its gross environmental exposure into Direct, which is subdivided further as: Accounts with future exposure greater than $2.5, Accounts with future exposure less than $2.5, and Other direct; Assumed Reinsurance; and London Market. The unallocated amounts in the Other direct category include an estimate of the necessary reserves for environmental claims related to direct insureds who have not previously tendered environmental claims to the Company.
An account may move between categories from one evaluation to the next. For example, an account with future expected exposure of greater than $2.5 in one evaluation may be reevaluated due to changing conditions and re-categorized as less than $2.5 in a subsequent evaluation or vice versa.
The following table displays gross environmental reserves and other statistics by category as of December 31, 2006.
The one year gross paid amount for total environmental claims is $112, resulting in a one year gross survival ratio of 3.2.
As of December 31, 2006, the allowance for uncollectible reinsurance for Other Operations totals $294. The Company currently expects to perform its regular comprehensive review of Other Operations reinsurance recoverables annually. 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.
Structured Settlements are those accounts where the Company has reached an agreement with the insured as to the amount and timing of the claim payments to be made to the insured.
The following table displays gross asbestos reserves and other statistics by policyholder category as of December 31, 2006
Gross Asbestos Reserves based on the second quarter 2006 asbestos reserve study.
Survival ratio is a commonly used industry ratio for comparing reserve levels between companies. While the method is commonly used, it is not a predictive technique. Survival ratios may vary over time for numerous reasons such as large payments due to the final resolution of certain asbestos liabilities, or reserve re-estimates. The survival ratio presented in the above table is computed by dividing the recorded reserves by the average of the past three years of payments. The ratio is the calculated number of years the recorded reserves would survive if future annual payments were equal to the average annual payments for the past three years. The 3-year gross survival ratio as December 31, 2006 is computed based on total paid losses of $2.7 billion for the period from January 1, 2004 to December 31, 2006.
As of December 31, 2006, the one year gross paid amount for total asbestos claims is $616, resulting in a one year gross survival ratio of 5.3.
Includes 28 open accounts at June 30, 2006. Included 32 open accounts at June 30, 2005.
Includes closed accounts (exclusive of Major Asbestos Defendants) and unallocated IBNR.
Excludes the $1.15 billion in payments for the MacArthur settlement in the first quarter of 2004.
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, 2006 of $2.57 billion ($2.25 billion and $322 for asbestos and environmental, respectively) is within an estimated range, unadjusted for covariance, of $1.99 billion to $3.05 billion. The process of estimating asbestos and environmental reserves remains subject to a wide variety of uncertainties, which are detailed in the “Critical Accounting Estimates-Property & Casualty Reserves, Net of Reinsurance” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations. Due to these uncertainties, further developments could cause the Company to change its estimates and ranges of its asbestos and environmental reserves, and the effect of these changes could be material to the Company’s consolidated operating results, financial condition and liquidity.
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.
London Market exposures are the most uncertain of the three categories of claims. As a participant in the London Market (comprised of both Lloyd’s of London and London Market companies), certain subsidiaries of the Company wrote business on a subscription basis, with those subsidiaries’ involvement being limited to a relatively small percentage of a total contract placement. Claims are reported, via a broker, to the “lead” underwriter and, once agreed to, are presented to the following markets for concurrence. This reporting and claim agreement process makes estimating liabilities for this business the most uncertain of the three categories of claims.
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 2007, Other Operations reinsurance recoverables and the allowance for uncollectible reinsurance in the second quarter 2007, and environmental liabilities in the third quarter of 2007. 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.
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 (losses) accounted for approximately 24%, 30% and 23% of the Company’s consolidated revenues for the years ended December 31, 2006, 2005 and 2004, respectively. The decrease in the percentage of consolidated revenues for 2006, as compared to the prior year, is primarily due to a smaller increase in the value of equity securities held for trading.
Fluctuations in interest rates affect the Company’s return on, and the fair value of, fixed maturity investments, which comprised approximately 68% and 72% of the fair value of its invested assets as of December 31, 2006 and 2005, respectively. Other events beyond the Company’s control could also adversely impact the fair value of these investments. Specifically, a downgrade of an issuer’s credit rating or default of payment by an issuer could reduce the Company’s investment return.
Derivative instruments are reported at fair value based upon either pricing valuation models, which utilize market data inputs or independent broker quotations. As of December 31, 2006 and 2005, approximately 84% and 81% of derivatives, respectively, based upon notional values, were priced via valuation models, while the remaining 16% and 19% of derivatives, respectively, were priced via broker quotations. These percentages exclude the GMWB rider and the associated reinsurance contracts, which are discussed in the Critical Accounting Estimates section of the MD&A under “Valuation of Guaranteed Minimum Withdrawal Benefit Derivatives”.
Fixed maturity investments increased $2.4 billion, or 5%, since December 31, 2005, primarily as the result of positive operating cash flows, product sales and an increase in the collateral held from increased securities lending activities, offset by an increase in interest rates. Equity securities held for trading increased $5.4 billion, or 22%, since December 31, 2005, due to positive cash flow primarily generated from sales and deposits related to variable annuity products sold in Japan and positive performance of the underlying investment funds supporting the Japanese variable annuity product. Mortgage loans increased $1.4 billion, or 92%, since December 31, 2005, as a result of a decision to continue to increase Life’s investment in this asset class primarily due to its attractive yields and diversification opportunities.
Limited partnerships increased by $363 or 84% during 2006. HIMCO believes investing in limited partnerships provides an opportunity to diversify its portfolio and earn above average returns over the long-term. However, significant price volatility can exist quarter to quarter. Prior to investing, HIMCO performs an extensive due diligence process which attempts to identify funds that have above average return potential and managers with proven track records for results, many of which utilize sophisticated risk management techniques. Due to capital requirements, HIMCO closely monitors the impact of these investments in relationship to the overall investment portfolio and the consolidated balance sheet. HIMCO does not expect investments in limited partnerships to exceed 3% of the fair value of Life’s investment portfolio excluding trading securities.
Hedge funds include investments in funds of funds as well as direct funds. The hedge funds of funds invest in approximately 40 to 90 different hedge funds within a variety of investment styles. Examples of hedge fund strategies include long/short equity or credit, event driven strategies and structured credit.
Private equity funds consist of investments in funds whose assets typically consist of a diversified pool of investments in small non-public businesses with high growth potential.
Mortgage and real estate funds consist of investments in funds whose assets consist of mortgage loans, participations in mortgage loans, mezzanine loans or other notes which may be below investment grade credit quality as well as equity real estate.
Represents dividend income and the change in value of equity securities held for trading.
Represents annualized net investment income (excluding income related to equity securities held for trading) divided by the monthly weighted average invested assets at cost or amortized cost, as applicable, excluding equity securities held for trading, the collateral received associated with securities lending programs and consolidated variable interest entity minority interests.
Primarily consists of changes in fair value on non-qualifying derivatives, changes in fair value of certain derivatives in fair value hedge relationships and hedge ineffectiveness on qualifying derivative instruments.
Net investment income, excluding equity securities held for trading and policy loans, increased $188, or 7%, compared to the prior year period. The increase in net investment income was primarily due to income earned on a higher average invested assets base, an increase in interest rates and a change in asset mix (i.e., greater investment in mortgage loans and limited partnerships). The increase in the average invested assets base, as compared to the prior year, was primarily due to positive operating cash flows, investment contract sales such as retail and institutional notes, and universal life-type product sales.
Net investment income on equity securities held for trading for the year ended December 31, 2006, can be primarily attributed to an increase in the value of the underlying investment funds supporting the Japanese variable annuity product generated by positive market performance.
For 2006, the yield on average invested assets increased slightly over the prior year. An increase in the yield on fixed maturities was offset by a decrease in the yield on limited partnerships. Based upon current market forward interest rate expectations, Life expects the average portfolio yield to remain consistent with 2006 levels in 2007. A higher yield is expected from changes in asset and quality mix offset by moderating partnership income.
Total net realized capital losses were higher in 2006 compared to 2005 primarily as a result of a higher interest rate environment. The components that drove the increase in net losses during the year ended December 31, 2006 included net losses on sales of fixed maturity securities, other-than-temporary impairments, periodic net coupon settlements and losses in Other, net, partially offset by a decrease in losses associated with GMWB derivatives and losses associated with the Japanese fixed annuity contract hedges. The circumstances giving rise to these components are as follows:
The periodic net coupon settlements on credit derivatives and the Japan fixed annuity cross currency swaps include the net periodic income/expense or coupon associated with the swap contracts. The net losses for the years ended December 31, 2006 and 2005,
were primarily associated with the Japan fixed annuity cross currency swaps and resulted from the interest rate differential between U.S. and Japanese interest rates. The increase in net losses in 2006 was primarily due to higher U.S. interest rates.
Other, net losses were primarily driven from the change in value of non-qualifying derivatives due to fluctuations in interest rates and foreign currency exchange rates. These losses were partially offset by a before-tax benefit of $25 received from the WorldCom security settlement.
A reduction in losses in 2006 compared to 2005, associated with the GMWB derivatives were primarily driven by a more significant impact from liability model refinements and assumption updates in 2005 as compared to 2006. For further discussion of the GMWB rider valuation assumption, see the Capital Markets Risk Management section of the MD&A under “Market Risk-Life”.
The Japanese fixed annuity contract hedges net amount consists of the foreign currency transaction remeasurements associated with the Yen denominated fixed annuity contracts offered in Japan and the corresponding offsetting cross currency swaps. Although the Japanese fixed annuity contracts are economically hedged, the net realized capital gains and losses result from the mixed attribute accounting model, which requires fixed annuity liabilities to be recorded at cost and remeasured only for foreign currency exchange rates but the associated derivatives to be reported at fair value. The net realized capital losses for the year ended December 31, 2006, resulted primarily from rising Japan interest rates while net realized capital losses for the year ended December 31, 2005, resulted from declining U.S. interest rates and rising Japan interest rates. The decrease in loss from 2005 to 2006 is primarily due to the hedging instruments used to manage the yen currency risk. Throughout 2006, the Company used pay variable U.S. dollar receive fixed yen, zero coupon currency swap while during the first half of 2005, the Company used pay fixed U.S. dollar receive fixed yen, zero coupon currency swap. This resulted in higher losses in 2005 as a result of declining U.S. interest rates. For additional discussion of the Japanese fixed annuity contract hedges see the Capital Markets Risk Management section of the MD&A under “Market Risk-Life” and Note 4 of Notes to Consolidated Financial Statements.
Net investment income on equity securities held for trading for the year ended December 31, 2005, can be primarily attributed to an increase in the value of the underlying investment funds supporting the Japanese variable annuity product generated by positive market performance. 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.
For 2005, the yield on average invested assets was relatively consistent with the prior year. An increase in yield as a result of higher partnership income was offset by a reduction in yield due to lower policy loan income.
Net realized capital losses were recognized for 2005 compared to net realized capital gains for 2004 primarily as a result of an increased interest rate environment. The significant components driving the changes in net realized capital gain and loss amounts between 2005 and 2004 include lower net gains on the sale of fixed maturity securities and losses associated with GMWB derivatives, Japanese fixed annuity contract hedges and periodic net coupon settlements. These losses were offset in part by gains in Other, net which was primarily related to changes in the value of non-qualifying foreign currency swaps. The circumstances giving rise to the changes in these components are as follows:
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.
The increase in net realized losses associated with the GMWB derivatives were primarily driven by the impact of liability model assumption updates in 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”.
The periodic net coupon settlements on credit derivatives and the Japan fixed annuity cross currency swaps includes the net periodic income/expense or coupon associated with the swap contracts. The net loss for 2005 is associated with the Japan fixed annuity cross currency swaps and results from the interest rate differential between U.S. and Japanese interest rates. The Japanese fixed annuity product was first offered by the Company in the fourth quarter 2004. The adverse change in 2005 in comparison to 2004 primarily resulted from a full year of the Japanese fixed annuity product swap accruals in 2005.
In 2005, gross gains were primarily within fixed maturities and included corporate, foreign government securities and CMBS. Corporate securities were sold primarily to reduce the Company’s exposure to certain lower credit quality issuers. The sale proceeds were primarily re-invested into higher credit quality securities. The gains on sales of corporate securities were primarily the result of credit spread tightening since the date of purchase. Foreign securities were sold primarily to reduce the foreign currency exposure in the portfolio due to the expected near term volatility in foreign exchange rates and to capture gains resulting from credit spread tightening since the date of purchase. The CMBS sales resulted from a decision to divest securities that were backed by a single asset due to the then scheduled expiration of the Terrorism Risk Insurance Act at the end of 2005, which was subsequently extended, in modified form, through the Terrorism Risk Insurance Act of 2005, through the end of 2007. Gains on these sales were realized as a result of an improved credit environment and interest rate declines from the date of purchase.
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 accounts wherein the policyholder assumes substantially all the risk and reward. Investment objectives for separate accounts, which consist of the participants’ account balances, vary by fund account type, as outlined in the applicable fund prospectus or separate account plan of operations. Separate account products include variable annuities (except those sold in Japan), variable universal life insurance contracts and variable corporate owned life insurance. The assets and liabilities associated with variable annuity products sold in Japan do not meet the criteria to be recognized as a separate account because the assets are not legally insulated from the Company. Therefore, these assets are included with the Company’s general account assets. As of December 31, 2006 and 2005, the Company’s separate accounts totaled $180.5 billion and $150.9 billion, respectively.
Before-tax net investment income increased $121, or 9%, and after-tax net investment income increased $91, or 9%, compared to the prior year. The increase in net investment income was primarily due to income earned on a higher average invested assets base, an increase in interest rates and a change in asset mix (i.e., greater investment in mortgage loans and limited partnerships). The increase in the average invested assets base, as compared to the prior year, can be attributed to positive operating cash flows.
For 2006, the yield on average invested assets was consistent with the prior year. An increase in the yield on fixed maturities was offset by a decrease in the yield on limited partnerships. Based upon current market forward interest rate expectancy, Property & Casualty expects the average portfolio yield to remain consistent with 2006 levels in 2007. A higher yield is expected from changes in asset and quality mix offset by moderating partnership income.
The decrease in net realized capital gains was primarily due to an increase in other-than-temporary impairments and losses on the sale of fixed maturity investments. For further discussion of gross gains and losses on fixed maturity investments and other-than-temporary impairments, see below.
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.
In 2005, the yield on average invested assets increased from the prior year as a result of higher partnership income. Excluding partnership income, the yield on average invested assets for 2005 was relatively consistent with the prior year.
As of December 31, 2006 and 2005, the Company had relationships with four and two VIEs, respectively, where the Company was the primary beneficiary.
The Company has a security monitoring process overseen by a committee of investment and accounting professionals that, on a quarterly basis, identifies securities that could potentially be other-than-temporarily impaired. When a security is deemed to be other-than-temporarily impaired, its cost or amortized cost is written down to current market value and a realized loss is recorded in the Company’s consolidated statements of operations. For fixed maturities, the company amortizes the new cost basis to par or to estimated future value over the remaining life of the security based on future estimated cash flows. For further discussion regarding the Company’s other-than-temporary impairment policy, see “Evaluation of Other-Than-Temporary Impairments on Available-for-Sale Securities” included in the Critical Accounting Estimates section of the MD&A and Note 1 of Notes to Consolidated Financial Statements.
The increase in other-than-temporary impairments during 2006 in comparison to 2005 and 2004 levels is primarily due to the decline in market value of certain issuers that may be adversely impacted by recapitalizations, pushing the Company’s interests lower in the repayment priority (i.e., leveraged buy-outs) or issuers using capital that would not benefit the company’s debt holders’ position (e.g., share repurchase programs) as well as an increase in interest rates from the date of security purchase.
During 2006, other-than-temporary impairments were primarily recorded on corporate fixed maturities, ABS and equity securities. Approximately $27 of other-than-temporary impairments were recorded on various corporate fixed maturities within the technology and communications sector, and approximately $19 relating to various companies within the consumer cyclical sector. Approximately $17 of other-than-temporary impairments were recorded on corporate fixed maturities within the utilities sector, of which $16 related to a single issuer. There were no other significant other-than-temporary impairments (i.e., $15 or greater) recorded on any single security or issuer. The ABS other-than-temporary impairments related primarily to investments backed by aircraft lease receivables. Impairments resulted from higher than expected maintenance expenses.
During 2005 there were no significant other-than-temporary impairments (i.e., $15 or greater) recorded on any single security or issuer. Other-than-temporary impairments recorded on ABS primarily related to deterioration of the underlying collateral supporting several securities and included $3 recorded on aircraft lease receivables related to one major U.S. carrier. These receivables are secured by certain older aircraft that recently experienced a significant decline in value. Other-than-temporary impairments recorded on equity securities primarily related to variable rate perpetual preferred securities issued by one highly-rated financial services company. These securities had sustained a decline in market value for an extended period of time as a result of issuer credit spread widening. The circumstances giving rise to the decline in value of these corporate securities since the date of purchase and potential impact on other material holdings of these issuers are as follows:
Approximately $15 of other-than-temporary impairments recorded on corporate securities related to three Canadian paper companies. These companies’ operations have recently suffered from high energy prices and falling demand, in part due to the appreciation of the Canadian dollar in comparison to the U.S. dollar. These investments continue to perform in accordance with the contractual terms of the securities. As of December 31, 2005, the Company held approximately $96 of securities issued by these three companies in a total net unrealized loss position of $5. Substantially all of the securities in an unrealized loss position, as of December 31, 2005, were depressed only to a minor extent and, as a result, the unrealized losses were deemed to be temporary in nature.
service burden. Through 2005, these investments performed in accordance with the contractual terms of the securities. As of December 31, 2005, the Company held approximately $137 of securities issued by these two companies in a total net unrealized loss position of $7. Substantially all of the securities in an unrealized loss position, as of December 31, 2005, were depressed only to a minor extent and, as a result, the unrealized losses were deemed to be temporary in nature.
During 2004, there were no significant other-than-temporary impairments (i.e., $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.
The Company has established investment credit policies that focus on the credit quality of obligors and counterparties, limit credit concentrations, encourage diversification and require frequent creditworthiness reviews. Investment activity, including setting of policy and defining acceptable risk levels, is subject to regular review and approval by senior management and by The Hartford’s Board of Directors.
The Company invests primarily in securities which are rated investment grade and has established exposure limits, diversification standards and review procedures for all credit risks including borrower, issuer and counterparty. Creditworthiness of specific obligors is determined by consideration of external determinants of creditworthiness, typically ratings assigned by nationally recognized ratings agencies and is supplemented by an internal credit evaluation. Obligor, asset sector and industry concentrations are subject to established Company limits and are monitored on a regular basis.
The Company is not exposed to any credit concentration risk of a single issuer greater than 10% of the Company’s stockholders’ equity other than U.S. government and certain U.S. government agencies. For further discussion of concentration of credit risk, see the “Concentration of Credit Risk” section in Note 4 of Notes to Consolidated Financial Statements.
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 A1/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 derivative contracts, other than exchange traded contracts, currency forward contracts, and certain embedded derivatives, be governed by an International Swaps and Derivatives Association Master Agreement which is structured by legal entity and by counterparty and permits right of offset. To date, the Company has not incurred any losses on derivative instruments due to counterparty nonperformance.
Credit default swaps involve a transfer of credit risk of one or many referenced entities 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 typically make a payment when there is a credit event and such payment will be
As of December 31, 2006, investment sector allocations as a percentage of total fixed maturities have not significantly changed since December 31, 2005, with the exception of CMBS and MBS. Throughout 2006, the Company increased its allocation to CMBS due to the securities’ attractive spread levels, underlying asset diversification and quality and increased participation in securities lending. The decrease in MBS is primarily related to an increase in dollar-roll activity. MBS dollar-roll transactions involve the sale and simultaneous agreement to repurchase a pool of underlying mortgage-backed securities at a future date. The forward purchase agreement is accounted for as a derivative until the repurchase of the MBS is settled, and accordingly, the rolled out securities are not included in the Consolidated Fixed Maturities by Type table above.
The following table presents the Company’s unrealized loss aging for total fixed maturity and equity securities classified as available-for-sale on a consolidated basis, as of December 31, 2006 and 2005, by length of time the security was in an unrealized loss position.
As a percentage of amortized cost, the average security unrealized loss at December 31, 2006, and December 31, 2005, was less than 3%. As of December 31, 2006, and December 31, 2005, fixed maturities represented $663, or 99%, and $750, or 99%, respectively, of the Company’s total unrealized loss associated with securities classified as available-for-sale. Other-than-temporary impairments for certain ABS and CMBS are recognized if the fair value of the security, as determined by external pricing sources, is less than its carrying amount and there has been a decrease in the present value of the expected cash flows since the last reporting period. There were no ABS or CMBS included in the table above, as of December 31, 2006 and 2005, for which management’s best estimate of future cash flows adversely changed during the reporting period for which an impairment has not been recorded. For further discussion of the other-than-temporary impairments criteria, see “Evaluation of Other-Than-Temporary Impairments on Available-for-Sale Securities” included in the Critical Accounting Estimates section of the MD&A and Note 1 of Notes to Consolidated Financial Statements.
The Company held no securities of a single issuer that were at an unrealized loss position in excess of 5% and 6%, respectively, of the total unrealized loss amount as of December 31, 2006 and 2005.
The increase in total unrealized losses greater than six months since December 31, 2005, was primarily driven by an increase in interest rates offset in part by asset sales and other-than-temporary impairments. With the exception of certain ABS security types, the majority of the securities in an unrealized loss position for six months or more as of December 31, 2006, were depressed primarily due to interest rate changes from the date of purchase. The sectors with the most significant concentration of unrealized losses were CMBS and corporate fixed maturities, most significantly within the financial services and utilities sectors. Also, ABS supported by aircraft lease receivables, although improving, continues to be a sector within the Company’s portfolios that contains the most significant concentration of credit risk. The Company’s current view of risk factors relative to these fixed maturity types is as follows:
CMBS - As of December 31, 2006, the Company held approximately 600 different securities that were in an unrealized loss position for greater than six months. The unrealized loss was 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, 2006. Additional changes in fair value of these securities are primarily dependent on future changes in interest rates.
Financial services - As of December 31, 2006, the Company held approximately 220 different securities in the financial services sector that were 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, 2006. 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 general market conditions, including interest rates and credit spread movements.
The evaluation for other-than-temporary impairments is a quantitative and qualitative process, which is subject to risks and uncertainties in the determination of whether declines in the fair value of investments are other-than-temporary. The risks and uncertainties include changes in general economic conditions, the issuer’s financial condition or near term recovery prospects and the effects of changes in interest rates. In addition, for securitized financial assets with contractual cash flows (e.g., ABS and CMBS), projections of expected future cash flows may change based upon new information regarding the performance of the underlying collateral. As of December 31, 2006 and 2005, 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 Company believes that an increase in interest rates from the current levels is generally a favorable development for the Company. Rate increases are expected to provide additional net investment income, increase sales of fixed rate Life investment products, reduce the cost of the GMWB hedging program, limit the potential risk of margin erosion due to minimum guaranteed crediting rates in certain Life products and, if sustained, could reduce the Company’s prospective pension expense. Conversely, a rise in interest rates will reduce the net unrealized gain position of the investment portfolio, increase interest expense on the Company’s variable rate debt obligations and, if long-term interest rates rise dramatically within a six to twelve month time period, certain Life businesses may be exposed to disintermediation risk. Disintermediation risk refers to the risk that policyholders will surrender their contracts in a rising interest rate environment requiring the Company to liquidate assets in an unrealized loss position. In conjunction with the interest rate risk measurement and management techniques, certain of Life’s fixed income product offerings have market value adjustment provisions at contract surrender.
The Company is also subject to equity risk based upon the assets that support its pension plans. The asset allocation mix is reviewed on a periodic basis. In order to minimize risk, the pension plans maintain a listing of permissible and prohibited investments. In addition, the pension plans have certain concentration limits and investment quality requirements imposed on permissible investment options. For further discussion of equity risk associated with the pension 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 foreign currency exchange risk is related to non-U.S. dollar denominated investments, which primarily consist of fixed maturity investments, the investment in and net income of the Japanese Life operation, and non-U.S. dollar denominated liability contracts, including 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.
Interest rate swaps and volatility swaps involve the periodic exchange of cash flows with other parties, at specified intervals, calculated using agreed upon rates or other financial variables and notional principal amounts. Generally, no cash or principal payments are exchanged at the inception of the contract. Typically, at the time a swap is entered into, the cash flow streams exchanged by the counterparties are equal in value.
Life is responsible for maximizing economic value within acceptable risk parameters, including the management of the interest rate sensitivity of invested assets, while generating sufficient after-tax income to support policyholder and corporate obligations. Life’s fixed maturity portfolios and certain investment contracts and insurance product liabilities have material market exposure to interest rate risk. In addition, Life’s operations are significantly influenced by changes in the equity markets. Life’s profitability depends largely on the amount of assets under management, which is primarily driven by the level of sales, equity market appreciation and depreciation and the persistency of the in-force block of business. Life’s foreign currency exposure is primarily related to non-U.S. dollar denominated fixed income securities, non-U.S. dollar denominated liability contracts, the investment in and net income of the Japanese Life operation and certain foreign currency based individual fixed annuity contracts, and its GMDB and GMIB benefits associated with its Japanese variable annuities.
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. Interest rate caps are also used to manage the duration risk in certain portfolios.
The Company’s operations are significantly influenced by changes in the equity markets, primarily in the U.S., but increasingly in Japan and other global markets. The Company’s profitability in its investment products businesses depends largely on the amount of assets under management, which is primarily driven by the level of sales, equity market appreciation and depreciation and the persistency of the in-force block of business. Prolonged and precipitous declines in the equity markets can have a significant effect on the Company’s operations, as sales of variable products may decline and surrender activity may increase, as customer sentiment towards the equity market turns negative. Lower assets under management will have a negative effect on the Company’s financial results, primarily due to lower fee income related to the Retail, Retirement Plans, Institutional and International and, to a lesser extent, the Individual Life segment, where a heavy concentration of equity linked products are administered and sold.
Furthermore, the Company may experience a reduction in profit margins if a significant portion of the assets held in the U.S. variable annuity separate accounts move to the general account and the Company is unable to earn an acceptable investment spread, particularly in light of the low to moderate interest rate environment and the presence of contractually guaranteed minimum interest credited rates, which for the most part are at a 3% rate.
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 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 in the U.S. 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 that allows the Company to offer attractive product features in tandem with prudent equity market risk management. In the absence of this innovation, the Company’s market share in one or more of its markets could decline. In recent years, the Company has experienced lower levels of U.S. variable annuity sales as competitors continue to introduce new equity guarantees of increasing risk and complexity. New product development is an ongoing process that the Company expects to use to combat competitive sales
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, absent an unlocking event, 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.
In Japan, the Company offers certain variable annuity products with both a guaranteed death benefit and a guaranteed income benefit. The Company maintains a liability for these death and income benefits, under SOP 03-1, of $35 as of December 31, 2006. Declines in equity markets as well as a strengthening of the Japanese Yen in comparison to the U.S. dollar may increase the Company’s exposure to these guaranteed benefits. This increased exposure may be significant in extreme market scenarios. For the guaranteed death benefits, the Company pays the greater of account value at death or a guaranteed death benefit which, depending on the contract, may be based upon the premium paid and/or the maximum anniversary value established no later than age 80, as adjusted for withdrawals under the terms of the contract. The guaranteed income benefit guarantees to return the contract holder’s initial investment, adjusted for any earnings or liquidity withdrawals, through periodic payments that commence at the end of a minimum deferral period of 10, 15 or 20 years as elected by the contract holder.
The net effect of the change in value of the embedded derivative net of the results of the hedging program for the years ended December 31, 2006 and 2005, was a (loss) of $(26) and $(46), respectively, before deferred policy acquisition costs and tax effects. As of December 31, 2006, the notional and fair value related to the embedded derivatives, the hedging strategy, and reinsurance was $53.3 billion and $377, respectively. As of December 31, 2005, the notional and fair value related to the embedded derivatives, the hedging strategy, and reinsurance was $45.5 billion and $166, respectively.
The Company employs additional strategies to manage equity market risk in addition to the derivative and reinsurance strategy described above that economically hedges the fair value of the U.S. GMWB rider. Notably, the Company purchases one and two year S&P 500 Index put option contracts to economically hedge certain other liabilities that could increase if the equity markets decline. As of December 31, 2006 and 2005, the notional value related to this strategy was $2.2 billion and $1.1 billion, respectively, while the fair value related to this strategy was $29 and $14, 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 risk associated with the non-U.S. dollar denominated fixed maturities relates to potential decreases in value and income resulting from unfavorable changes in foreign exchange rates. The fair value of the non-U.S. dollar denominated fixed maturities, which are primarily denominated in euro, sterling, yen and Canadian dollars, at December 31, 2006 and 2005, were approximately $1.9 billion. In order to manage its currency exposures, Life enters into foreign currency swaps and forwards to hedge the variability in cash flows associated with certain foreign denominated fixed maturities. These foreign currency swap agreements are structured to match the foreign currency cash flows of the hedged foreign denominated securities. At December 31, 2006 and 2005, the derivatives used to hedge currency exchange risk related to non-U.S. dollar denominated fixed maturities had a total notional value of $1.6 billion and $2.0 billion, respectively, and total fair value of $(336) and $(232), respectively.
In 2006, Life began issuing non-U.S. dollar denominated funding agreement liability contracts. The Company hedges the foreign currency risk associated with these liability contracts with currency rate swaps. At December 31, 2006, the derivatives used to hedge foreign currency exchange risk related to foreign denominated liability contracts had a total notional value of $585 and a total fair value of $(11).
Based on the fair values of Life’s non-U.S. dollar denominated investments and derivative instruments (including its yen based individual fixed annuity product) as of December 31, 2006 and 2005, management estimates that a 10% unfavorable change in exchange rates would decrease the fair values by an after-tax total of $3 and $6, respectively. The estimated impact was based upon a 10% change in December 31 spot rates. The selection of the 10% unfavorable change was made only for illustration of the potential hypothetical impact of such an event and should not be construed as a prediction of future market events. Actual results could differ materially from those illustrated above due to the nature of the estimates and assumptions used in the above analysis.
The primary exposure to interest rate risk in Property & Casualty relates to its fixed maturity securities, including corporate bonds, ABS, municipal bonds, CMBS and CMOs. The fair value of these investments was $27.2 billion and $25.3 billion at December 31, 2006 and 2005, 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 declines. A variety of derivative instruments, primarily swaps, are used to manage interest rate risk and had a total notional amount as of December 31, 2006 and 2005 of $2.1 billion and $1.5 billion, respectively, and fair value of $(4) and $(9), 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, 2006 and 2005, the derivatives used to hedge currency exchange risk had a total notional value of $805 and $515, respectively, and total fair value of $(45) and $(19), respectively.
Based on the fair values of Property & Casualty’s non-U.S. dollar denominated securities and derivative instruments as of December 31, 2006 and 2005, management estimates that a 10% unfavorable change in exchange rates would decrease the fair values by an after-tax total of approximately $34 and $50, respectively. The estimated impact was based upon a 10% change in December 31 spot rates. The selection of the 10% unfavorable change was made only for illustration of the potential hypothetical impact of such an event and should not be construed as a prediction of future market events. Actual results could differ materially from those illustrated above due to the nature of the estimates and assumptions used in the above analysis.
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 or other capital 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 were 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 than usual realized capital gains and losses or the Company would enter the capital markets to raise further funds to provide the requisite liquidity. For a discussion and tabular presentation of the Company’s current contractual obligations by period including those related to its Life and Property & Casualty insurance refer to the Off-Balance Sheet and Aggregate Contractual Obligations section below.
The 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 a good portion of the Company’s investment in its Japanese operations to be included as part of the aggregate statutory capital (for the purposes of regulatory and rating agency capital adequacy measures) of HLA.
On December 3, 2003, The Hartford’s shelf registration statement (Registration No. 333-108067) for the potential offering and sale of debt and equity securities in an aggregate amount of up to $3.0 billion was declared effective by the Securities and Exchange Commission. The Registration Statement allows for the following types of securities to be offered: (i) debt securities, preferred stock, common stock, depositary shares, warrants, stock purchase contracts, stock purchase units and junior subordinated deferrable interest debentures of the Company, and (ii) preferred securities of any of one or more capital trusts organized by The Hartford (“The Hartford Trusts”). The Company may enter into guarantees with respect to the preferred securities of any of The Hartford Trusts. As of December 31, 2006, the Company had $1.4 billion remaining under the shelf registration.
On February 12, 2007, The Hartford entered into a put option agreement (the “Put Option Agreement”) with Glen Meadow ABC Trust, a Delaware statutory trust (the “ABC Trust”), and LaSalle Bank National Association, as put option calculation agent. The Put Option Agreement provides The Hartford with the right to require the ABC Trust, at any time and from time to time, to purchase The Hartford’s junior subordinated notes (the “Notes”) in a maximum aggregate principal amount not to exceed $500. Under the Put Option Agreement, The Hartford will pay the ABC Trust premiums on a periodic basis, calculated with respect to the aggregate principal amount of Notes that The Hartford had the right to put to the ABC Trust for such period. The Hartford has agreed to reimburse the ABC Trust for certain fees and ordinary expenses.
As of December 31, 2006 and 2005, the Company’s Japanese operation line of credit in yen was ¥5 billion and ¥2 billion, respectively.
The revolving credit facility provides for up to $1.6 billion of unsecured credit. Of the total availability under the revolving credit facility, up to $100 is available to support letters of credit issued on behalf of The Hartford or other subsidiaries of The Hartford. Under the revolving credit facility, the Company must maintain a minimum level of consolidated 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 the syndicate of participating financial institutions. As of December 31, 2006, the Company was in compliance with all such covenants.
Under generally accepted accounting principles, the Company is only permitted to discount reserves for losses and loss adjustment expenses in cases where the payment pattern and ultimate loss costs are fixed and determinable on an individual claim basis. For the Company, these include claim settlements with permanently disabled claimants and certain structured settlement contracts that fund loss runoffs for unrelated parties. As of December 31, 2006, the total property and casualty reserves in the above table are gross of a reserve discount of $605.
Includes junior subordinated debentures of $0 and $691 and debt associated with equity units of $0 and $1,020 as of December 31, 2006 and 2005, respectively.
The Hartford’s total capitalization increased $2.9 billion as of December 31, 2006 as compared with December 31, 2005. This increase was due to a $3.6 billion increase in equity partially offset by a $664 decrease in debt. Total stockholders’ equity increased due to net income of $2.7 billion and issuance of shares from equity unit contracts of $1.0 billion in 2006. The decrease in debt was primarily due to repayments of commercial paper and long-term debt of $173 and $1.4 billion, respectively, partially offset by debt issuances of $990 in 2006.
In May 2006, $690 of senior notes originally issued in May 2003 in connection with the Company’s 7% equity units were remarketed on behalf of the holders of the equity units and the interest rate on the senior notes was reset to 5.55%. In connection with the remarketing, the Company purchased and retired $265 of the senior notes classified in long-term debt. See Note 14 of Notes to Consolidated Financial Statements.
On June 1, 2006, the Company repaid $250 of 2.375% senior notes at maturity.
During 2006, the Company issued $715 of commercial paper to finance the retirement of $265 of senior notes connected with the 7% equity units, the repayment of $250 of senior notes described above, and the redemption of $200 junior subordinated debentures described below. The Company used the proceeds from the settlement of the forward purchase contracts associated with the 7% equity units in August 2006 and cash on hand to pay down $690 of commercial paper.
On July 14, 2006, The Hartford retired its $200 7.625% junior subordinated debentures underlying the trust preferred securities due 2050 issued by Hartford Life Capital II at par.
On November 17, 2006, The Hartford retired its $500 7.45% junior subordinated debentures underlying the trust preferred securities due 2050 issued by Hartford Capital III at par. The Company recognized a loss on extinguishment of $17, after-tax, for the write-off of the unamortized issue costs and discount.
On November 16, 2006, the Company issued approximately 5.7 million shares of common stock in connection with the settlement of purchase contracts originally issued in September 2002 as components of our 6% equity units. The Company received proceeds of approximately $330 from the issuance of common stock in settlement of the purchase contracts.
Dividends - On February 22, 2007, The Hartford’s Board of Directors declared a quarterly dividend of $0.50 per share payable on April 2, 2007 to shareholders of record as of March 1, 2007.
The Hartford declared $531 and paid $460 in dividends to shareholders in 2006 and declared $350 and paid $345 in dividends to shareholders in 2005.
AOCI - AOCI increased by $88 to $178 as of December 31, 2006 compared with $90 as of December 31, 2005. The increase in AOCI is primarily due to total other comprehensive income of $554, offset by a $(466) decrease from SFAS 158 adjustment.
For the pension plans, an increase of $70, after-tax, which coincided with a $108 before-tax reduction in the liability. This was driven by:
For additional information on stockholders’ equity, AOCI, and pension and other postretirement plans see Notes 15, 16 and 17, respectively, of Notes to Consolidated Financial Statements.
The increase in cash from operating activities was primarily the result of premium cash flows in excess of claim payments and increased net income as compared to prior year period. Net purchases of available-for-sale securities accounted for the majority of cash used for investing activities. Cash provided by financing activities increased primarily due to higher net receipts from policyholder’s accounts related to investment and universal life contracts, proceeds from issuance of consumer notes and proceeds from issuance of shares from equity unit contracts, less the portion that was used for debt repayments.
On May 9, 2006, Standard & Poor’s raised its long-term and short-term counterparty credit ratings on The Hartford Financial Services Group, Inc. and Hartford Life Inc. to A/A-1 from A-/A-2. In addition, Standard & Poor’s affirmed its ‘AA-’ counterparty credit and financial strength ratings on the insurance operating companies. The outlook is stable.
On May 17, 2006, the President signed into law the Tax Increase Prevention and Reconciliation Act of 2005, which is not expected to be material to the Company. In addition, other tax proposals and regulatory initiatives which have been or are being considered by Congress could have a material effect on the insurance business. These proposals and initiatives include changes pertaining to the tax treatment of insurance companies and life insurance products and annuities, repeal or reform of the estate tax and comprehensive federal tax reform. The nature and timing of any Congressional action with respect to these efforts is unclear.
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 pay certain claims of the insolvent insurer. A particular state’s fund assesses its members based on their respective written premiums in the state for the classes of insurance in which the insolvent insurer was engaged. Assessments are generally limited for any year to one or two percent of premiums written per year depending on the state.