Total revenues of The Hartford are impacted by net investment income and mark-to-market effects of equity securities held for trading supporting the international variable annuity business, which have corresponding amounts credited to policyholders within benefits losses and loss adjustment expenses. 2008 revenues include net investment losses on equity securities held for trading of $10.3 billion. Also included in 2008 revenues are net realized capital losses of $5.9 billion.
2008 includes net realized capital losses of $3.6 billion, after-tax, including $2.5 billion, after-tax, in impairments.
Due to the net loss for the year ended December 31, 2008, no allocation of the net loss was made to the preferred shareholders under the two-class method in the calculation of basic earnings per share, as the preferred shareholders had no contractual obligation to fund the net losses of the Company. In the absence of the net loss, any such income would be allocated to the preferred shareholders based on the weighted average number of preferred shares outstanding as of December 31, 2008.
(Dollar amounts in millions, except for per share data, unless otherwise stated)
The Hartford is an insurance and financial services company with operations dating back to 1810. The Company is headquartered in Connecticut and is organized into two major operations: Life and Property & Casualty, each containing reporting segments. Within the Life and Property & Casualty operations, The Hartford conducts business principally in eleven reporting segments. Corporate primarily includes the Company’s debt financing and related interest expense, as well as other capital raising activities and purchase accounting adjustments.
Many of the principal factors that drive the profitability of The Hartford’s Life and Property & Casualty operations are separate and distinct. To present its operations in a more meaningful and organized way, management has included separate overviews within the Life and Property & Casualty sections of the MD&A. For further overview of Life’s profitability and analysis, see page 70. For further overview of Property & Casualty’s profitability and analysis, see page 94.
Reinsurance recoverables include an estimate of the amount of gross loss and loss adjustment expense reserves that may be ceded under the terms of the reinsurance agreements, including incurred but not reported unpaid losses. The Company calculates its ceded reinsurance projection based on the terms of any applicable facultative and treaty reinsurance, including an estimate of how incurred but not reported losses will ultimately be ceded by reinsurance agreement. Accordingly, the Company’s estimate of reinsurance recoverables is subject to similar risks and uncertainties as the estimate of the gross reserve for unpaid losses and loss adjustment expenses.
The Company provides an allowance for uncollectible reinsurance, reflecting management’s best estimate of reinsurance cessions that may be uncollectible in the future due to reinsurers’ unwillingness or inability to pay. The Company analyzes recent developments in commutation activity between reinsurers and cedants, recent trends in arbitration and litigation outcomes in disputes between reinsurers and cedants and the overall credit quality of the Company’s reinsurers. Where its contracts permit, the Company secures future claim obligations with various forms of collateral, including irrevocable letters of credit, secured trusts, funds held accounts and group-wide offsets. The allowance for uncollectible reinsurance was $379 as of December 31, 2008, including $254 related to Other Operations and $125 related to Ongoing Operations.
Reserves are set by line of business within the various operating segments. As indicated in the above table, a single line of business may be written in one or more of the segments. Case reserves are established by a claims handler on each individual claim and are adjusted as new information becomes known during the course of handling the claim. Lines of business for which loss data (e.g., paid losses and case reserves) emerge (i.e., is reported) over a long period of time are referred to as long-tail lines of business. Lines of business for which loss data emerge more quickly are referred to as short-tail lines of business. Within the Company’s Ongoing Operations, the shortest-tail lines of business are property and auto physical damage. The longest tail lines of business within Ongoing Operations include workers’ compensation, general liability, and professional liability. Assumed reinsurance, which is within Other Operations, is also long-tail business.
For short-tail lines of business, emergence of paid loss and case reserves is credible and likely indicative of ultimate losses. For long-tail lines of business, emergence of paid losses and case reserves is less credible in the early periods and, accordingly, may not be indicative of ultimate losses.
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”).
Compared to the paid development technique, the reported development technique has the advantage that a higher percentage of ultimate losses are reflected in reported losses than in cumulative paid losses. The reported development technique estimates only the unreported losses rather than the total unpaid losses. While the reported development technique takes advantage of information contained in the case reserves, estimates determined from this technique are affected by changes in case reserving practices.
The Company may analyze the data by coverage (e.g., bodily injury separate from property damage);
For one sub-set of professional liability business, management estimates frequency, not through historical claim count development, but through an analysis of the securities class actions filed and policy listings;
In the commercial liability lines, the Company performs the frequency / severity technique only on claims over a certain size;
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 given less emphasis 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.
Auto Liability - Commercial Lines, Package Business and Short-Tailed General Liability. As with Personal Lines auto liability, the Company performs a variety of techniques, including the paid and reported development methods and frequency / severity techniques. For older, more mature accident years, management finds that reported development techniques are best. For more recent accident years, management typically prefers frequency / severity techniques that allow it to make assumptions about the frequency of larger claims.
Long-Tailed General Liability, Fidelity and Surety and Large Deductible Workers’ Compensation. For these 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.
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. Total recorded net reserves, excluding asbestos and environmental, were higher than the actuarial indication of the reserves by 3.8% as of December 31, 2008 compared to 2.9% as of December 31, 2007.
During 2008, there were numerous changes to non-A&E reserve estimates. Among other loss developments in 2008, these changes included a $156 release of reserves for workers’ compensation claims, primarily related to accident years 2000 to 2007, a $105 release of general liability claims, primarily related to accident years 2001 to 2007, and a $75 release of reserves for professional liability claims related to accident years 2003 through 2006. See “Reserves” within the Property & Casualty MD&A for further discussion of reserve developments.
Within the commercial segments and the Other Operations segment, the Company has exposure to claims asserted for bodily injury as a result of long-term or continuous exposure to harmful products or substances. Examples include, but are not limited to, pharmaceutical products, silica and lead paint. The Company also has exposure to claims from construction defects, where property damage or bodily injury from negligent construction is alleged. The Company also has exposure to claims asserted against religious institutions and other organizations relating to molestation or abuse. Such exposures may involve potentially long latency periods and may implicate coverage in multiple policy periods. These factors make reserves for such claims more uncertain than other bodily injury or property damage claims. With regard to these exposures, the Company is monitoring trends in litigation, the external environment, the similarities to other mass torts and the potential impact on the Company’s reserves.
In both Small Commercial and Middle Market, workers’ compensation is the Company’s single biggest line of business and the line of business with the longest pattern of loss emergence. Reserve estimates for workers’ compensation are particularly sensitive to assumptions about medical inflation and the changing use of medical care procedures. In addition, changes in state legislative and regulatory environments impact the Company’s estimates. These changes increase the uncertainty in the application of development patterns. In addition, over the past several accident years, the Company has experienced favorable claim frequency on workers’ compensation claims. The Company’s reserve estimates assume that reported losses for recent accident years will continue to emerge favorably and that severity will not be adversely impacted by the lower volume of reported claims.
Recorded reserves for auto liability, net of reinsurance, are $2.3 billion across all lines, $1.6 billion of which is in Personal Lines. Personal auto liability reserves are shorter-tailed than other lines of business (such as workers’ compensation) and, therefore, less volatile. However, the size of the reserve base means that future changes in estimates could be material to the Company’s results of operations in any given period. The key assumption for Personal Lines auto liability is the annual loss cost trend, particularly the severity trend component of loss costs. A review of Insurance Services Office (“ISO”) data suggests that annual growth in industry severity since 1999 has varied from +1% to +6%. The ISO data shows recent severity changes to be in the middle of this range. A 2.5 point change in assumed annual severity is within historical variation for the industry and for the Company. A 2.5 point change in assumed annual severity for the two most recent accident years would change the estimated net reserve need by $90, in either direction. Assumed annual severity for accident years prior to the two most recent accident years is likely to have minimal variability.
Recorded reserves for workers’ compensation, net of reinsurance, are $6.3 billion in total for Ongoing Operations. Paid loss development patterns are a key assumption for this line of business, particularly for more mature accident years. Historically, paid loss development patterns have been impacted by, among other things, medical cost inflation. The Company has reviewed the historical variation in reported loss development patterns. If the reported loss development patterns change by 4%, the estimated net reserve need would change by $400, in either direction. A 4% change in reported loss development patterns is within historical variation, as measured by the variation around the average development factors as reported in statutory accident year reports.
Similarly, a ground-up exposure review approach is used to establish environmental reserves. The Company’s evaluation of its insureds’ estimated liabilities for environmental claims involves consideration of several factors, including historical values of similar claims, the number of sites involved, the insureds’ alleged activities at each site, the alleged environmental damage at each site, the 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.
It is also not possible to predict changes in the legal and legislative environment and their effect on the future development of asbestos and environmental claims. Although potential Federal asbestos-related legislation was considered by the Senate in 2006, it is uncertain whether such legislation will be reconsidered or enacted in the future and, if enacted, what its effect would be on the Company’s aggregate asbestos liabilities.
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, 2008 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.
Life’s deferred policy acquisition costs asset and present value of future profits (“PVFP”) intangible asset (hereafter, referred to collectively as “DAC”) related to investment contracts and universal life-type contracts (including variable annuities) are amortized in the same way, over the estimated life of the contracts acquired 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 (“URR”). Components of EGPs are used to determine reserves for guaranteed minimum death, income and universal life secondary guarantee benefits accounted for and collectively referred to as “SOP 03-1 reserves”. The specific breakdown of the most significant EGP based balances by segment is as follows:
Products sold in a particular year are aggregated into cohorts. Future gross profits for each cohort are projected over the estimated lives of the underlying contracts, and are, to a large extent, a function of future account value projections for variable annuity products and to a lesser extent for variable universal life products. The projection of future account values requires the use of certain assumptions. The assumptions considered to be important in the projection of future account value, and hence the EGPs, include separate account fund performance, which is impacted by separate account fund mix, less fees assessed against the contract holder’s account balance, surrender and lapse rates, interest margin, mortality, and hedging costs. The assumptions are developed as part of an annual process and are dependent upon the Company’s current best estimates of future events. The Company’s current 20 year separate account return assumption is approximately 7.2% (after fund fees, but before mortality and expense charges) for U.S. products and 5.1% (after fund fees, but before mortality and expense charges) in aggregate for all Japanese products, but varies from product to product. The Company estimates gross profits using the mean of EGPs derived from a set of stochastic scenarios that have been calibrated to our estimated separate account return. The following table summarizes the general impacts to individual variable annuity EGPs and earnings for DAC amortization caused by changes in separate account returns, mortality and future lapse rate assumptions:
Increase: Expected fee income would increase because the time period in which fees would be collected would increase and claims would decrease
Increase: Expected fee income would increase because the time period in which fees would be collected would increase and claims would increase.
As described above, as of September 30 2008, the Company completed a comprehensive study of assumptions underlying EGPs, resulting in an Unlock. The study covered all assumptions, including mortality, lapses, expenses, interest rate spreads, hedging costs, and separate account returns, in substantially all product lines. The new best estimate assumptions were applied to the current policy related in-force or account values to project future gross profits. The after-tax impact on the Company’s assets and liabilities as a result of the Unlock during the third quarter of 2008 was as follows:
Actual separate account returns from the period ending July 31, 2007 to September 30, 2008 were significantly below our aggregated estimated return.
The overall actual return generated by the U.S. variable annuity separate accounts is dependent on several factors, including the relative mix of the underlying sub-accounts among bond funds and equity funds as well as equity sector weightings and as a result of the large proportion of separate account assets invested in U.S. equity markets, the Company’s overall U.S. separate account fund performance has been reasonably correlated to the overall performance of the S&P 500 although no assurance can be provided that this correlation will continue in the future. Since September 30, 2008, the date of the last unlock, the actual return on U.S. variable annuity assets has been 21% below our estimated aggregate return. The Company estimates the actual return would need to drop by an additional 6% since December 31, 2008, before EGPs in the Company’s models fall outside of the statistical ranges of reasonable EGPs.
For the Company’s 3Win product in Japan, decreases in the contract holder’s account value (which is partially dependent upon equity market movements due to fixed contractual investment allocations) of greater than 20% of the initial deposit require the contract holder to withdraw 80% of their initial deposit without penalty or recover their initial investment through a payout annuity. The exercise of these options results in an acceleration of the amount of DAC amortization in a specific reporting period. During the fourth quarter of 2008 approximately 97% of all 3Win contractholders had account values that fell by 20% or more from their initial deposit. This resulted in accelerated amortization of DAC in the fourth quarter of 2008 of $194, pre-tax. Further declines in equity markets during 2009 could cause the entire remaining DAC balance of $11 to be amortized.
Capital market assumptions can significantly change the value of embedded derivative living benefit guarantees. 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 increasing the value of the embedded derivative liability as of December 31, 2008 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 decreasing mortality, future increasing usage of the step-up feature and decreases in lapses will all have the effect of increasing the value of the GMWB embedded derivative liability as of December 31, 2008 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 decreasing the value of the embedded derivative liability as of December 31, 2008 resulting in a realized gain in net income. As markets change, mature and evolve and actual policyholder behavior emerges, management continually evaluates the appropriateness of its assumptions. In addition, management regularly evaluates the valuation model, incorporating emerging valuation techniques where appropriate, including drawing on the expertise of market participants and valuation experts.
Represents securities for which adjustments were made to reduce prices received from third parties and certain private equity investments that are carried at the Company’s determination of fair value from inception. [2] Short-term investments are primarily valued at amortized cost, which approximates fair value.
Corporate matrix priced represents private placement securities that are thinly traded and priced using a pricing matrix which includes significant non-observable inputs.
CMBS primarily represents CMBS bonds and commercial real estate collateralized debt obligations (“CRE CDOs”) which were either fair valued by the Company or by independent brokers due to the illiquidity of this sector.
Derivative instruments are reported on the consolidated balance sheets at fair value and are reported in Other Investments and Other Liabilities. Derivative instruments are fair valued using pricing valuation models, which utilize market data inputs or independent broker quotations. As of December 31, 2008 and 2007, 94% and 89% of derivatives, respectively, based upon notional values, were priced by valuation models, which utilize independent market data. The remaining derivatives were priced by broker quotations. The derivatives are valued using mid-market level inputs, with the exception of the customized swap contracts that hedge GMWB liabilities, that are predominantly observable in the market. Inputs used to value derivatives include, but are not limited to, interest swap rates, foreign currency forward and spot rates, credit spreads and correlations, interest and equity volatility and equity index levels. The Company performs a monthly analysis on derivative valuations which includes both quantitative and qualitative analysis. Examples of procedures performed include, but are not limited to, review of pricing statistics and trends, back testing recent trades, analyzing the impacts of changes in the market environment, and review of changes in market value for each derivative including those derivatives priced by brokers.
The evaluation of securities for impairments is a quantitative and qualitative process, which is subject to risks and uncertainties and is intended to determine whether declines in the fair value of investments should be recognized in current period earnings. The risks and uncertainties include changes in general economic conditions, the issuer’s financial condition or future prospects, the effects of changes in interest rates or credit spreads and the expected recovery period. The Company has a security monitoring process overseen by a committee of investment and accounting professionals (“the committee”) that identifies securities that, due to certain characteristics, as described below, are subjected to an enhanced analysis on a quarterly basis. Based on this evaluation, during 2008, the Company concluded $4.0 billion of unrealized losses were other-than-temporarily impaired and as of December 31, 2008, the Company’s unrealized losses on available-for-sale securities of $14.6 billion were temporarily impaired.
Each quarter, during this analysis, the Company asserts its intent and ability to retain until recovery those securities judged to be temporarily impaired. Once identified, these securities are systematically restricted from trading unless approved by the committee. The committee will only authorize the sale of these securities based on predefined criteria that relate to events that could not have been reasonably foreseen. Examples of the criteria include, but are not limited to, the deterioration in the issuer’s creditworthiness, a change in regulatory requirements or a major business combination or major disposition.
Pursuant to accounting principles related to the Company’s pension and other postretirement obligations to employees under its various benefit plans, the Company is required to make a significant number of assumptions in order to calculate the related liabilities and expenses each period. The two economic assumptions that have the most impact on pension and other postretirement expense are the discount rate and the expected long-term rate of return on plan assets. In determining the discount rate assumption, the Company utilizes a discounted cash flow analysis of the Company’s pension and other postretirement obligations and currently available market and industry data. The yield curve utilized in the cash flow analysis is comprised of bonds rated Aa or higher with maturities primarily between zero and thirty years. Based on all available information, it was determined that 6.25% was the appropriate discount rate as of December 31, 2008 to calculate the Company’s pension and other postretirement obligation. Accordingly, the 6.25% discount rate will also be used to determine the Company’s 2009 pension and other postretirement expense. At December 31, 2007, the discount rate was also 6.25%.
Pension expense reflected in the Company’s net income was $122, $131 and $152 in 2008, 2007 and 2006, respectively. The Company estimates its 2009 pension expense will be approximately $134, based on current assumptions. To illustrate the impact of these assumptions on annual pension expense for 2009 and going forward, a 25 basis point decrease in the discount rate will increase pension expense by approximately $12 and a 25 basis point change in the long-term asset return assumption will increase/decrease pension expense by approximately $9.
Management follows the requirements of SFAS No. 5 “Accounting for Contingencies.” This statement requires management to evaluate each contingent matter separately. A loss is recorded if probable and reasonably estimable. Management establishes reserves for these contingencies at its “best estimate,” or, if no one number within the range of possible losses is more probable than any other, the Company records an estimated reserve at the low end of the range of losses.
In 2008, the Company completed three acquisitions that resulted in additional goodwill of $79 in Retirement Plans.
As of December 31, 2007, the Company had goodwill allocated to the following reporting units:
Management’s determination of the fair value of each reporting unit incorporates multiple inputs including discounted cash flow calculations, peer company price to earnings multiples, the level of the Company’s own share price and assumptions that market participants would make in valuing the reporting unit. Other assumptions include levels of economic capital, future business growth, earnings projections, assets under management for Life reporting units and the weighted average cost of capital used for purposes of discounting. Decreases in the amount of economic capital allocated to a reporting unit, decreases in business growth, decreases in earnings projections and increases in the weighted average cost of capital will all cause the reporting unit’s fair value to decrease.
The Company completed its annual goodwill assessment for the individual reporting units within Life and Property & Casualty as of January 1, 2008 and September 30, 2008, respectively. The conclusion reached as a result of the annual goodwill impairment testing was that the fair value of each reporting unit, for which goodwill had been allocated, was in excess of the respective reporting unit’s carrying value (the first step of the goodwill impairment test).
As a result of the testing performed during the fourth quarter of 2008, which included the effects of decreasing sales outlooks and declining equity markets on future earnings, the fair value for each reporting unit continued to be in excess of the respective reporting unit’s carrying value except for the Life Individual Annuity and International reporting units. For both of these reporting units, the Company concluded that the fair value of the reporting unit had declined significantly, as evidenced by the decline in the Company’s share price, due to the significant risks associated with the product suite discussed above. As a result of the step 2 analysis, the allocation of the fair value of the Individual Annuity and International reporting units to their respective assets and liabilities as of December 31, 2008 indicated an implied level of goodwill of $0 for both reporting units. Therefore, the Company recorded an impairment charge of $730 and $15 of goodwill which had been allocated to the Individual Annuity and International reporting units, respectively.
Net income decreased primarily due to decreases in Life of $4.0 billion for the year ended December 31, 2008 compared to the year ended December 31, 2007. Additionally, Property & Casualty net income decreased $1.4 billion for the year ended December 31, 2008 compared to the year ended December 31, 2007. Corporate results decreased primarily due to a goodwill impairment charge of $323, after-tax.
Realized losses increased as compared to the comparable prior year period primarily due to impairments on investment securities and net losses from the adoption of SFAS 157. For further discussion, please refer to the Realized Capital Gains and Losses by Segment table under Life’s Operating Section of the MD&A.
Net investment income on securities, available-for-sale, and other declined primarily due to declines in limited partnership and other alternative investments income and a decrease in investment yield for fixed maturities.
The effective tax rate for 2008, 2007 and 2006 was 40%, 26%, and 24%, respectively. The principal causes of the difference between the effective rate and the U.S. statutory rate of 35% for 2008, 2007 and 2006 were tax-exempt interest earned on invested assets and the separate account dividends received deduction (“DRD”). This caused an increase in the tax benefit on the 2008 pre-tax loss and a decrease in the tax expense on the 2007 and 2006 pre-tax income. Income taxes paid in 2008, 2007 and 2006 were $253, $451, and $179 respectively. For additional information, see Note 13 of Notes to Consolidated Financial Statements.
For additional information on earnings (losses) per common share see Note 2 of Notes to Consolidated Financial Statements.
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, and in the past have differed, 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.
During 2008, the Company has been negatively impacted by conditions in the global financial markets and economic conditions in general. As these conditions persist in 2009, the Company would anticipate that it would continue to be negatively impacted, including the effect of rating downgrades that have occurred and those that could occur in the future. See Risk Factors in Item 1A.
Significant declines in equity markets and increased equity market volatility are also likely to continue to impact the cost and effectiveness of our GMWB hedging program. Continued equity market volatility could result in material losses in our hedging program. For more information on the GMWB hedging program, see the Equity Risk Management section within Capital Markets Risk Management.
During periods of volatile equity markets, policyholders may allocate more of their variable account assets to the fixed account options and fixed annuities may see increased deposits. In the fourth quarter of 2008, the Company has seen an increase in fixed annuity deposits compared to prior quarters. Management expects this trend to continue throughout 2009 or until the equity markets begin to stabilize and improve.
For the retail mutual fund business net sales can vary significantly depending on market conditions. The Company has seen a decline in mutual fund deposits and net flows during the fourth quarter as a result of increased equity market volatility and the declines in equity values throughout the fourth quarter. As this business continues to evolve, success will be driven by diversifying net sales across the mutual fund platform, delivering superior investment performance and creating new investment solutions for current and future mutual fund shareholders.
The future financial results of the Retirement Plans segment will depend on Life’s ability to increase assets under management across all businesses, achieve scale in areas with a high degree of fixed costs and maintain its investment spread earnings on the general account products sold largely in the 403(b)/457 business. Disciplined expense management will continue to be a focus and additional investments in service and technology will occur.
During 2008, the Company completed three Retirement Plans acquisitions. The acquisition of part of the defined contribution record keeping business of Princeton Retirement Group gives Life a foothold in the business of providing recordkeeping services to large financial firms which offer defined contribution plans to their clients and at acquisition added $2.9 billion in mutual funds to Retirement Plans assets under management and $5.7 billion of assets under administration. The acquisition of Sun Life Retirement Services, Inc., at acquisition added $15.8 billion in Retirement Plans assets under management across 6,000 plans and provides new service locations in Boston, Massachusetts and Phoenix, Arizona. The acquisition of TopNoggin LLC., provides web-based technology to address data management, administration and benefit calculations. These three acquisitions were not accretive to 2008 net income. Furthermore, net income as a percentage of assets is expected to be lower in 2009 reflecting a full year of the new business mix represented by the acquisitions, which includes larger, more institutionally priced plans, predominantly executed on a mutual fund platform, and the cost of maintaining multiple technology platforms during the integration period.
Given the recent market declines and increased volatility during the fourth quarter of 2008, the Company has seen and expects that growth in Retirement deposits will be negatively affected if businesses reduce their workforces and offer more modest salary increases and as workers potentially allocate less to retirement accounts in the near term. The severe decline in equity markets in the second half of 2008 has significantly reduced Retirement Plans assets under management, which has strained its net income. This earnings strain is expected to continue throughout 2009 or until the equity markets improve.
The current economic downturn has resulted in rising unemployment combined with the potential for employees to lessen spending on the Company’s products may impact future premium growth. Nonetheless, employees continue to look to the workplace for a broader and ever expanding array of insurance products. As employers design benefit strategies to attract and retain employees, while attempting to control their benefit costs, management believes that the need for the Company’s products will continue to expand. This combined with the significant number of employees who currently do not have coverage or adequate levels of coverage, creates opportunities for our products and services.
Financial results depend on the account values of our customers, which are affected by equity, bond and currency markets. Periods of favorable market performance will increase assets under management and thus increase fee income earned on those assets, while unfavorable market performance will have the reverse effect. In addition, higher or lower account value levels, whether driven by market or currency impacts on the underlying investments, will generally reduce or increase, respectively, certain costs for individual annuities to the Company, such as guaranteed minimum death benefits (“GMDB”), guaranteed minimum income benefits (“GMIB”), guaranteed minimum accumulation benefits (“GMAB”) and guaranteed minimum withdrawal benefits (“GMWB”). In addition, International’s financial results are significantly impacted by the exchange rate between the U.S. dollar and the Japanese yen. Prudent expense management is also an important component of product financial results.
In 2009, the Company expects to increase its auto and homeowners written premium generated from direct sales to the consumer and from agents selling the AARP product. In 2008, the Company launched a brand and channel expansion pilot in four states: Arizona, Illinois, Tennessee and Minnesota and expects to expand the initiative to additional states in 2009. In the targeted states, the Company will increase Personal Lines brand advertising and launch direct marketing efforts beyond its existing AARP program. In addition, certain agents in the targeted states will be authorized to offer the Company’s AARP product.
Within Specialty Commercial, management expects written premium to be flat to slightly lower, primarily driven by a decrease in property written premium, largely offset by an increase in professional liability, fidelity and surety written premium and an increase in casualty written premium.
Small Commercial experienced favorable frequency on workers’ compensation claims in recent accident years and management expects favorable frequency to continue for the 2009 accident year though not as favorable as it has been. While the Company experienced favorable non-catastrophe property losses on package business and commercial auto claims in 2008, management expects that severity will increase for non-catastrophe property claims in 2009 and that frequency will be less favorable.
On professional liability business within Specialty Commercial, the Company expects its losses from the fallout of the sub-prime mortgage market and from the alleged Madoff fraud to be manageable based on several factors. Principal among them is the diversified nature of the product and customer portfolio, with the majority of the Company’s total in-force professional liability net written premium derived from policyholders with privately-held ownership and, therefore, relatively low shareholder class action exposure. The Company’s average net limit exposed is $8 at an average attachment point of $74 on reported claims or notices of potential claims on sub-prime exposed policies. While the Madoff alleged fraud case continues to evolve, based on the involved parties noted in press reports to date, the Company expects a limited number of its policies will be exposed and, based on the net limits expected to be at risk, does not expect its losses from the Madoff case will be material.
Current accident year catastrophe losses in 2008, at 5.3 percent of Ongoing Operations’ earned premium, were higher than the long-term historical average due principally to hurricane Ike and higher than average losses from tornadoes and thunderstorms in the South and Midwest. While catastrophe losses vary significantly from year to year and are unpredictable, management has assumed that catastrophe losses in 2009 will be closer to 3% to 3.5% of earned premium. The Company will continue to manage its exposure to catastrophe losses through the ongoing assessment of its risk, disciplined underwriting and the use of reinsurance and other risk transfer alternatives, as appropriate. As of January 1, 2009, the Company’s retention under its principal property catastrophe reinsurance program remained at $250 per catastrophe event. With the January 1, 2009 renewal, the cost of the Company’s principal property catastrophe reinsurance program increased modestly.
Driven primarily by an expected increase in loss costs and underwriting expenses, the Company expects the Ongoing Operations’ combined ratio before catastrophes and prior accident year development in 2009 to be higher than the 88.9 achieved in 2008. At the segment level, the combined ratio before catastrophes and prior accident year development is expected to be higher in 2009 for Personal Lines, Small Commercial and Middle Market as increases in loss costs are expected to outpace earned pricing. For Specialty Commercial, management expects that the combined ratio before catastrophes and prior accident year development for 2009 will be in line with the ratio for 2008.
Property & Casualty operating cash flow is expected to be less favorable in 2009 than in 2008, although still positive. Based upon the current interest rate and credit environment, Property & Casualty expects a slightly higher investment portfolio yield for 2009.
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. The Company expects to perform its regular reviews of asbestos liabilities in the second quarter of 2009, Other Operations reinsurance recoverables and the allowance for uncollectible reinsurance in the second quarter 2009, and environmental liabilities in the third quarter of 2009. 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.
Retirement Plans offers retirement plan products and services to corporations and municipalities under Section 401(k), 403(b) and 457 plans.
International, which has operations located in Japan, Brazil, Ireland and the United Kingdom, provides investments, retirement savings and other insurance and savings products to individuals and groups outside the United States and Canada.
Includes the effect of the triggering of the guaranteed minimum income benefit (“GMIB”) for the 3 Win product of which $(809) relates to policyholders surrendering and $(170) relates to the current period annuity payments.
Assets under management, across all businesses have had substantial reductions in values from prior year primarily due to declines in equity markets during 2008. The changes in line of business assets under management have also been affected by:
Individual Life insurance in-force growth has occurred across multiple product lines, including term, universal life and variable universal life.
Retirement Plans group annuities has seen positive net flows driven by higher deposits as a result of the expanded sales force obtained through the 2008 acquisitions.
Retirement Plans mutual funds reflects an increase of $18.7 billion from the acquisition of servicing rights of Sun Life Retirement Services, Inc and Princeton Retirement Group, both of which closed in the first quarter of 2008. Net sales for 2008 reflect expected outflows on the acquired business.
International - Japan Annuities has seen positive net flows and favorable effects from currency exchange rates for 2008. Net flows have decreased in Japan annuities due the 3 Win trigger and to increased competition from domestic and foreign insurers, particularly competition relating to products offered with living benefit guarantees.
Individual Life variable universal life account values increased primarily due to market appreciation and positive net flows. Life insurance in-force increased from the prior periods due to business growth.
International - Japan annuity account values continue to grow as a result of positive net flows and a strengthening of the yen versus the dollar offset by a decline in market performance throughout the year
Fully insured ongoing sales, excluding buyouts, increased in 2008 from 2007 primarily due to national account and small case sales growth. Fully insured ongoing sales, excluding buyouts, declined in 2007 from 2006 primarily due to fewer large national account sales, and the small case competitive environment remained intense. The Company also completed a renewal rights arrangement associated with its medical stop loss business during the second quarter of 2007 eliminating new sales related to this business. In addition, there was an anticipated decrease in association life sales from an unusually high comparable prior year period.
The second major category is insurance operating costs and expenses, which is commonly expressed in a ratio of a revenue measure depending on the type of business. The third major category is the amortization of deferred policy acquisition costs and the present value of future profits, which is typically expressed as a percentage of pre-tax income before the cost of this amortization (an approximation of actual gross profits). Retail - Individual Annuity business accounts for the majority of the amortization of deferred policy acquisition costs and present value of future profits for Life.
Excludes the effects of realized gains and losses except for net periodic settlements. Included in the net realized capital gains (losses) are amounts that represent the net periodic accruals on currency rate swaps used in the risk management of Japan fixed annuity products.
See Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A.
Group Benefits expense ratio, excluding buyouts decreased primarily due to lower commission expense.
Retail - Individual Annuity general insurance expense ratio increased in 2007 primarily due to higher service and technology costs.
Included in the net realized capital gain (losses) are amounts that represent the net periodic accruals on currency rate swaps used in the risk management of Japan fixed annuity products.
See Unlock and Sensitivity Analysis within the Critical Accounting Estimates section of the MD&A.
The decrease in Individual Life’s after-tax margin, excluding realized gains (losses) and the effect of the DAC Unlock, was due to lower net investment income from limited partnership and other alternative investments, unfavorable mortality expense, reduced net investment income associated with a more efficient capital approach for our secondary guarantee universal life business which released assets supporting capital and lower variable life insurance fees from equity market declines, partially offset by life insurance in-force growth, lower credited rates and higher surrender charges.
The decrease in Institutional’s ROA, excluding realized gains (losses), is primarily due to a decline in limited partnership and other alternative investment income. The decrease is also due to unfavorable mortality and lower yields on fixed maturity investments.
The increase in Individual Annuity’s ROA, excluding realized gains (losses) and DAC Unlock, was primarily due to increased net investment income on allocated capital and an increase in limited partnership and other alternative investment income. This was partially offset by an increase in the effective tax rate as a result of revisions in the estimates of the separate account DRD and FTC.
Individual Life’s decrease in after-tax margin, excluding realized gains (losses) and DAC Unlock, was primarily due to unfavorable mortality experience.
The increase in the Group Benefits after-tax margin, excluding buyouts, excluding realized gains (losses), was due to an improvement in the loss ratio, partially offset by higher DAC amortization.
The transition impact related to the SFAS 157 adoption was a reduction in net income of $220 for the year ended December 31, 2008. For further discussion of the SFAS 157 transition impact, refer to Note 4 of the Notes to the Consolidated Financial Statements.
Realized losses increased as compared to the comparable prior year period primarily due to net losses from the adoption of SFAS 157 and impairments on investment securities. For further discussion, please refer to the Realized Capital Gains and Losses by Segment table under Life’s Operating Section of the MD&A.
Life recorded a DAC unlock charge of $941, after-tax, during the third quarter of 2008 as compared to a DAC unlock benefit of $210, after-tax, during the third quarter of 2007. See Critical Accounting Estimates with Managements Discussion and Analysis for a further discussion on the DAC unlock.
The DAC Unlock benefit of $210 recorded in the third quarter of 2007.
See Note 4 of the Notes to the Consolidated Financial Statements for a discussion of the SFAS 157 transition impact.
See Note 4 of the Notes to the Consolidated Financial Statements for a discussion of variable annuity hedge program gains and losses.
Other, net losses for the year ended December 31, 2008 were primarily related to net losses of $291 related to transactional foreign currency losses predominately on the internal reinsurance of the Japan variable annuity business, which is entirely offset in AOCI, resulting from appreciation of the Yen and credit derivative losses of $222 due to significant credit spread widening. Also included were losses on HIMCO managed CLOs in the first quarter and derivative related losses of $39 in the third quarter due to counterparty default related to the bankruptcy of Lehman Brothers Holdings Inc. For more information regarding the CLO losses, refer to the Variable Interest Entities section below.
Other, net losses for the year ended December 31, 2007 were primarily driven by the change in value of non-qualifying derivatives due to credit spread widening as well as fluctuations in interest rates and foreign currency exchange rates. Credit spreads widened primarily due to the deterioration in the U.S. housing market, tightened lending conditions and the market’s flight to quality securities.
For the year ended December 31, 2008, the transition impact related to the SFAS 157 adoption was a reduction in revenues of $616. For further discussion of the SFAS 157 transition impact, refer to Note 4 in the Notes to the Consolidated Financial Statements.
Net income decreased primarily as a result of increased realized capital losses, the impact of the 2008 Unlock charge, the impairment of goodwill attributed to the individual annuity line of business and the effect of equity market declines on variable annuity and mutual fund fee income. Included in net realized capital losses in 2008 were changes in value on GMWB derivatives, impairments, and the adoption of SFAS 157 during the first quarter of 2008. For further discussion of the SFAS 157 transition impact, see Note 4 in the Notes to the Consolidated Financial Statements. For further discussion of realized capital losses, see the Realized Capital Gains and Losses by Segment table under Life’s Operating Section of the MD&A. For further discussion of the 2008 and 2007 Unlock; and the impairment of goodwill, see the Critical Accounting Estimates section of the MD&A. The following other factors contributed to the changes in net income:
Net investment income was lower primarily due to a $77 decline in income from limited partnerships and other alternative investments, combined with lower yields on fixed maturity investments due to interest rate declines, partially offset by an increase in general account assets from increased fixed account sales.
Net realized capital losses increased primarily as a result of losses on GMWB derivatives of $(631); the adoption of SFAS 157 during the first quarter of 2008, which resulted in realized capital losses of $(616); and impairments of $(474).
Amortization of DAC increased primarily due to the impact of the 2008 Unlock charge as compared to the 2007 Unlock benefit. This was partially offset by a DAC benefit associated with the adoption of SFAS 157 at the beginning of the first quarter of 2008.
The effective tax rate increased from 21% to 41% for the year ended December 31, 2008 as compared to the prior year primarily due to losses before income taxes in 2008 compared to pre-tax earnings in 2007. The impact of DRD and other permanent differences caused an increase in the tax benefit to above 35% on the 2008 pre tax loss and a decrease in the tax expense on the 2007 pre tax income.
Net investment income declined for the year ended December 31, 2007 due to a decrease in variable annuity fixed option account values of 11% or $635. The decrease in these account values can be attributed to a combination of transfers into separate accounts and surrender activity. Offsetting this decrease in net investment income was an increase in the returns from limited partnership and other alternative investment income of $14 for the year ended December 31, 2007.
Insurance operating costs and other expenses increased for the year ended December 31, 2007. These increases were principally driven by mutual fund commission increases of $75 for the year ended December 31, 2007 due to growth in deposits of 29%. In addition, non-deferrable variable annuity asset based commissions increased $67 for the year ended December 31, 2007 due to a 4% growth in assets under management, as well as an increase in the number of contracts reaching anniversaries when trail commission payments begin.
Net income decreased for the year ended December 31, 2008, driven primarily by significantly higher realized capital losses and the impacts of the Unlock in the third quarter of 2008 as compared to the third quarter of 2007. For further discussion on the Unlock, see Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A. For further discussion of net realized capital losses, see Realized Capital Gains and Losses by Segment table under Life’s Operating Section of the MD&A. The following other factors contributed to the changes in net income:
Benefits, losses and loss adjustment expenses increased as a result of higher death benefits consistent with a larger life insurance in-force and unfavorable mortality, as well as the impact of the 2008 Unlock.
Net income increased for the year ended December 31, 2007, driven primarily by the unlock benefit in the third quarter of 2007 as compared to an unlock expense in the fourth quarter of 2006 partially offset by unfavorable mortality in 2007. For further discussion on the Unlock, see Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A. The year ended December 31, 2006 also included favorable revisions to prior period DAC estimates of $7, after-tax. A more expanded discussion of income growth is presented below:
The income tax benefit for 2008 as compared to the prior year periods income tax expense was due to lower income before income taxes primarily due to increased realized capital losses and increased tax benefits associated with the dividends received deduction of $12.
Net income in Retirement Plans decreased for the year ended December 31, 2007 due to higher amortization of DAC as a result of the unlock expense in the third quarter of 2007, partially offset by a growth in fee income. In addition, realized capital losses increased $25 for the year ended December 31, 2007 as compared to the prior year period. For further discussion, see Realized Capital Gains and Losses by Segment table under Life’s Operating Section of the MD&A. The following other factors contributed to the changes in income:
Fee income increased for the year ended December 31, 2007 primarily due to an increase in 401(k) average account values. This growth in 401(k) business is primarily driven by positive net flows of $1.8 billion over the past four quarters resulting from strong sales and increased ongoing deposits. Market appreciation contributed an additional $888 to assets under management in 2007.
Amortization of deferred policy acquisition costs and present value of future profits
The Group Benefits segment provides employers, associations, affinity groups and financial institutions with group life, accident and disability coverage, along with other products and services, including voluntary benefits, and group retiree health. The Company also offers disability underwriting, administration, claims processing services and reinsurance to other insurers and self-funded employer plans.
The decrease in net income for the year ended December 31, 2008, was primarily due to increased realized capital losses. For further discussion, see Realized Capital Gains and Losses by Segment table under Life’s Operating Section of the MD&A. The following other factors contributed to the changes in net income:
The transition impact related to the SFAS 157 adoption was a reduction in net income of $11, for the year ended December 31, 2008. For further discussion of the SFAS 157 transition impact, refer to Note 4 of the Notes to the Consolidated Financial Statements.
Fee income increased primarily due to growth in Japan’s variable annuity average assets under management. The increase in average assets under management over the past four quarters was driven by deposits of $3.0 billion and a $6.6 billion increase due to foreign currency exchange translation as the yen strengthened compared to the U.S. dollar. Deposits and favorable foreign currency exchange were offset by unfavorable market performance of $10.9 billion.
Benefits, losses and loss adjustment expense increased as a result of the impacts of the Unlock in the third quarter of 2008 as compared to the third quarter of 2007, the impact of the 3 Win trigger, as well as higher GMDB net amount at risk and increased claims costs. For further discussion of the 3 Win trigger, see Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A.
Insurance operating costs and other expenses increased due to the growth and strategic investment in the Japan and Other International operations, as well as lower capitalization of deferred policy acquisition costs, as acquisition costs exceeded pricing allowables.
Amortization of deferred policy acquisition costs increased as a result of the impacts of the Unlock in the third quarter of 2008 as compared to the third quarter of 2007, as well as the accelerated amortization associated with the 3 Win trigger. For further discussion of the 3 Win trigger see Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A.
The increase in benefits, losses and loss adjustment expenses for the year ended December 31, 2007 over the prior year period was due to the unlock benefit in the fourth quarter of 2006 exceeding the unlock benefit in the third quarter of 2007. For further discussion, see Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A.
Institutional provides customized investment, insurance, and income solutions to select markets. Products include PPLI owned by corporations and high net worth individuals, institutional annuities, mutual funds owned by institutional investors, structured settlements, and stable value contracts. Furthermore, Institutional offers individual products including income annuities and longevity assurance.
Net income in Institutional decreased primarily due to increased net realized capital losses and lower net investment income. For additional discussion of realized capital losses, see Realized Capital Gains and Losses by Segment table under Life’s Operating Section of the MD&A. Further discussion of income is presented below:
• Net investment income declined due to a decrease in returns from limited partnership and other alternative investments income of $(127), lower yields on fixed maturity investments indexed to LIBOR, and lower assets under management. The decline in yield on fixed maturities was largely offset by a corresponding decrease in interest credited on liabilities reported in benefits, losses, and loss adjustment expenses. Assets under management decreased primarily due to stable value outflows.
• Net investment income increased due to higher assets under management resulting from positive net flows of $1.5 billion during the year, and higher returns on limited partnerships and other alternative investments. Net flows were favorable primarily as a result of the Company’s funding agreement backed Investor Notes program.
• Benefits, losses and loss adjustment expenses increased as compared to the comparable prior year period primarily due to higher assets under management, in addition to one large terminal funding life contingent case sold in the third quarter of 2007.
• Insurance operating costs and other expenses increased due to greater premium tax, driven by increased PPLI deposits.
Life includes in Other its leveraged PPLI product line of business; corporate items not directly allocated to any of its reportable operating segments; inter-segment eliminations and the mark-to-mark adjustment for the International variable annuity assets that are classified as equity securities held for trading reported in net investment income and the related change in interest credited reported as a component of benefits, losses and loss adjustment expenses.
• Net investment income on securities available-for-sale and other declined primarily due to decreases in yields on fixed maturity investments and declines in limited partnerships and other alternative investment income.
• See Realized Capital Gains and Losses by Segment table under Life’s Operating section of the MD&A.
• During the first quarter of 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 (“leveraged COLI”) policies in the early to mid-1990s. The Company ceased offering this product in 1996. Based on the favorable outcome of these cases, together with the Company’s current assessment of the few remaining leveraged COLI cases, the Company reduced its estimate of the ultimate cost of these cases as of June 30, 2006. This reserve reduction, recorded in insurance operating costs and other expenses, resulted in an after-tax benefit of $34.
Service fees principally include revenues from third party claims administration services provided by Specialty Risk Services and revenues from member contact center services provided through the AARP Health program.
• Earned premium grew by $37, or 1%, due to a $97, or 4%, increase in AARP earned premiums, partially offset by a $60, or 5%, decrease in Agency and other earned premiums. AARP earned premiums grew primarily due to modest earned pricing increases for both auto and homeowners and the effect of new business premium outpacing non-renewals in the last nine months of 2007. Agency earned premium decreased $43, or 4%, largely due to a decline in new business premium and premium renewal retention since the middle of 2007, partially offset by the effect of modest earned pricing increases.
• Earned premium decreased slightly, to $2,724, as a decrease in commercial auto was largely offset by an increase in worker’s compensation. Earned premium decreases were largely due to the effect of non-renewals outpacing new business for commercial auto business in 2008 and to earned pricing decreases, largely offset by new business outpacing non-renewals in workers’ compensation business over the last nine months of 2007 and first nine months of 2008.
• Earned premium decreased by $64, or 4%, driven primarily by a decrease in property earned premiums and, to a lesser extent, casualty earned premiums. Property earned premiums decreased due largely to the Company’s decision to stop writing specialty property business with large, national accounts and lower new business and renewal retention for core excess and surplus lines business. Casualty earned premiums decreased primarily because of lower earned premium from captive programs and a decline in new business premium on loss-sensitive business written with larger accounts over the last nine months of 2007 and first three months of 2008.
• Earned premium decreased by $103, or 4%, driven by decreases in all lines, including commercial auto, general liability, workers’ compensation and property. Earned premium decreases were driven by declines in earned pricing and premium renewal retention in all lines and a decline in new business premiums in all lines except workers’ compensation.
Net income decreased by $1,415, from net income of $1,507 in 2007 to net income of $92 in 2008, primarily driven by an increase in net realized capital losses and a decrease in net investment income.
• Gross gains and losses on sales in 2008 primarily resulted from the sale of corporate fixed maturities resulting from the decision to reallocate the portfolio to securities with more favorable risk/return profiles. Also included were losses on sales of CLOs in the first quarter for which HIMCO is the collateral manager. For more information regarding losses on the sale of HIMCO managed CLOs, refer to the Variable Interest Entities section of the “Investments” section of the MD&A.
• Impairments of $1.5 billion in 2008 were primarily of subordinated fixed maturities and preferred equities within the financial services sector, as well as of securitized assets. (See the Other-Than-Temporary Impairments discussion within “Investment Results” in the “Investments” section of the MD&A for more information on the impairments recorded in 2008).
• Other, net realized capital losses in 2007 primarily resulted from the change in value associated with credit derivatives due to credit spreads widening. Credit spreads widened primarily due to the deterioration in the U.S. housing market, tightened lending conditions, and the market’s flight to quality securities.
• Underwriting results before catastrophes and prior accident year reserve development increased by $145 as the result of a lower current accident year loss and loss adjustment expense ratio before catastrophes, partially offset by the effect of the decline in earned premiums in Middle Market and Specialty Commercial. The 2008 results benefited from a lower current accident year loss and loss adjustment expense ratio before catastrophes for Small Commercial and Middle Market workers’ compensation claims, lower claim frequency on Personal Lines auto claims and lower non-catastrophe loss costs on Small Commercial package business, partially offset by higher non-catastrophe losses on Middle Market property and Personal Lines homeowners’ business.
• The change to favorable prior accident year reserve development was largely due to a $210 increase in net favorable reserve development in Ongoing Operations, driven largely by an increase in net reserve releases for workers’ compensation, professional liability and personal auto liability claims. Refer to the “Reserves” section of the MD&A for further discussion.
Net income decreased by $12, or 1%, in 2007, primarily driven by a decrease in Ongoing Operations’ current accident year underwriting results before catastrophes and a change to net realized capital losses, largely offset by an increase in net investment income and a decrease in Other Operations’ net unfavorable reserve development.
• Current accident year underwriting results before catastrophes decreased by $256, primarily due to a higher loss and loss adjustment expense ratio before catastrophes and prior accident year development, partially offset by the effect of exiting the Omni non-standard auto business, which generated a current accident year underwriting loss before catastrophes in 2006. The higher current accident year loss and loss adjustment expense ratio before catastrophes was driven by increased severity on Personal Lines auto liability claims, increased frequency on Personal Lines auto property damage claims and, to a lesser extent, increased severity on Personal Lines homeowners claims and a higher loss and loss adjustment expense ratio for both Small Commercial package business and Middle Market workers’ compensation claims.
• The $248 reduction in net unfavorable prior accident year development was due to a $167 decrease in unfavorable reserve development in Other Operations and an $81 increase in net favorable reserve development in Ongoing Operations. The lower adverse development in Other Operations was primarily due to a $243 charge in 2006 to recognize the effect of the Equitas agreement and strengthening of the allowance for uncollectible reinsurance, partially offset by a $99 strengthening of reserves in 2007, primarily related to an adverse arbitration decision. The $81 increase in net favorable reserve development in Ongoing Operations was primarily due to a $151 release of workers’ compensation loss and loss adjustment expenses reserves in 2007 related to accident years 2002 to 2006, partially offset by an $83 net release of prior accident year hurricane reserves in 2006. Refer to the “Reserves” section of the MD&A for further discussion.
• Gross gains and losses on sales in 2007 were primarily comprised of sales of foreign government, corporate, and municipal fixed maturity securities.
• Other net realized capital losses in 2007 were primarily due to decreases in the fair value of non-qualifying derivatives attributable to credit spreads widening. Credit spreads widened primarily due to the deterioration in the U.S. housing market, tightened lending conditions, and the market’s flight to quality securities.
• The $26 increase in other expenses was primarily due to $49 of interest charged by Corporate on the amount of capital held by the Property & Casualty operation in excess of the amount needed to support the capital requirements of the Property & Casualty operation, partially offset by a reduction in the estimated cost of legal settlements in 2007.
The Company considers several measures and ratios to be the key performance indicators for the property and casualty underwriting businesses. The following table and the segment discussions for the years ended December 31, 2008, 2007 and 2006 include various ratios and measures of profitability. Management believes that these ratios and measures are useful in understanding the underlying trends in The Hartford’s property and casualty insurance underwriting business. However, these key performance indicators should only be used in conjunction with, and not in lieu of, underwriting income for the underwriting segments of Personal Lines, Small Commercial, Middle Market and Specialty Commercial and net income for the Property & Casualty business as a whole, Ongoing Operations and Other Operations. These ratios and measures may not be comparable to other performance measures used by the Company’s competitors.
• The decrease in the earned premium growth rate from 2007 to 2008 was due to a significantly lower growth rate on AARP business and a change to declining earned premium in Agency, partially offset by the effect of the sale of Omni in 2006 which lowered the growth rate in 2007. Excluding Omni, Personal Lines earned premium grew 7% in 2007. The effects of larger declines in auto and homeowners’ new business premium and a change to declining homeowners’ renewal retention since the middle of 2007 were largely offset by the effect of a change to modest earned pricing increases in auto.
Other Operations reported a net loss of $97 in 2008 compared to net income of $30 in 2007. The change from net income in 2007 to a net loss in 2008 was primarily due to an increase in net realized capital losses and lower net investment income, partially offset by a decrease in net unfavorable prior accident year reserve development. See the Other Operations segment MD&A for further discussion.
• The change from an increase in earned premium in 2006 to a decrease in earned premium in 2007 was primarily attributable to earned pricing decreases, a decrease in new business written premium over the last six months of 2006 and the first six months of 2007 and a decrease in premium renewal retention over the first six months of 2007.
• The catastrophe ratio increased, primarily due to the effect of net favorable reserve development of prior accident year catastrophe losses in 2006. In 2006, the Company recognized $83 of net reserve releases related to the 2005 and 2004 hurricanes.
In 2007, the after-tax investment yield increased due to a higher yield on limited partnerships and other alternative investments and mortgage loans as well as due to a change in asset mix, including shifting a greater share of investments to these asset classes.
Net income is a 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 Personal Lines, Small Commercial, Middle Market and Specialty Commercial are evaluated by The Hartford’s management primarily based upon underwriting results. Underwriting results within Ongoing Operations are influenced significantly by changes in earned premium 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.
Pricing adequacy depends on a number of factors, including the ability to obtain regulatory approval for rate changes, proper evaluation of underwriting risks, the ability to project future loss cost frequency and severity based on historical loss experience adjusted for known trends, the Company’s response to rate actions taken by competitors, and expectations about regulatory and legal developments and expense levels. Property & Casualty seeks to price its insurance policies such that insurance premiums and future net investment income earned on premiums received will cover underwriting expenses and the ultimate cost of paying claims reported on the policies and provide for a profit margin. For many of its insurance products, Property & Casualty is required to obtain approval for its premium rates from state insurance departments.
In setting its pricing, Property & Casualty assumes an expected level of losses from natural or man-made catastrophes that will cover the Company’s exposure to catastrophes over the long-term. In most years, however, Property & Casualty’s actual losses from catastrophes will be more or less than that assumed in its pricing due to the significant volatility of catastrophe losses. Insurance Services Office, Inc. (“ISO”) defines a catastrophe loss as an event that causes $25 or more in industry insured property losses and affects a significant number of property and casualty policyholders and insurers.
Written premiums are earned over the policy term, which is six months for certain Personal Lines auto business and 12 months for substantially all of the remainder of the Company’s business. Because the Company earns premiums over the 6 to 12 month term of the policies, earned pricing increases (decreases) lag written pricing increases (decreases) by 6 to 12 months.
The combined ratio is the sum of the loss and loss adjustment expense ratio, the expense ratio and the policyholder dividend ratio. This ratio is a relative measurement that describes the related cost of losses and expenses for every $100 of earned premiums. A combined ratio below 100.0 demonstrates underwriting profit; a combined ratio above 100.0 demonstrates underwriting losses.
The catastrophe ratio (a component of the loss and loss adjustment expense ratio) represents the ratio of catastrophe losses (net of reinsurance) to earned premiums. By their nature, catastrophe losses vary dramatically from year to year. Based on the mix and geographic dispersion of premium written and estimates derived from various catastrophe loss models, the Company’s expected catastrophe ratio over the long-term is 3.0 to 3.5 points. See “Risk Management Strategy” below for a discussion of the Company’s catastrophe risk management program that serves to mitigate the Company’s net exposure to catastrophe losses. Catastrophe losses used to calculate the catastrophe ratio do not include the effect of reinstatement premiums or assessments.
When fixed maturity, equity or other 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 other-than-temporary impairments in the fair value of investments, changes in the fair value of non-qualifying derivatives and hedge ineffectiveness on qualifying derivative instruments. Refer to the Investment section of MD&A for further discussion of net investment income and net realized capital gains (losses).
For example, the Company has experienced favorable emergence of reported workers’ compensation claims for recent accident years and, during 2008, released workers’ compensation reserves in Small Commercial and Middle Market by a total of $156, primarily related to accident years 2000 to 2007. If reported losses on workers’ compensation claims for recent accident years continue to emerge favorably, reserves could be reduced further.
The Company expects to perform its regular reviews of asbestos liabilities in the second quarter of 2009, Other Operations’ reinsurance recoverables and the allowance for uncollectible reinsurance in the second quarter of 2009 and environmental liabilities in the third quarter of 2009. If there are significant developments that affect particular exposures, reinsurance arrangements or the financial conditions of particular reinsurers, the Company will make adjustments to its reserves, or the portion of liabilities it expects to cede to reinsurers.
Released reserves for extra-contractual liability claims under non-standard personal auto policies by $24. As part of the agreement to sell its non-standard auto insurance business in November, 2006, the Company continues to be obligated for certain extra-contractual liability claims arising prior to the date of sale. Reserve estimates for extra-contractual liability claims are subject to significant variability depending on the expected settlement of individually large claims and, during 2008, the Company determined that the settlement value of a number of these claims was expected to be less than previously anticipated, resulting in a $24 release of reserves. The $24 reserve release represented 1% of the Company’s net reserves for Personal Lines auto liability claims as of December 31, 2007.
Released reserves for construction defect claims in Specialty Commercial by $10 for accident years 2005 and prior due to lower than expected reported claim activity. Lower than expected claim activity was first noted in the first quarter of 2007 and continued throughout 2007. In the first quarter of 2008, management determined that this was a verifiable trend and reduced reserves accordingly. The $10 reserve release represented 1% of the Company’s net reserves for Specialty Commercial general liability claims as of December 31, 2007.
During the third quarter of 2008, the Company completed its annual ground up environmental reserve evaluation. As part of this evaluation, the Company reviewed all of its open direct domestic insurance accounts exposed to environmental liability as well as assumed reinsurance accounts and its London Market exposures for both direct insurance and assumed reinsurance. The Company found estimates for individual cases changed based upon the particular circumstances of each account. These changes were case specific and not as a result of any underlying change in the current environment. In addition, the decline in the reporting of new accounts and sites has been slower than anticipated in our previous review. The net effect of these changes resulted in a $53 increase in net environmental reserves.
During the second quarter of 2008, the Company completed its annual ground up asbestos reserve evaluation. As part of this evaluation, the Company reviewed all of its open direct domestic insurance accounts exposed to asbestos liability as well as assumed reinsurance accounts and its London Market exposures for both direct insurance and assumed reinsurance. The Company found estimates for individual cases changed based upon the particular circumstances of each account. These changes were case specific and not as a result of any underlying change in the current environment. The net effect of these changes resulted in a $50 increase in net asbestos reserves.
Included within prior accident year development for the year ended December 31, 2007 were the following reserve strengthenings (releases).
Released Personal Lines auto liability reserves by $31 related to the fourth accident quarter of 2005 as a result of better than expected frequency trends. During the third and fourth quarter of 2005, the Company had reduced the 2005 accident year loss and loss adjustment expense ratio for Personal Lines auto liability claims related to the first three accident quarters of 2005. Favorable frequency for the fourth accident quarter of 2005 emerged during the fourth quarter of 2005. However, the Company did not release reserves at that time, since reserve indications at only three months of development were not reliable. The Company released reserves in 2006 after further development indicated that early indications of reduced frequency were representative of a real trend. The $31 reserve release represented 2% of the Company’s net reserves for Personal Lines auto liability claims as of December 31, 2005.
Released Personal Lines auto liability reserves related to AARP and other affinity business by $22. AARP auto liability reserves for accident year 2004 were reduced as a result of favorable loss cost severity trends. AARP auto liability severity, as measured by reported data, began declining in 2005; however, the Company was uncertain whether this trend would prove persistent over time since paid loss data did not support a decline. During the second quarter of 2006, the Company determined that all the metrics supported a decline in severity estimates and, therefore, the Company released reserves. Auto liability reserves for other affinity business related to accident years 2003 to 2005 were reduced to recognize favorable developments in loss costs that have emerged. The $22 reserve release represented 1% of the Company’s net reserves for Personal Lines auto liability claims as of December 31, 2005.
Strengthened Specialty Commercial workers’ compensation allocated loss adjustment expense reserves by $20 for loss adjustment expense payments expected to emerge after 20 years of development. During 2005, the Company had done an in-depth study of loss payments expected to emerge after 20 years of development. At that time, it was believed that allocated loss adjustment expenses for a particular subset of business (primary policies on national accounts business) developed more quickly than allocated loss adjustment expenses for smaller insureds and that a similar reserve strengthening for national accounts business was not required. During the second quarter of 2006, the Company’s reserve review indicated that the development pattern for this business should be adjusted to be more consistent with that for smaller insureds. Because the Company has written very little of this business in recent years, the increase in reserves affects accident years 1995 and prior. The $20 of reserve strengthening represented 1% of the Company’s net reserves for Specialty Commercial workers’ compensation claims as of December 31, 2005.
Strengthened environmental reserves by $43 as a result of an environmental reserve evaluation completed in the third quarter of 2006. As part of this evaluation, 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. The Company found estimates for individual cases changed based upon the particular circumstances of each account, although the review found no underlying cause or change in the claim environment. The $43 of reserve strengthening represented 2% of the Company’s net reserves for asbestos and environmental claims as of December 31, 2005.
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 of required reserve levels. Subsequent changes can generally be thought of as being the result of the emergence of additional facts that were not known or anticipated at the time of the prior reserve estimate and/or changes in interpretations of information and trends.
The Hartford’s property and casualty operations have processes to manage risk to natural disasters, such as hurricanes and earthquakes, and other perils, such as terrorism. The Hartford’s risk management processes include, but are not limited to, disciplined underwriting protocols, exposure controls, sophisticated risk modeling, risk transfer, and capital management strategies.
In managing risk, The Hartford utilizes reinsurance to transfer risk to well-established and financially secure reinsurers. Reinsurance is used to manage aggregations of risk as well as specific risks based on accumulated property and casualty liabilities in certain geographic zones. All treaty purchases related to the Company’s property and casualty operations are administered by a centralized function to support a consistent strategy and ensure that the reinsurance activities are fully integrated into the organization’s risk management processes.
A variety of traditional reinsurance products are used as part of the Company’s risk management strategy, including excess of loss occurrence-based products that protect property and workers’ compensation exposures, and individual risk or quota share arrangements, that protect specific classes or lines of business. There are no significant finite risk contracts in place and the statutory surplus benefit from all such prior year contracts is immaterial. Facultative reinsurance is also used to manage policy-specific risk exposures based on established underwriting guidelines. The Hartford also participates in governmentally administered reinsurance facilities such as the Florida Hurricane Catastrophe Fund (“FHCF”), the Terrorism Risk Insurance Program established under The Terrorism Risk Insurance Program Reauthorization Act of 2007 (“TRIPRA”) 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, 2009:
The per occurrence limit on the FHCF treaty is $382 for the 6/1/2008 to 6/1/2009 treaty year based on the Company’s election to purchase additional limits under the “Temporary Increase in Coverage Limit (TICL)” statutory provision in excess of the coverage the Company is required to purchase from the FHCF.
In addition to the property catastrophe reinsurance coverage described in the above table, the Company has other treaties and facultative reinsurance agreements that cover property catastrophe losses on an aggregate excess of loss and on a per risk basis. The principal property catastrophe reinsurance program and other reinsurance programs include a provision to reinstate limits in the event that a catastrophe loss exhausts limits on one or more layers under the treaties.
The following table summarizes the terms of the reinsurance treaties with Foundation Re and Foundation Re II that were in place as of January 1, 2009:
The Company is exposed to losses from terrorist attacks, including losses caused by nuclear, biological, chemical or radiological weapons (NBCR) attacks. For terrorism, private sector catastrophe reinsurance capacity is limited and generally unavailable for terrorism losses caused by nuclear, biological, chemical or radiological weapons attacks. As such, the Company’s principal reinsurance protection against large-scale terrorist attacks is the coverage currently provided through the Terrorism Risk Insurance Program Reauthorization Act (“TRIPRA”). On December 26, 2007, the President signed TRIPRA extending the Terrorism Risk Insurance Act of 2002 (“TRIA”) through the end of 2014. TRIPRA provides a backstop for insurance-related losses resulting from any “act of terrorism” certified by the Secretary of the Treasury, in concurrence with the Secretary of State and Attorney General, that result in industry losses in excess of $100. In addition, TRIPRA revised the TRIA definition of a certified “act of terrorism” by removing the requirement that an act be committed “on behalf of any foreign person or foreign interest.” As a result, domestic acts of terrorism can now be certified as “acts of terrorism” under the program, subject to the other requirements of TRIPRA. Under the program, in any one calendar year, the federal government would pay 85% of covered losses from a certified act of terrorism after an insurer’s losses exceed 20% of the company’s eligible direct commercial earned premiums of the prior calendar year, up to a combined annual aggregate limit for the federal government and all insurers of $100 billion. If an act of terrorism or acts of terrorism result in covered losses exceeding the $100 billion annual industry aggregate limit, a future Congress would be responsible for determining how additional losses in excess of $100 billion will be paid.
During 2008, the board of directors of TWIA notified its member companies that it would assess them $100 to cover TWIA losses from hurricane Dolly and a total of $430 for hurricane Ike. For hurricane Dolly, the Company’s share of the assessment was $4, which was recorded as incurred losses within current accident year catastrophes in 2008.
For hurricane Ike, the TWIA board indicated that the first $370 of TWIA losses from hurricane Ike would be covered by the CRTF, but that the cost of TWIA losses and reinstatement premium above that amount would be funded by assessments. Of the $430 in assessments, $230 is to fund the first $230 of TWIA losses in excess of the $370 available in the CRTF and $200 is to fund additional reinsurance premiums that TWIA must pay to reinstate a layer of coverage that reimburses TWIA for up to $1.5 billion of TWIA losses in excess of $600 per occurrence. Thus, TWIA’s assessment notice for $430 is based on an estimate that TWIA losses from hurricane Ike will total approximately $2.1 billion. If TWIA losses exceed $2.1 billion, the entire amount in excess of $2.1 billion would be recovered from assessing member companies according to their market share. In notifying member companies, TWIA’s board of directors stated that actual TWIA losses will likely be greater than $2.1 billion and management has accrued a total of $27 in assessments for Ike based on an estimate that TWIA’s Ike losses will be approximately $2.5 billion and that TWIA assessments to the industry will ultimately be approximately $830. Of the $27 in assessments for Ike recorded in 2008, $7 has been recorded as incurred losses within current accident year catastrophes and $20 has been recorded as insurance operating costs and expenses.
In 2006, Citizens assessed the Company to fund deficits arising from hurricane losses in 2004 and 2005. In 2006, the Company reduced its estimate of Citizens assessments by $41 from the amount that had been originally estimated in 2005.
The following table shows the components of the gross and net reinsurance recoverable as of December 31, 2008 and 2007:
Reinsurance recoverables represent loss and loss adjustment expenses recoverable from a number of entities, including reinsurers and pools. As shown in the following table, a portion of the total gross reinsurance recoverable relates to the Company’s mandatory participation in various involuntary assigned risk pools and the value of annuity contracts held under structured settlement agreements. Reinsurance recoverables due from mandatory pools are backed by the financial strength of the property and casualty insurance industry. Annuities purchased from third party life insurers under structured settlements are recognized as reinsurance recoverables in cases where the Company has not obtained a release from the claimant. Of the remaining gross reinsurance recoverable as of December 31, 2008 and 2007, the following table shows the portion of recoverables due from companies rated by A.M. Best.
Based on A.M. Best ratings as of December 31, 2008 and 2007, respectively.
Where its contracts permit, the Company secures future claim obligations with various forms of collateral, including irrevocable letters of credit, secured trusts, funds held accounts and group wide offsets. As part of its reinsurance recoverable review, the Company analyzes recent developments in commutation activity between reinsurers and cedants, recent trends in arbitration and litigation outcomes in disputes between cedants and reinsurers and the overall credit quality of the Company’s reinsurers. Due largely to investment losses sustained by reinsurers in 2008, the financial strength ratings of some reinsurers have been downgraded and the financial strength ratings of other reinsurers have been put on negative watch. Nevertheless, as indicated in the above table, approximately 98% of the gross reinsurance recoverables due from reinsurers rated by A.M. Best were rated A- (excellent) or better as of December 31, 2008. Due to the inherent uncertainties as to collection and the length of time before such amounts will be due, it is possible that future adjustments to the Company’s reinsurance recoverables, net of the allowance, could be required, which could have a material adverse effect on the Company’s consolidated results of operations or cash flows in a particular quarterly or annual period.
Annually, the Company completes an evaluation of the reinsurance recoverable asset associated with older, long-term casualty liabilities reported in the Other Operations segment. As a result of this evaluation, the Company reduced its net reinsurance recoverable by $243 in 2006. See the “Other Operations” section of the MD&A for further discussion.
Includes net realized capital gains (losses), after tax, of $(1,223), $(112) and $46 for the years ended December 31, 2008, 2007 and 2006, respectively.
Net income decreased by $1,288, from $1,477 in 2007 to $189 in 2008, due primarily to an increase in net realized capital losses and a decrease in net investment income.
The increase in net realized capital losses of $1,509 in 2008 was primarily due to realized losses in 2008 from impairments of subordinated fixed maturities and preferred equity securities in the financial services sector as well as of securitized assets. (See the Other-Than-Temporary Impairments discussion within “Investment Results” in the “Investments” section of the MD&A for more information on the impairments recorded in 2008).
Ongoing Operations’ earned premium decreased by $160, or 2%, primarily due to a 5% decrease in Middle Market and a 4% decrease in Specialty Commercial. Refer to the earned premium discussion in the Executive Overview section of the Property & Casualty MD&A for further discussion of the decrease in earned premium.
Ongoing Operations’ current accident year losses and loss adjustment expenses before catastrophes decreased by $302 due to a decrease in the current accident year loss and loss adjustment expense ratio before catastrophes and a decrease in earned premium. The current accident year loss and loss adjustment expense ratio before catastrophes decreased by 1.9 points, to 61.9, due primarily to decreases in Personal Lines, Small Commercial and Middle Market.
• The current accident year loss and loss adjustment expense ratio before catastrophes in Specialty Commercial increased by 1.5 points, primarily due to a higher loss and loss adjustment ratio on directors and officers insurance in professional liability driven by earned pricing decreases.
Net favorable prior accident year reserve development increased from net favorable development of $145, or 1.4 points, in 2007, to net favorable development of $355, or 3.4 points, in 2008. Among other reserve developments, net favorable development in 2008 included a $156 release of workers’ compensation reserves, primarily related to accident years 2000 to 2007, a $105 release of general liability reserves, primarily related to accident years 2001 to 2007 and a $75 release of reserves for directors’ and officers insurance and errors and omissions insurance claims related to accident years 2003 to 2006. Refer to the “Reserves” section of the MD&A for further discussion of the prior accident year reserve development in 2008.
Net favorable reserve development of $145 in 2007 included several changes in reserves, including a $151 release of workers’ compensation loss and loss adjustment expense reserves, primarily for accident years 2002 to 2006. Refer to the “Reserves” section of the MD&A for further discussion of the prior accident year reserve development in 2007.
The $9 decrease in the amortization of deferred policy acquisition costs was primarily due to the decrease in earned premium, partially offset by the amortization of higher acquisition costs on AARP business and higher underwriting costs in Middle Market. Insurance operating costs and expenses increased by $7, primarily due to higher IT costs and an estimated $20 of assessments owed to TWIA to fund Texas Gulf Coast losses sustained by TWIA in 2008 due to hurricane Ike, partially offset by lower compensation-related costs. The expense ratio increased by 0.3 points, to 26.6, primarily due to the amortization of higher acquisition costs on AARP business and higher underwriting costs in Middle Market and the increase in insurance operating costs and expenses.
The Company sold its Omni non-standard auto business in the fourth quarter of 2006. Omni accounted for an underwriting loss of $52 in 2006, including $127 of earned premiums, $140 of loss and loss adjustment expenses, $30 of amortization of deferred policy acquisition costs and $9 of insurance operating costs and expenses.
Current accident year loss and loss adjustment expenses before catastrophes increased by $185
• The 1.4 point increase in the current accident year loss and loss adjustment expense ratio before catastrophes in Small Commercial was primarily due to a higher loss ratio and loss adjustment expense ratio for package business and commercial auto claims, partially offset by a lower loss and loss adjustment expense ratio for workers’ compensation claims.
• The 1.8 point decrease in the current accident year loss and loss adjustment expense ratio before catastrophes in Specialty Commercial was primarily due to a lower loss and loss adjustment ratio on directors and officers insurance in professional liability, partially offset by a higher loss and loss adjustment expense ratio on casualty business.
The 0.7 point increase in the expense ratio and the 0.3 point increase in the policyholder dividend ratio was primarily due to an increase in insurance operating costs and expenses. Insurance operating costs and expenses increased by $125, partly because insurance operating costs and expenses in 2006 included the effect of a $41 reduction of estimated Citizens’ assessments related to the 2005 Florida hurricanes. Also contributing to the increase in insurance and operating costs and expenses was a $34 increase in policyholder dividends due largely to a $20 increase in the estimated amount of dividends payable to certain workers’ compensation policyholders due to underwriting profits. Apart from the effect of Citizens assessments and policyholder dividends, insurance operating costs and expenses increased by $50, primarily due to an increase in IT costs and an increase in non-deferrable salaries and benefits and other internal operating costs.
AARP earned premium grew $97, reflecting modest earned pricing increases for both auto and homeowners and the effect of new business premium outpacing non-renewals in the last nine months of 2007. New business has offset non-renewals in 2008 and new business in 2008 has been driven by growth in the size of the AARP target market, the effect of direct marketing programs and the effect of cross selling homeowners insurance to insureds who have auto policies.
Agency earned premium decreased by $43 as the effect of a decline in new business premium and premium renewal retention since the middle of 2007 was partially offset by the effect of modest earned pricing increases. The market environment continues to be intensely competitive. The increase in advertising for auto business among the top carriers is also occurring with homeowners’ business, particularly in non-coastal and non-catastrophe prone areas. In 2008, a number of Personal Lines carriers began to increase rates although a significant portion of the market continues to compete heavily on price.
• Both auto and homeowners’ new business written premium decreased in 2008. Auto new business decreased by $60, or 14%, including decreases in both AARP and Agency. Homeowners’ new business decreased by $34, or 24%, including decreases in both AARP and Agency. AARP new business written premium decreased primarily due to lower auto and homeowners’ policy conversion rates, driven by increased competition, including the effect of price decreases by some carriers and the effect of continued advertising among carriers for new business. Agency new business written premium decreased primarily due to price competition driven, in part, by a greater number of agents using comparative rating software to obtain quotes from multiple carriers.
• Premium renewal retention for auto decreased from 88% to 87%, driven primarily by a decrease in policy retention for both AARP and Agency business, partially offset by the effect of modest written pricing increases in 2008. Premium renewal retention for homeowners decreased from 96% to 89% driven by a decrease in retention for both AARP and Agency business. The decrease in premium renewal retention for AARP homeowners’ business was driven by increased price competition by some carriers and mandated homeowners rate declines in Florida for AARP policies. The decrease in premium renewal retention for Agency homeowners’ business was due, in part, to Florida policyholders non-renewing as a result of the Company’s decision to stop renewing Florida homeowners’ policies sold through agents.
Other earned premium decreased by $141, primarily due to the sale of Omni on November 30, 2006 and a strategic decision to reduce other affinity business. Omni accounted for earned premiums of $127 for the year ended December 31, 2006.
• Premium renewal retention for auto increased from 87% to 88% for the year ended December 31, 2007, primarily due to the sale of the Omni non-standard auto business during 2006, which had a lower premium renewal retention than the Company’s standard auto business. Excluding Omni business, premium renewal retention decreased slightly, from 89% to 88%, as renewal retention remained flat in AARP and decreased in Agency. Premium renewal retention for homeowners increased from 94% to 96% for the year ended December 31, 2007, primarily due to an increase in retention of Agency business.
• 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.
Underwriting results decreased by $42, from $322 in 2007 to $280 in 2008, with a corresponding 1.2 point increase in the combined ratio, from 91.7 to 92.9 due to:
Personal Lines current accident year losses and loss adjustment expenses before catastrophes decreased by $34, to $2,542, due to a decrease in the current accident year loss and loss adjustment expense ratio before catastrophes, partially offset by the effect of higher earned premium. The current accident year loss and loss adjustment expense ratio before catastrophes decreased by 1.4 points, to 64.8. The decrease was primarily due to favorable expected frequency on auto liability claims and the effect of earned pricing increases for both auto and homeowners, partially offset by increased frequency and severity of non-catastrophe losses on homeowners business.
Current accident year catastrophe losses of $258, or 6.6 points, in 2008 were higher than current accident year catastrophe losses of $125, or 3.2 points, in 2007, primarily due to losses from hurricane Ike and tornadoes and thunderstorms in the South and Midwest.
Current accident year catastrophe losses of $125, or 3.2 points, in 2007 were slightly higher than current accident year catastrophe losses of $120, or 3.2 points, in 2006. The largest catastrophe losses in 2007 were from wildfires in California, spring windstorms in the Southeast and Northeast, tornadoes and thunderstorms in the Midwest and a December ice storm in the Midwest. Catastrophes losses during 2006 included tornadoes and hail storms in the Midwest and windstorms in Texas and on the East coast.
Earned premiums for the Small Commercial segment increased $84, or 3%, primarily due to new business premiums outpacing non-renewals for workers’ compensation business over the last six months of 2006 and the first six months of 2007.
• New business written premium for Small Commercial decreased by $52, or 10%, as increased competition led to a reduction in new business for workers’ compensation, package business and commercial auto. While the Company has focused on increasing new business from its agents and expanding writings in certain territories, actions taken by some of the Company’s competitors to increase market share and increase business appetite in certain classes of risks may be contributing to the Company’s lower new business growth. Also contributing to the decrease in new business premium is lower average premium per account partly due to writing more liability-only policies.
• Premium renewal retention for Small Commercial decreased due, in part, to lower retention of larger accounts and a reduction in average premium per account.
Underwriting results decreased by $71, from $508 to $437, with a corresponding 2.6 point increase in the combined ratio, from 81.4 to 84.0, due to:
Small Commercial’s current accident year losses and loss adjustment expenses before catastrophes decreased by $147 in 2008, to $1,447, primarily due to a 5.2 point decrease in the current accident year loss and loss adjustment expense ratio before catastrophes, to 53.1. The decrease in this ratio was primarily due to a lower loss and loss adjustment expense ratio for workers’ compensation business and, to a lesser extent, a lower loss and loss adjustment expense ratio for package business. Workers’ compensation claim frequency has been trending favorably for recent accident years due to improved workplace safety and underwriting actions and the lower loss and loss adjustment expense ratio for the 2008 accident year includes an assumption that this lower of claim frequency would continue for the 2008 accident year. The loss and loss adjustment expense ratio for the 2007 accident year recorded in 2007 did not give as much credence to this lower level of claim frequency. The effect of lower claim frequency for workers’ compensation claims was partially offset by the effect of earned pricing decreases.
Insurance operating costs and expenses decreased by $9, primarily due to lower compensation-related and servicing costs, partially offset by an estimated $7 of TWIA assessments in 2008. Amortization of deferred policy acquisition costs of $636 was relatively flat consistent with the change in earned premium. The expense ratio decreased slightly in 2008, to 29.1, driven by the decrease in insurance operating costs and expenses.
Middle Market provides standard commercial insurance coverage to middle market commercial businesses, primarily throughout the United States, with greater than $5 in annual payroll, $15 in annual revenues or $15 in total property values. This segment offers workers’ compensation, property, automobile, liability, umbrella, marine and livestock coverages.
• Earned pricing decreased in all lines of business, including workers’ compensation, commercial auto, general liability, property and marine. As written premium is earned over the 12-month term of the policies, the earned pricing decreases in 2008 were primarily a reflection of mid-single digit written pricing decreases over the last nine months of 2007 and the first nine months of 2008. A number of carriers have continued to compete fairly aggressively on price, particularly on larger accounts within Middle Market, which has contributed to mid-single digit price decreases across the industry.
Earned premiums for the Middle Market segment decreased by $103, or 4%. The decrease was primarily due to earned pricing decreases and a decrease in new business written premium and premium renewal retention over the last six months of 2006 and the first six months of 2007.
• Earned pricing decreased in all lines of business, including property, commercial auto, general liability, workers’ compensation and marine.
• Despite the decrease in earned premium, the number of policies in force has increased. The change in policies in force does not correspond directly with the change in earned premiums due to a reduction in the average premium per policy and because policy in force counts are as of a point in time rather than over a period of time.
Earned premiums for the Middle Market segment decreased by $121, or 5%, driven primarily by decreases in commercial auto, workers’ compensation and general liability. Refer to the earned premium section for further discussion.
Net favorable prior accident year reserve development increased from $16, or 0.7 points, in 2007 to $134, or 5.9 points, in 2008. Net favorable reserve development of $134 in 2008 primarily included a $90 release of reserves for high hazard and umbrella general liability claims, primarily related to the 2001 to 2007 accident years, a $64 release of workers’ compensation reserves, primarily related to accident years 2000 to 2007 and a $27 release of commercial auto liability reserves, primarily related to accident years 2002 to 2007, partially offset by a $50 strengthening of reserves for general liability and products liability claims primarily for accident years 2004 and prior.
Middle Market earned premium decreased by $103, or 4%, to $2,420. Refer to the earned premium discussion for a description of the decrease in earned premium.
Current accident year loss and loss adjustment expenses before catastrophes decreased by $16
Current accident year catastrophe losses decreased by $21, from $36, or 1.5 points, in 2006 to $15, or 0.6 points, in 2007. Compared to 2007, there were more severe catastrophes in 2006, including tornadoes and hail storms in the Midwest and windstorms in Texas and on the East coast. The largest catastrophe losses in 2007 were from spring windstorms in the Southeast and wildfires in California.
Prior accident year reserve development changed from net unfavorable prior accident year reserve development of $13, or 0.5 points, in 2006 to net favorable prior accident year reserve development of $16, or 0.7 points, in 2007. Net favorable reserve development of $16 in 2007 included a $49 release of general liability loss and loss adjustment expense reserves for accident years 2003 to 2006 and an $18 release of commercial auto liability reserves for accident years 2003 and 2004, partially offset by a $40 strengthening of workers’ compensation reserves for accident years 1973 & prior and a $14 strengthening of general liability reserves for accident years more than 20 years old.
The 1.8 point increase in the expense ratio and the 0.4 point increase in the policyholder dividend ratio was primarily due to an increase in insurance operating costs and expenses and the decrease in earned premiums. Insurance operating costs and expenses increased by $35, partially due to the effect of a $12 reduction of estimated Citizens’ assessments related to the 2005 Florida hurricanes recorded in 2006. Also contributing to the increase in insurance operating costs and expenses was an increase in IT costs, an increase in non-deferrable salaries and benefits, and an $8 increase in policyholder dividends. The increase in policyholder dividends was largely due to an $8 increase in the estimated amount of dividends payable to certain workers’ compensation policyholders due to underwriting profits.
Amortization of deferred policy acquisition costs decreased by $15, due largely to the decrease in earned premium and corresponding decrease in acquisition costs.
Earned premiums for the Specialty Commercial segment decreased by $64, or 4%, primarily due to a decrease in property earned premiums and, to a lesser extent, casualty earned premiums.
Current accident year losses and loss adjustment expenses before catastrophes decreased by $20
Specialty Commercial current accident year losses and loss adjustment expenses before catastrophes decreased by $20 in 2008, to $941, due to a decrease in earned premium, partially offset by an increase in the loss and loss adjustment expense ratio before catastrophes and prior accident year development. The loss and loss adjustment expense ratio before catastrophes and prior accident year development increased by 1.5 points, to 68.1, primarily due to a higher loss and loss adjustment expense ratio for directors and officers insurance in professional liability, driven by earned pricing decreases, and a lower mix of property business which has a lower loss and loss adjustment ratio than other businesses within Specialty Commercial.
Specialty Commercial current accident year loss and loss adjustment expenses before catastrophes decreased by $64 in 2007 to $961, due to a decrease in earned premium and a 1.8 point decrease in the loss and loss adjustment expense ratio before catastrophes and prior accident year development, to 66.6. The decrease in the loss and loss adjustment expense ratio before catastrophes and prior accident year development was driven by a lower loss and loss adjustment ratio on directors and officers insurance in professional liability and a decrease in non-catastrophe property loss costs on property business, partially offset by a higher loss and loss adjustment expense ratio on casualty business.
Net unfavorable prior accident year reserve development increased from $36, or 2.5 points, in 2006 to $84, or 5.8 points, in 2007. Net unfavorable prior accident year reserve development of $84 in 2007 consisted primarily of a $47 strengthening of workers’ compensation loss and loss adjustment expense reserves for accident years 1987 to 2001, a $34 strengthening of general liability reserves, primarily related to accident years 1987 to 1997, and a $25 strengthening of general liability reserves for accident years more than 20 years old. Partially offsetting the unfavorable reserve development in 2007 was a $22 release of reserves for surety business for accident years 2003 to 2006.
Insurance operating costs and expenses increased by $16, primarily due to a $16 increase in policyholder dividends. The $16 increase in policyholder dividends was largely due to a $10 reduction in estimated policyholder dividends recorded in 2006 and a $7 increase in estimated policyholder dividends recorded in 2007. The $7 increase in dividends in 2007 was primarily driven by an increase in the estimated amount of dividends payable to certain workers’ compensation policyholders due to underwriting profits. Amortization of deferred policy acquisition costs increased by $17, due largely to an increase in amortization for professional liability, fidelity and surety business driven largely by the increase in earned premiums for that business and a reduction in ceding commissions. The expense ratio increased by 1.8 points, to 27.4, due largely to the reduction in ceding commission on professional liability business and the decrease in earned premiums.
A $57 increase in income tax benefit, primarily as a result of a change from pre-tax income in 2007 to a pre-tax loss in 2008.
Other Operations reported net income of $30 in 2007 compared to a net loss of $35 in 2006, driven by the following:
A $156 increase in underwriting results, primarily due to a $167 decrease in unfavorable prior year loss development. Reserve development in 2007 included $99 principally as a result of an adverse arbitration decision and $25 of environmental reserve strengthening. In 2006, reserve development included a $243 reduction in net reinsurance recoverables, $43 of environmental reserve strengthening and $12 of reserve strengthening for assumed reinsurance.
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, 2008, 2007 and 2006.
The one year and average three year net paid amounts for asbestos claims, including Ongoing Operations, were $189 and $283, respectively, resulting in a one year net survival ratio of 10.0 and a three year net survival ratio of 6.7. Net survival ratio is the quotient of the net carried reserves divided by the average annual payment amount and is an indication of the number of years that the net carried reserve would last (i.e. survive) if the future annual claim payments were consistent with the calculated historical average.
Gross Environmental Reserves based on the third quarter 2008 environmental reserve study.
The one year gross paid amount for total environmental claims is $52, resulting in a one year gross survival ratio of 5.9.
During the second quarters of 2008, 2007 and 2006, the Company completed its annual ground up asbestos reserve evaluations. As part of these evaluations, the Company reviewed all of its open direct domestic insurance accounts exposed to asbestos liability as well as assumed reinsurance accounts and its London Market exposures for both direct insurance and assumed reinsurance. In the second quarter of 2008, the Company found estimates for individual cases changed based upon the particular circumstances of each account. These changes were case specific and not as a result of any underlying change in the current environment. The net effect of these changes resulted in a $50 increase in net asbestos reserves. In 2007 and 2006, these evaluations resulted in no addition to the Company’s net asbestos reserves. The Company currently expects to continue to perform an evaluation of its asbestos liabilities annually.
The following table displays gross asbestos reserves and other statistics by policyholder category as of December 31, 2008.
Includes 25 open accounts at June 30, 2008. Included 26 open accounts at June 30, 2007.
For paid and incurred losses and loss adjustment expenses reporting, the Company classifies its asbestos and environmental reserves into three categories: Direct, Assumed - Domestic and London Market. Direct insurance includes primary and excess coverage. Assumed reinsurance includes both “treaty” reinsurance (covering broad categories of claims or blocks of business) and “facultative” reinsurance (covering specific risks or individual policies of primary or excess insurance companies). London Market business includes the business written by one or more of the Company’s subsidiaries in the United Kingdom, which are no longer active in the insurance or reinsurance business. Such business includes both direct insurance and assumed reinsurance.
Of the three categories of claims (Direct, Assumed - Domestic and London Market), direct policies tend to have the greatest factual development from which to estimate the Company’s exposures.
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 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 and losses reduced the Company’s consolidated revenues by $11.9 billion for the year ended December 31, 2008, and contributed to the Company’s consolidated revenues by $4.4 billion and $6.3 billion for the years ended December 31, 2007 and 2006, respectively. Net investment income and net realized capital gains and losses, excluding net investment income from trading securities, reduced the Company’s consolidated revenues by $1.6 billion for the year ended December 31, 2008, and contributed to the Company’s consolidated revenues by $4.2 billion and $4.4 billion for the years ended December 31, 2007 and 2006, respectively. The reduction to consolidated revenues for 2008, as compared to prior year periods, is primarily due to a net loss in the value of equity securities, held for trading, and realized capital losses.
Total investments decreased $5.7 billion since December 31, 2007 primarily as a result of a decline in value of equity securities, held for trading, and increased unrealized losses on available-for-sale securities due to credit spread widening, offset by positive operating cash flows. The decline in value in equity securities, held for trading, was due to negative market performance of the underlying investment funds supporting the Japanese variable annuity product and policyholder transfers from the accumulation to the annuitization phase of the contract. These losses were partially offset by gains resulting from translation as the Yen strengthened compared to the U.S. dollar. In addition, Life increased its investment in short-term securities in preparation for funding liability outflows and to maintain higher than average liquidity while waiting for market and asset valuations to stabilize. Mortgage loans increased due to diversification opportunities.
Limited partnerships and other alternative investments decreased by $177 during 2008. Life continuously evaluates its allocation to limited partnerships and other alternative investments and has taken steps to reduce its exposure to hedge funds, most of which will occur in 2009. In addition, HIMCO does not expect significant additions to limited partnerships and other alternative investments in 2009 except for unfunded commitments. HIMCO closely monitors the impact of these investments in relationship to the overall investment portfolio and the consolidated balance sheets.
Yields calculated using investment income before investment expenses divided by the monthly weighted average invested assets at cost, amortized cost, or adjusted carrying value, as applicable excluding collateral received associated with the securities lending program and consolidated variable interest entity minority interests. Included in the fixed maturity yield is Other income (loss) as it primarily relates to fixed maturities (see footnote [3] below). Included in the total net investment income yield is investment expense.
Includes investment income and mark-to-market effects of equity securities, held for trading.
The decrease in net investment income on equity securities, held for trading, for the year ended December 31, 2008 compared to the prior year period was primarily attributed to a decline in the value of the underlying investment funds supporting the Japanese variable annuity product due to negative market performance year over year.
Net investment income, excluding securities held for trading, increased $313, or 10%, for the year ended December 31, 2007, compared to the prior year period. The increase in net investment income was primarily due to a higher average invested asset base and a higher total portfolio yield. The increase in the average invested assets base as compared to the prior year period was primarily due to positive operating cash flows, investment contract sales such as retail and institutional notes, and universal life-type product sales. Limited partnerships and other alternative investments contributed to the increase in income compared to the prior year period, despite a lower yield, due to a greater allocation of investments to this asset class. While the limited partnership and other alternative investment yield continued to exceed the overall portfolio yield, it decreased compared to the prior year period primarily due to the market performance of Life’s hedge fund investments largely due to disruptions in the credit market associated with structured securities.
Net investment income on equity securities, held for trading, for the year ended December 31, 2007 was primarily attributed to a change in the value of the underlying investment funds supporting the Japanese variable annuity product due to market performance.
• Gross gains and losses on sales for the year ended December 31, 2008 primarily resulted from the decision to reallocate the portfolio to securities with more favorable risk/return profiles. Also included was a gain of $141 from the sale of a synthetic CDO, as well as losses on sales of HIMCO managed CLOs in the first quarter. For more information regarding these CLO losses, refer to the Variable Interest Entities section below. During the year ended December 31, 2008, securities sold at a loss were depressed, on average, approximately 2% at the respective period’s impairment review date and were deemed to be temporarily impaired.
• See the Other-Than-Temporary Impairments section that follows for information on impairment losses.
• Other, net losses for the year ended December 31, 2007 were primarily driven by the change in value of non-qualifying derivatives due to credit spread widening as well as fluctuations in interest rates and foreign currency exchange rates. Credit spreads widened primarily due to the deterioration in the U.S. housing market, tightened lending conditions and the market’s flight to quality securities.
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, 401(k), and variable corporate owned life insurance. The assets and liabilities associated with variable annuity products sold in Japan and the United Kingdom 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, 2008 and 2007, the Company’s separate accounts totaled $130.2 billion and $199.9 billion, respectively.
Limited partnerships and other alternative investments decreased by $94 during 2008. Property & Casualty continuously evaluates its allocation to limited partnerships and other alternative investments and has taken steps to reduce its exposure to hedge funds, some of which will occur in 2009. In addition, HIMCO does not expect significant additions to limited partnerships and other alternative investments in 2009 except for unfunded commitments. HIMCO closely monitors the impact of these investments in relationship to the overall investment portfolio and the consolidated balance sheets.
Includes fees associated with securities lending activities of $30, $41 and $0, respectively, for the years ended December 31, 2008, 2007 and 2006. The income from securities lending activities is included within fixed maturities. Also included are derivatives that qualify for hedge accounting under SFAS 133. These derivatives hedge fixed maturities.
• Gross gains and losses on sales for the year ended December 31, 2008 primarily resulted from the decision to reallocate the portfolio to securities with more favorable risk/return profiles. Also included were losses on sales of HIMCO managed CLOs in the first quarter. For more information regarding these CLO losses, refer to the Variable Interest Entities section below. During the year ended December 31, 2008, securities sold at a loss were depressed, on average, approximately 2% at the respective period’s impairment review date and were deemed to be temporarily impaired.
• Other, net losses for the year ended December 31, 2008 were primarily related to net losses on credit derivatives of $90 as a result of credit spread widening on credit derivatives that assume credit exposure. Also included were losses on HIMCO managed CLOs in the first quarter and derivative related losses of $7 during the third quarter due to counterparty default related to the bankruptcy of Lehman Brothers Holdings Inc. For more information regarding the CLO losses, refer to the Variable Interest Entities section below.
• Other, net losses for the year ended December 31, 2007 primarily resulted from the change in value associated with credit derivatives due to credit spreads widening. Credit spreads widened primarily due to the deterioration in the U.S. housing market, tightened lending conditions and the market’s flight to quality securities.
The Company is involved with variable interest entities primarily as a collateral manager and as an investor through normal investment activities. The Company’s involvement includes providing investment management and administrative services for a fee and holding ownership or other interests as an investor. The Company also has involvement with VIEs as a means of accessing capital.
As of December 31, 2007, HIMCO was the collateral manager of four VIEs with provisions that allowed for termination if the fair value of the aggregate referenced bank loan portfolio declined below a stated level. These VIEs were market value CLOs that invested in senior secured bank loans through total return swaps. Two of these market value CLOs were consolidated, and two were not consolidated. During the first quarter of 2008, the fair value of the aggregate referenced bank loan portfolio declined below the stated level in all four market value CLOs and the total return swap counterparties terminated the transactions. Three of these CLOs were restructured from market value CLOs to cash flow CLOs without market value triggers and the remaining CLO terminated in January 2009. The Company realized a capital loss of $90, before-tax, from the termination of these CLOs. In connection with the restructurings, the Company purchased interests in two of the resulting VIEs, one of which the Company is the primary beneficiary. These purchases resulted in an increase in the Company’s maximum exposure to loss for both consolidated and non-consolidated VIEs.
CLOs represent one fund at December 31, 2008, which is a cash flow CLO financed by issuing debt in tranches of varying seniority and is a VIE due to the lack of voting equity in the capital structure. The Company provides collateral management services to the CLO and earns a fee for those services and also has investments in debt issued by the CLO. Taking those interests into consideration, the Company has performed a quantitative analysis and determined that it will absorb a majority of the expected losses or residual returns in the fund and as a result is the primary beneficiary. Consolidated assets are classified in cash and fixed maturities and consolidated liabilities are classified in other liabilities. At December 31, 2007, CLOs represent two market value CLOs, one of which converted to the cash flow CLO described above and the second which terminated during the fourth quarter of 2008.
As of December 31, 2008 and 2007, the Company also held significant variable interests in four and five VIEs, respectively, where the Company is not the primary beneficiary. That determination has been made based on a quantitative analysis of whether the Company will absorb a majority of the expected losses or residual returns of the VIE, considering its variable interests as well as those of other variable interest holders. These investments have been held by the Company for two years.
The following table sets forth the carrying value of assets and liabilities that relate to the Company’s variable interests in unconsolidated VIEs, and the Company’s maximum exposure to loss resulting from involvement with those VIEs.
At December 31, 2008, CLOs include one fund that is financed by issuing debt securities in tranches of varying seniority. That fund is a cash flow CLO and a VIE due to the lack of voting equity in its capital structure. The Company holds variable interests through fees earned as the collateral manager and investments in debt and preferred equity issued by the fund with a carrying amount at December 31, 2008 of $306 and $2, respectively. At December 31, 2007, CLOs represent two market value CLOs, one of which converted to the cash flow CLO described above and the second for which the Company is no longer involved with following its conversion from a market value to a cash flow CLO.
At December 31, 2008 and 2007, CDOs consist of two VIEs that are financed by issuing debt having no voting rights to investors. The Company has variable interests in each CDO by virtue of its investment in that debt and fees received as the collateral manager. The carrying amount of the investment in debt issued by the CDOs is $3 at December 31, 2008 and is classified in fixed maturities.
Other, at December 31, 2008 and 2007, represents the Company’s variable interest in the Glen Meadow ABC Trust, which is a put option agreement that requires the trust, at any time, to purchase the Company’s junior subordinated notes in a maximum principal amount not to exceed $500. There is no equity investment and thus the trust is a VIE based on that lack of voting equity. The put option agreement held by the Company is a variable interest in the trust. The carrying amount of that option at December 31, 2008 classified in other assets is $42 and the carrying value of the liability for premiums due under the option contract at December 31, 2008 classified in other liabilities is $40.
For the year ended December 31, 2008, impairments of $3,964 were concentrated in subordinated fixed maturities and preferred equities within the financial services sector, as well as, in CMBS securities.
Of the $2,484 of impairments on financial services companies for 2008, the Company does not anticipate substantial recovery of $850 due to bankruptcy, financial restructurings or concerns about the issuer’s ability to continue to make contractual payments. The remaining balance primarily relates to securities that experienced extensive credit spread widening and the Company could not reasonably assert that the security would recover in value in a reasonable period of time or the Company did not wish to assert its intent to hold the security until recovery. To the extent the Company does not sell these securities, the Company expects to recover principal and interest in accordance with the security’s contractual terms over a period up to and including the security’s contractual maturity.
Impairments on securitized securities totaled $899 for the year ended December 31, 2008. For these securities, the Company determines impairments by modeling cash flows in a severe negative economic outlook scenario. If the results of this cash flow modeling result in an economic loss, an impairment was taken. The Company continues to receive contractual principal and interest payments on the majority of CMBS and sub-prime ABS securities impaired, however the Company is uncertain of its ability to recover principal and interest in accordance with the security’s original contractual terms.
The remaining impairments of $581 were primarily recorded on securities in various sectors, primarily high yield non-financial services corporate securities that experienced significant credit spread widening and for which the Company was uncertain of its intent to retain the investments for a period of time sufficient to allow for recovery.
In the normal course of business, the Company uses various derivative counterparties in executing its derivative transactions. The use of counterparties creates credit risk that the counterparty may not perform in accordance with the terms of the derivative transaction. The Company has developed a derivative counterparty exposure policy which limits the Company’s exposure to credit risk.
The Company has developed credit exposure thresholds which are based upon counterparty ratings. Credit exposures are measured using the market value of the derivatives, resulting in amounts owed to the Company by its counterparties or potential payment obligations from the Company to its counterparties. Credit exposures are generally quantified daily based on the prior business day’s market value and collateral is pledged to and held by, or on behalf of, the Company to the extent the current value of derivatives exceeds the contractual thresholds. In accordance with industry standards and the contractual agreements, collateral is typically settled on the next business day. The Company has exposure to credit risk for amounts below the exposure thresholds which are uncollateralized as well as for market fluctuations that may occur between contractual settlement periods of collateral movements.
The maximum uncollateralized threshold for a derivative counterparty for a single legal entity is $10, excluding reinsurance derivatives. The Company currently transacts derivatives in five legal entities and therefore the maximum combined threshold for a single counterparty over all legal entities that use derivatives is $50. In addition, the Company may have exposure to multiple counterparties in a single corporate family due to a common credit support provider. As of December 31, 2008, the maximum combined threshold for all counterparties under a single credit support provider over all legal entities that use derivatives is $100. Based on the contractual terms of the collateral agreements, these thresholds may be immediately reduced due to a downgrade in a counterparty’s credit rating.
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. The party that purchases credit protection will make periodic payments based on an agreed upon rate and notional amount, and for certain transactions there will also be an upfront premium payment. The second party, who assumes credit exposure, will typically only make a payment if there is a credit event and such payment will be equal to the notional value of the swap contract less the value of the referenced security issuer’s debt obligation. A credit event is generally defined as default on contractually obligated interest or principal payments or bankruptcy of the referenced entity.
During 2008, the Company continued to reduce overall credit risk exposure to general credit spread movements by both reducing and rebalancing the total notional amount of the credit default swap portfolio. In addition, all credit derivatives that reference the first loss position of a basket of corporate issuers were terminated during 2008. The Company’s credit default swap portfolio has experienced and may continue to experience market value fluctuations based upon certain market conditions, including credit spread movement of specific referenced entities. For the year ended December 31, 2008, the Company realized losses of $153, including net periodic coupon settlements, on credit default swaps.
The following table identifies available-for-sale securities by type on a consolidated basis.
As of December 31, 2008, 99% of these senior secured bank loan CLOs were AAA rated with an average subordination of 29%.
Includes securities with an amortized cost and fair value of $14 and $10, respectively, as of December 31, 2008, and $40 and $37, respectively, as of December 31, 2007, which were backed by pools of loans issued to prime borrowers. Includes securities with an amortized cost and fair value of $91 and $62, respectively, as of December 31, 2008, and $96 and $87, respectively, as of December 31, 2007, which were backed by pools of loans issued to Alt-A borrowers.
Includes CDO securities with an amortized cost and fair value of $8 and $5, respectively, as of December 31, 2008, and $16 and $15, respectively, as of December 31, 2007, that contain a below-prime residential mortgage loan component. Typically these CDOs are also backed by assets other than below-prime loans.
As of December 31, 2008 and 2007, 95% and 92%, respectively, of corporate securities were rated investment grade.
Includes structured investments with an amortized cost and fair value of $526 and $364, respectively, as of December 31, 2008, and $782 and $730, respectively, as of December 31, 2007. The underlying securities supporting these investments are primarily diversified pools of investment grade corporate issuers which can withstand a 15% cumulative default rate, assuming a 35% recovery.
The available-for-sale net unrealized loss position increased $12.5 billion since December 31, 2007 primarily as a result of credit spread widening, partially offset by declining interest rates and impairments. Credit spreads widened primarily due to continued deterioration in the U.S. housing market, tightened lending conditions and the market’s flight to quality securities, as well as, a U.S. recession and a declining global economy. Despite steps taken by the government to stabilize the financial system, liquidity and confidence in the markets have not yet been restored. The sectors most significantly impacted include financial services, residential and commercial mortgage backed investments, and consumer loan backed investments. The following sections illustrate the Company’s holdings and provide commentary on these sectors.
The Company has exposure to the financial services sector predominantly through banking, insurance and finance firms. A comparison of fair value to amortized cost is not indicative of the pricing of individual securities as rating downgrades and impairments have occurred. The following table represents the Company’s exposure to the financial services sector included in the corporate and equity securities, available-for-sale lines in the Consolidated Available-for-Sale Securities by Type table above. Of the Company’s $7.9 billion on a fair value basis, $3.4 billion is senior debt, $1.9 billion is subordinate and Tier 2 holdings and $2.6 billion is Tier 1 and preferred exposure. The Company’s exposure to European financial institutions comprises $702 of senior debt, $816 of subordinate and Tier 2 holdings and $875 of Tier 1 and preferred holdings.
The Company has exposure to sub-prime and Alt-A residential mortgage backed securities included in the Consolidated Available-for-Sale Securities by Type table above. These securities continue to be affected by uncertainty surrounding the decline in home prices, negative technical factors and deterioration in collateral performance.
The Company’s exposure to second lien residential mortgages is composed primarily of loans to prime and Alt-A borrowers, of which approximately over half were wrapped by monoline insurers. These securities are included in the table above and have an amortized cost and fair value of $173 and $82, respectively, as of December 31, 2008 and $260 and $217, respectively, as of December 31, 2007.
The Company has observed weakness in commercial real estate market fundamentals and expects continued pressure on these fundamentals including increased vacancies, rising delinquencies, lower rent growth and declining property values. The following tables represent the Company’s exposure to CMBS bonds, commercial real estate CDOs, and IOs by current credit quality and vintage year. A comparison of fair value to amortized cost is not indicative of the pricing of individual securities as rating downgrades and impairments have occurred. Credit protection represents the current weighted average percentage of the outstanding capital structure subordinated to the Company’s investment holding that is available to absorb losses before the security incurs the first dollar loss of principal. This credit protection does not include any equity interest or property value in excess of outstanding debt.
For certain CDOs, the collateral manager has the ability to reinvest proceeds that become available, primarily from collateral maturities. The increase in the 2008 vintage year represents reinvestment under these CDOs.
In addition to commercial mortgage backed securities, the Company has whole loan commercial real estate investments. The carrying value of mortgage loans on real estate was $6.5 billion and $5.4 billion as of December 31, 2008 and 2007, respectively. The Company’s mortgage loans are collateralized by a variety of commercial and agricultural properties. The mortgage loans are diversified both geographically throughout the United States and by property type.
At December 31, 2008, the Company held delinquent mortgage loans on three properties with a carrying value of $91 which were deemed impaired and accordingly, a valuation allowance of $26 was established. At December 31, 2007, the Company held no impaired, restructured, delinquent or in-process-of-foreclosure mortgage loans and therefore had no valuation allowance.
As of December 31, 2008, approximately 6% of the securities were issued by lenders that lend primarily to sub-prime borrowers.
Monoline insurers guarantee the timely payment of principal and interest of certain securities. Municipalities will often purchase monoline insurance to “wrap” a security issuance in order to benefit from better market execution. Rating agency downgrades of bond insurers have not had a significant impact on the fair value of the Company’s insured portfolio; however, these downgrades have caused a downshift in rating quality from AAA rated since December 31, 2007. As of December 31, 2008, the fair value of the Company’s total monoline insured securities was $6.6 billion, with the fair value of the insured municipal securities totaling $6.1 billion. At December 31, 2008 and 2007, the overall credit quality of the municipal bond portfolio, including the benefits of monoline insurance, was AA- and AA+, respectively, and excluding the benefits of monoline insurance, the overall credit quality was AA-. In addition to the insured municipal securities, as of December 31, 2008, the Company has other insured securities with a fair value of approximately $500. These securities include the below prime mortgage-backed securities and other consumer loan receivables discussed above, as well as, corporate securities. The Company also has direct investments in monoline insurers with a fair value of approximately $48 as of December 31, 2008.
The following table presents the Company’s unrealized loss aging for available-for-sale securities on a consolidated basis by length of time the security was in a continuous unrealized loss position.
The following tables present the Company’s unrealized loss aging for available-for-sale securities (included in the tables above) by length of time the security was in a continuous greater than 50% unrealized loss position.
The majority of all other securities depressed over 20% for six consecutive months or greater in the tables above primarily relate to financial services sector securities that include corporate bonds, as well as, preferred equities issued by large high quality financial institutions that are lower in the capital structure, and as a result have incurred greater price depressions. Based upon the Company’s analysis of these securities and current macroeconomic conditions, the Company expects to see significant price recovery on these securities over time and, therefore, has determined that these securities are temporarily impaired as of December 31, 2008. For further discussion on these securities, see the discussion below the “Consolidated Available-for-Sale Securities by Type” table in this section above.
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 and/or future prospects, the effects of changes in interest rates or credit spreads and the expected recovery period. In addition, for securitized 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, 2008 and 2007, 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, “Other-Than-Temporary Impairments on Available-for-Sale Securities” section in Note 1 of Notes to Consolidated Financial Statements and Item 1A, Risk Factors.
The Company is also exposed to interest rate risk based upon the discount rate assumption associated with the Company’s pension and other postretirement benefit obligations. The discount rate assumption is based upon an interest rate yield curve comprised of bonds rated Aa or higher with maturities primarily between zero and thirty years. For further discussion of interest rate risk associated with the benefit obligations, 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 believes that an increase in interest rates from the current levels is generally a favorable development for the Company. Rate increases are expected to provide additional net investment income, increase sales of fixed rate Life investment products, reduce the cost of the variable annuity hedging program, limit the potential risk of margin erosion due to minimum guaranteed crediting rates in certain Life products and, if sustained, could reduce the Company’s prospective pension expense. Conversely, a rise in interest rates will reduce the fair value of the investment portfolio, increase interest expense on the Company’s variable rate debt obligations and, if long-term interest rates rise dramatically within a six to twelve month time period, certain Life businesses may be exposed to disintermediation risk. Disintermediation risk refers to the risk that policyholders will surrender their contracts in a rising interest rate environment requiring the Company to liquidate assets in an unrealized loss position. In conjunction with the interest rate risk measurement and management techniques, certain of Life’s fixed income product offerings have market value adjustment provisions at contract surrender.
The Company does not have significant equity risk exposure from invested assets. The Company’s primary exposure to equity risk relates to the potential for lower earnings associated with certain of the Life’s businesses such as variable annuities where fee income is earned based upon the fair value of the assets under management. During 2008, Life’s fee income declined $302 or 6%. In addition, Life offers certain guaranteed benefits, primarily associated with variable annuity products, which increases the Company’s potential benefit exposure as the equity markets decline. For a further discussion, see Life Equity Risk in this section of the MD&A.
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 and U.K. Life operations, and non-U.S. dollar denominated liability contracts, including its GMDB, GMAB, GMWB, and GMIB benefits associated with its Japanese and U.K. variable annuities, and a yen denominated individual fixed annuity product. A portion of the Company’s foreign currency exposure is mitigated through the use of derivatives.
Interest rate, volatility, dividend, credit default and index 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.
Derivative activities are monitored and evaluated by the Company’s risk management team and reviewed by senior management. In addition, the internal compliance unit monitors counterparty credit exposure on a monthly basis to ensure compliance with Company policies and statutory limitations. The notional amounts of derivative contracts represent the basis upon which pay or receive amounts are calculated and are not reflective of credit risk. Notional amounts pertaining to derivative instruments used in the management of market risk, excluding the credit derivatives as discussed in the “Investment Credit Risk” section, at December 31, 2008 and 2007, were $106.6 billion and $101.0 billion, respectively. The increase in the derivative notional amount during 2008 was primarily due to the derivatives associated with the GMWB product feature. For further information, see Note 4 of the Notes to Consolidated Financial Statements. For further discussion on credit derivatives, see the “Investment Credit Risk” section.
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 and U.K. Life operations and certain foreign currency based individual fixed annuity contracts, and its GMDB, GMAB, GMWB, and GMIB benefits associated with its Japanese and U.K. variable annuities.
At December 31, 2008 and 2007, notional amounts pertaining to derivatives utilized to manage interest rate risk totaled $17.0 billion and $16.8 billion, respectively ($15.0 billion and $13.1 billion, respectively, related to investments and $1.9 billion and $3.7 billion, respectively, related to life liabilities). The fair value of these derivatives was $435 and $45 as of December 31, 2008 and 2007, respectively.
The after-tax change in the net economic value of investment contracts (e.g., guaranteed investment contracts) and certain insurance product liabilities (e.g., short-term and long-term disability contracts), for which the payment rates are fixed at contract issuance and the investment experience is substantially absorbed by Life, are included in the following table along with the corresponding invested assets. Also included in this analysis are the interest rate sensitive derivatives used by Life to hedge its exposure to interest rate risk. Certain financial instruments, such as limited partnerships, have been omitted from the analysis due to the fact that the investments are accounted for under the equity method and generally lack sensitivity to interest rate changes. Separate account assets and liabilities and equity securities held for trading and the corresponding liabilities associated with the variable annuity products sold in Japan are excluded from the analysis because gains and losses in separate accounts accrue to policyholders. The calculation of the estimated hypothetical change in net economic value below assumes a 100 basis point upward and downward parallel shift in the yield curve.
The fixed liabilities included above represented approximately 63% and 45% of Life’s general account liabilities as of December 31, 2008 and 2007, respectively. The assets supporting the fixed liabilities are monitored and managed within rigorous duration guidelines, and are evaluated on a monthly basis as well as annually using scenario simulation techniques in compliance with regulatory requirements.
decrease the Company’s actual gross profits, resulting in a negative true-up to current period DAC amortization.
cause a significant decrease in the range of reasonable estimates of future gross profits used in the Company’s quantitative assessment of its modeled estimates of gross profits. If, in a given financial statement period, the modeled estimates of gross profits are determined to be unreasonable, the Company will accelerate the amount of DAC amortization in that period. Particularly in the case of variable annuities, an acceleration of DAC amortization could potentially cause a material adverse deviation in that period’s earnings, but it would not affect the Company’s cash flow or liquidity position. See Life Estimated Gross Profits Used in the Valuation and Amortization of Assets and Liabilities Associated with Variable Annuity and Other Universal Life-Type Contracts within Critical Accounting Estimates for further information on DAC and related equity market sensitivities. During 2008, the Company recorded an unlock charge of $932.
The majority of the Company’s U.S. and U.K. variable annuities are sold with a GMWB living benefit rider or a GMAB living benefit rider, which are accounted for under SFAS 133. Declines in the equity market may increase the Company’s exposure to benefits, under the GMWB and GMAB contracts, leading to an increase in the Company’s existing liability for those benefits.
For example, a GMWB and/or GMAB contract is ‘in the money’ if the contract holder’s guaranteed remaining benefit (GRB) becomes greater than the account value. As of December 31, 2008 and December 31, 2007, 88% and 19%, respectively, of all unreinsured U.S. GMWB ‘in-force’ contracts were ‘in the money’. For U.S. and U.K. GMWB contracts that were ‘in the money’ the Company’s exposure to the GRB, after reinsurance, as of December 31, 2008 and December 31, 2007, was $7.7 billion and $146, respectively. For GMAB contracts that were ‘in the money’ the Company’s exposure, as of December 31, 2008 and December 31, 2007, was $15 and $38, respectively.
However, the only ways the GMWB contract holder can monetize the excess of the GRB over the account value of the contract is upon death or if their account value is reduced to a contractually specified minimum level, through a combination of a series of withdrawals that do not exceed a specific percentage of the premiums paid per year and market declines. If the account value is reduced to the contractually specified minimum level, the contract holder will receive an annuity equal to the remaining GRB and, for the Company’s “life-time” GMWB products, the annuity can continue beyond the GRB. As the amount of the excess of the GRB over the account value can fluctuate with equity market returns on a daily basis, and the ultimate life-time GMWB payments can exceed the GRB, the ultimate amount to be paid by the Company, if any, is uncertain and could be significantly more or less than $7.7 billion.
In the U.S., the Company sells variable annuity contracts that offer various guaranteed death benefits. Declines in the equity market may increase the Company’s exposure to death benefits under these contracts. The Company accounts for these death benefit liabilities under SOP 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts, and, as such, these liabilities are not carried at fair value under SFAS 157.
In Japan, the Company offers certain variable annuity products with both a guaranteed death benefit and a guaranteed income benefit. Declines in equity markets as well as a strengthening of the Japanese yen in comparison to the U.S. dollar and other currencies may increase the Company’s exposure to these guaranteed benefits. This increased exposure may be significant in extreme market scenarios.
The Company’s total gross exposure (i.e., before reinsurance) to these guaranteed death benefits and income benefits offered in Japan as of December 31, 2008 is $9 billion. However, the Company will incur these guaranteed death or income benefits in the future only if the contract holder has an in-the-money guaranteed benefit at either the time of their death or if the account value is insufficient to fund the guaranteed living benefits. The Company currently reinsures 15% of the death benefit guarantees. Under certain of these reinsurance agreements, the reinsurers’ exposure is subject to an annual cap. For these products, the Company’s retained net amount at risk is $7.8 billion.
The accounting for living and death benefit guarantees can be significantly different and may influence the form of risk management employed by the Company. Many benefit guarantees meet the definition of an embedded derivative under SFAS 133 (GMWB and GMAB) and are recorded at fair value under SFAS 157, incorporating changes in equity indices and equity index volatility, with changes in fair value recorded in earnings. However, for other benefit guarantees, certain contract features that define how the contract holder can access the value and substance of the guaranteed benefit change the accounting from SFAS 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 when the benefit received is in substance a long-term financing (GMIB), the accounting for the benefit is prescribed by SOP 03-1.
The Company has made considerable investment in analyzing current and potential future market risk exposures arising from a number of factors, including but not limited to, product guarantees (GMDB, GMWB, GMAB, and GMIB), equity market and interest rate risks (in both the U.S. and Japan), and foreign currency exchange rates. The Company evaluates these risks individually and, increasingly, in the aggregate to determine the risk profiles of all of its products and to judge their potential impacts on financial metrics including U.S. GAAP earnings and statutory surplus. The Company manages the equity market, interest rate and foreign currency exchange risks embedded in these product guarantees through product design, reinsurance, customized derivatives, and dynamic hedging and macro hedging programs.
The Company maintains derivative hedging programs for its product guarantee risk to meet multiple, and in some cases, competing risk management objectives, including providing protection against tail scenario equity market events, providing resources to pay product guarantee claims, and minimizing U.S. GAAP earnings volatility, statutory surplus volatility and other economic metrics. For reinsurance and derivatives, the Company retains credit risk associated with the third parties. Refer to preceding section “Credit Risk” for the Company’s discussion of credit risk.
The Company’s dynamic hedging program uses derivative instruments to manage the U.S. GAAP earnings volatility associated with variable annuity product guarantees including equity market declines, equity implied volatility, declines in interest rates and foreign currency exchange risk. The Company uses hedging instruments including interest rate futures and swaps, variance swaps, S&P 500, NASDAQ and EAFE index put options and futures contracts. The dynamic hedging program involves a detailed monitoring of policyholder behavior and capital markets conditions on a daily basis and rebalancing of the hedge position as needed depending upon the risk strategy employed. While the Company actively manages this dynamic hedging program, increased U.S. GAAP earnings volatility may result from factors including, but not limited to, policyholder behavior, capital markets dislocation or discontinuity, divergence between the performance of the underlying funds and the hedging indices, and the relative emphasis placed on various risk management objectives.
The Company’s macro hedge program uses derivative instruments to partially hedge the statutory tail scenario risk associated primarily with its U.S. and Japan living and death benefit statutory reserves, providing an additional measure of protection, under tail scenarios, on statutory surplus and the associated RBC ratios. A consequence of the macro hedge program will be additional cost and volatility, under non-tail scenarios, as the macro hedge is intended to partially hedge certain equity-market sensitive liabilities calculated under statutory accounting (see Capital Resources and Liquidity) and changes in the value of the derivatives may not be closely aligned to changes in liabilities determined in accordance with U.S. GAAP, causing volatility in U.S. GAAP earnings.
During the fourth quarter of 2008, the Company maintained a reduced level of dynamic hedge protection on U.S. GAAP earnings while placing a greater relative emphasis on the protection of statutory surplus. This shift in emphasis includes the macro hedge program.
Life’s exposure to foreign currency exchange risk exists with respect to non-U.S. dollar denominated investments, Life’s investment in foreign operations, primarily in Japan and the U.K., and non-U.S. dollar denominated liability contracts, including the yen based individual fixed annuity product and its GMDB, GMAB, GMWB, and GMIB benefits associated with its Japanese and U.K. variable annuities. A significant portion of the Company’s foreign fixed maturity currency exposure is mitigated through the use of derivatives.
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, 2008 and 2007, were approximately $3.0 billion and $1.6 billion, respectively. 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 and forward agreements are structured to match the foreign currency cash flows of the hedged foreign denominated securities. At December 31, 2008 and 2007, the derivatives used to hedge currency exchange risk related to non-U.S. dollar denominated fixed maturities had a total notional amount of $1.3 billion and $1.5 billion, respectively, and total fair value of $19 and $(296), respectively.
Life issues 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, 2008 and 2007, the derivatives used to hedge foreign currency exchange risk related to foreign denominated liability contracts had a total notional amount of $792 and $790, respectively, and a total fair value of $(76) and $32, respectively.
The liquidity requirements of The Hartford have been and will continue to be met by funds from operations as well as the issuance of commercial paper, common stock, debt or other capital securities and borrowings from its contingent capital facility and 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 over the next twelve months. 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, would enter the capital markets to raise further funds to provide the requisite liquidity or take other actions. 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 operations refer to the Off-Balance Sheet Arrangements and Aggregate Contractual Obligations section below. Also see Item 1A, Risk Factors.
The Hartford endeavors to maintain a capital structure that provides financial and operational flexibility to its insurance subsidiaries, ratings that support its competitive position in the financial services marketplace (see the “Ratings” section below for further discussion), and strong shareholder returns. As a result, the Company may from time to time raise capital from the issuance of stock, debt or other capital securities and is continuously evaluating strategic opportunities. The issuance of common stock, debt or other capital securities could result in the dilution of shareholder interests or reduced net income due to additional interest expense.
HFSG and HLI are holding companies which rely upon operating cash flow in the form of dividends from their subsidiaries, which enable them to service debt, pay dividends, and pay certain business expenses. Dividends to the Company from its insurance subsidiaries are restricted. The payment of dividends by Connecticut-domiciled insurers is limited under the insurance holding company laws of Connecticut. These laws require notice to and approval by the state insurance commissioner for the declaration or payment of any dividend, which, together with other dividends or distributions made within the preceding twelve months, exceeds the greater of (i) 10% of the insurer’s policyholder surplus as of December 31 of the preceding year or (ii) net income (or net gain from operations, if such company is a life insurance company) for the twelve-month period ending on the thirty-first day of December last preceding, in each case determined under statutory insurance accounting principles. In addition, if any dividend of a Connecticut-domiciled insurer exceeds the insurer’s earned surplus, it requires the prior approval of the Connecticut Insurance Commissioner. The insurance holding company laws of the other jurisdictions in which The Hartford’s insurance subsidiaries are incorporated (or deemed commercially domiciled) generally contain similar (although in certain instances somewhat more restrictive) limitations on the payment of dividends. It is estimated that the Company’s property-casualty insurance subsidiaries will be permitted to pay up to a maximum of approximately $1.2 billion in dividends to HFSG in 2009 without prior approval from the applicable insurance commissioner. Through at least October 30, 2009, substantially all dividend payments from the Company’s property-casualty insurance subsidiaries will be subject to prior approval of the Connecticut Insurance Commissioner due to extraordinary dividend limitations under the insurance holding company laws of Connecticut. With respect to dividends to HLI, it is estimated that the Company’s life insurance subsidiaries’ non-extraordinary dividend limitation under the insurance holding company laws of Connecticut is approximately $631 in 2009. However, because the life insurance subsidiaries’ earned surplus is only approximately $597 as of December 31, 2008, the Company’s life insurance subsidiaries will be permitted to pay dividends up to this amount to HLI in 2009 without prior approval from the applicable insurance commissioner. In 2008, HFSG and HLI received a combined total of $2.8 billion from their insurance subsidiaries.
In June 2008, The Hartford’s Board of Directors authorized an incremental $1 billion stock repurchase program which was in addition to the previously announced $2 billion program. The Company’s repurchase authorization permits purchases of common stock, which may be in the open market or through privately negotiated transactions. The Company also may enter into derivative transactions to facilitate future repurchases of common stock. The timing of any future repurchases will be dependent upon several factors, including the market price of the Company’s securities, the Company’s capital position, consideration of the effect of any repurchases on the Company’s financial strength or credit ratings, the Company’s potential participation in the CPP, and other corporate considerations. The repurchase program may be modified, extended or terminated by the Board of Directors at any time. As of December 31, 2008, The Hartford has completed the $2 billion stock repurchase program and has $807 remaining for stock repurchase under the $1 billion repurchase program. For further discussion of common stock acquired in 2008, refer to the Stockholders’ Equity section below.
On April 11, 2007, The Hartford filed an automatic shelf registration statement (Registration No. 333-142044) for the potential offering and sale of debt and equity securities with 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. In that The Hartford is a well-known seasoned issuer, as defined in Rule 405 under the Securities Act of 1933, the registration statement went effective immediately upon filing and The Hartford may offer and sell an unlimited amount of securities under the registration statement during the three-year life of the shelf.
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. The Company holds a variable interest in the ABC Trust where the Company is not the primary beneficiary. As a result, the Company did not consolidate the ABC Trust, as they did not meet the consolidation requirements under FASB Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51” (“FIN 46(R)”).
As of December 31, 2008 and 2007, the Company’s Japanese operation line of credit in yen was ¥5 billion.
Warrants issued to Allianz to purchase 34,806,452 shares of the Company’s common stock, classified at issuance in equity at a fair value of $276. See Note 21 of Notes to Consolidated Financial Statements.
Reserves for Property & Casualty unpaid losses and loss adjustment expenses include case reserves for reported claims and reserves for claims incurred but not reported (IBNR). While payments due on claim reserves are considered contractual obligations because they relate to insurance policies issued by the Company, the ultimate amount to be paid to settle both case reserves and IBNR is an estimate, subject to significant uncertainty. The actual amount to be paid is not finally determined until the Company reaches a settlement with the claimant. Final claim settlements may vary significantly from the present estimates, particularly since many claims will not be settled until well into the future.
Under U.S. GAAP, the Company is only permitted to discount reserves for losses and loss adjustment expenses in cases where the payment pattern and ultimate loss costs are fixed and determinable on an individual claim basis. For the Company, these include claim settlements with permanently disabled claimants. As of December 31, 2008, the total property and casualty reserves in the above table are gross of a reserve discount of $488.
Consumer notes include principal payments and contractual interest for fixed rate notes and interest based on current rates for floating rate notes and the market value of embedded derivatives for equity-linked notes. See Note 14 of Notes to Consolidated Financial Statements for additional discussion of consumer notes.
Includes $1.1 billion in commitments to purchase investments including about $1.0 billion of limited partnership and $99 of mortgage and construction loans. Outstanding commitments under these limited partnerships and mortgage and construction loans are included in payments due in less than 1 year since the timing of funding these commitments cannot be reliably estimated. The remaining commitments to purchase investments primarily represent payables for securities purchased which are reflected on the Company’s consolidated balance sheet.
Includes cash collateral of $6.3 billion which the Company has accepted in connection with the Company’s securities lending program and derivative instruments. Since the timing of the return of the collateral is uncertain, the return of the collateral has been included in the payments due in less than 1 year.
Also included in other long term liabilities is $91 of net unrecognized tax benefits related to Financial Accounting Standards Board Interpretation No 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). See Note 13 of the Notes to Consolidated Financial Statements for additional discussion of FIN 48.
Does not include estimated voluntary contribution of $200 to the Company’s pension plan in 2009.
While the Company has significant discretion in making voluntary contributions to the U. S. qualified defined benefit pension plan, the Employee Retirement Income Security Act of 1974, as amended by the Pension Protection Act of 2006 and further amended by the Worker, Retiree, and Employer Recovery Act of 2008, and Internal Revenue Code regulations mandate minimum contributions in certain circumstances. The Company made contributions to its pension plans of $2, $158, and $402 in 2008, 2007 and 2006, respectively, and contributions to its other postretirement plans of $46 in 2007. No contributions were made to the other postretirement plans in 2008 and 2006. The Company’s 2008 required minimum funding contribution was immaterial. The Company presently anticipates contributing approximately $200 to its pension plans and other postretirement plans in 2009, based upon certain economic and business assumptions. These assumptions include, but are not limited to, equity market performance, changes in interest rates and the Company’s other capital requirements. The Company does not have a required minimum funding contribution for the U.S. qualified defined benefit pension plan for 2009 and the funding requirements for all of the pension plans are expected to be immaterial.
Total debt of the Company excludes $1.2 billion and $809 of consumer notes as of December 31, 2008 and 2007, respectively.
The Hartford’s debt increased $1.7 billion or 38% primarily due to the issuance of $500 in 8.125% junior subordinated debentures in June 2008 and $1.75 billion in 10% junior subordinated debentures issued in October 2008. The $1.75 billion in 10% junior subordinated debentures relate to Allianz’s investment in The Hartford, and include warrants of $547, which reduced the carrying value of the debt.
The Company has also agreed that, for the one-year period following October 17, 2008, it will pay certain amounts to Allianz if the Company effects or agrees to effect any transaction (or series of transactions) pursuant to which any person or group (within the meaning of the U.S. federal securities laws) is issued common stock or certain equity-related instruments constituting more than 5% of the Company’s fully-diluted common stock outstanding at the time for an effective price per share (determined as provided in the Investment Agreement) of less than $25.32. Amounts so payable depend on the effective price for the applicable transaction (or the weighted average price for a series of transactions) and range from $50 if the effective price per share is between $25.31 and $23.00, $150 if the effective price per share is between $22.99 and $20.00, $200 if the effective price per share is between $19.99 and $15.00 and $300 if the effective price per share is $14.99 or less.
In addition to the receipt of specified regulatory approvals, the conversion into 34,308,872 shares of common stock of the Series C Preferred Stock underlying certain of the Warrants is subject to the approval of the Company’s stockholders in accordance with applicable regulations of the New York Stock Exchange. Under the Investment Agreement, the Company is obligated to pay Allianz $75 if such stockholder approval is not obtained at the first stockholder meeting to consider such approval, and $50 if such stockholder approval is not obtained at a second such meeting. Because the conversion of the Series C Preferred Stock is subject to stockholder approval and the related payment provision represents a form of net cash settlement outside the Company’s control, the Warrants to purchase the Series C Preferred Stock and the stockholder approval payment were recorded as a derivative liability at a relative fair value of $273 at issuance. As of December 31, 2008, the Warrants to purchase the Series C Preferred Stock had a fair value of $163. The Company recognized a gain of $110, after-tax, for the year ended December 31, 2008, representing the change in fair value of the Warrants to purchase the Series C Preferred Stock.
The following discussion describes the Company’s debt financing activities for 2008. For additional information regarding debt including Allianz’s investment in The Hartford, see Notes 14 and 21 of Notes to Consolidated Financial Statements.
On November 16, 2008, The Hartford repaid its $330, 5.663% senior notes at maturity.
On March 4, 2008, The Hartford issued $500 of 6.3% senior notes due March 15, 2018. The issuance was made pursuant to the Company’s shelf registration statement (Registration No. 333-142044).
Subject to the replacement capital covenant described below, the Company can redeem the debentures at its option, in whole or in part, at any time on or after June 15, 2018 at a redemption price of 100% of the principal amount being redeemed plus accrued but unpaid interest. The Company can redeem the debentures at its option prior to June 15, 2018 (a) in whole at any time or in part from time to time or (b) in whole, but not in part, in the event of certain tax or rating agency events relating to the debentures, at a redemption price equal to the greater of 100% of the principal amount being redeemed and the applicable make-whole amount, in each case plus any accrued and unpaid interest.
In connection with the offering of the debentures, the Company entered into a “replacement capital covenant” for the benefit of holders of one or more designated series of the Company’s indebtedness, initially the Company’s 6.1% notes due 2041. Under the terms of the replacement capital covenant, if the Company redeems the debentures at any time prior to June 15, 2048 it can only do so with the proceeds from the sale of certain qualifying replacement securities.
The Company recorded capital leases of $92 and $128 in 2008 and 2007, respectively. Capital lease obligations are included in long-term debt, except for the current maturities, which are included in short-term debt, in the consolidated balance sheet as of December 31, 2008 and 2007, respectively. See Note 12 for further information on capital lease commitments.
On June 4, 2008, the Company entered into a collared accelerated share repurchase agreement (“ASR”) with a major financial institution. Under the terms of the agreement, The Hartford paid $500 and received 7.3 million shares. The Company has accounted for this transaction in accordance with EITF Issue No. 99-7, “Accounting for an Accelerated Share Repurchase Program.”
For additional information on stockholders’ equity, AOCI, net of tax, pension and other postretirement plans and Allianz’s investment in The Hartford see Notes 15, 16, 17 and 21, respectively, of Notes to Consolidated Financial Statements.
The decrease in cash from operating activities compared to prior year period was primarily the result of a decrease in net investment income as a result of lower yields and reduced fee income as a result of declines in equity markets. Net purchases of available-for-sale securities continue to account for the majority of cash used for investing activities. Cash from financing activities increased primarily due to $2.5 billion in investment in The Hartford by Allianz SE, increased transfers from the separate account to the general account for investment and universal life-type contracts and net issuances of long-term debt and consumer notes, offset by treasury stock acquired and dividends paid.
The increase in cash from operating activities compared to prior year period was primarily the result of premium cash flows in excess of claim payments, partially offset by increases in taxes paid. Net purchases of available-for-sale securities accounted for the majority of cash used for investing activities. Cash from financing activities decreased primarily due to treasury stock acquired and increases in dividends paid; partially offset by higher net receipts from policyholder’s accounts related to investment and universal life contracts, proceeds from consumer notes, and issuance of long-term debt, net of repayments.
On February 6, 2009, Moody’s downgraded the senior debt ratings to Baa1 from A3 and the insurance financial strength ratings for the Company’s lead property and casualty and life insurance operating companies to A1 from Aa3. The ratings outlook is negative.
On February 9, 2009, Fitch Ratings downgraded the senior debt ratings to BBB from A-. Fitch also downgraded the insurer financial strength ratings of our primary life insurance subsidiaries to A from AA- and property/casualty insurance subsidiaries to A+ from AA-. The ratings outlook is negative.
The following table summarizes The Hartford’s significant member companies’ financial ratings from the major independent rating organizations as of February 10, 2009.
The Company has received approval from the Connecticut Insurance Department regarding the use of two permitted practices in the statutory financial statements of its Connecticut-domiciled life insurance subsidiaries as of December 31, 2008. The first permitted practice relates to the statutory accounting for deferred income taxes. Specifically, this permitted practice modifies the accounting for deferred income taxes prescribed by the NAIC by increasing the realization period for deferred tax assets from one year to three years and increasing the asset recognition limit from 10% to 15% of adjusted statutory capital and surplus. The benefits of this permitted practice may not be considered by the Company when determining surplus available for dividends. The second permitted practice relates to the statutory reserving requirements for variable annuities with guaranteed living benefit riders. Actuarial guidelines prescribed by the NAIC require a stand-alone asset adequacy analysis reflecting only benefits, expenses and charges that are associated with the riders for variable annuities with guaranteed living benefits. The permitted practice allows for all benefits, expenses and charges associated with the variable annuity contract to be reflected in the stand-alone asset adequacy test. These permitted practices resulted in an increase to Life operations estimated statutory surplus of $987 as of December 31, 2008. The effects of these permitted practices are included in the 2008 Life operations surplus amount in the table above.
Costs incurred by the Company to acquire insurance policies are deferred under U.S. GAAP while those costs are expensed immediately under US STAT.
The difference between the amortized cost and fair value of fixed maturity and other investments, net of tax, is recorded as an increase or decrease to the carrying value of the related asset and to equity under U.S. GAAP, while US STAT only records certain securities at fair value, such as equity securities and certain lower rated bonds required by the NAIC to be recorded at the lower of amortized cost or fair value. In the case of the Company’s market value adjusted (MVA) fixed annuity products, invested assets are marked to fair value (including the impact of credit spreads) and liabilities are marked to fair value (but generally actual credit spreads are not fully reflected) for statutory purposes only.
US STAT for life insurance companies establishes a formula reserve for realized and unrealized losses due to default and equity risks associated with certain invested assets (the Asset Valuation Reserve), while U.S. GAAP does not. Also, for those realized gains and losses caused by changes in interest rates, US STAT for life insurance companies defers and amortizes the gains and losses, caused by changes in interest rates, into income over the original life to maturity of the asset sold (the Interest Maintenance Reserve) while U.S. GAAP does not.
Goodwill arising from the acquisition of a business is tested for recoverability on an annual basis (or more frequently, as necessary) for U.S. GAAP, while under US STAT goodwill is amortized over a period not to exceed 10 years and the amount of goodwill is limited.
In addition, certain assets, including a portion of premiums receivable and fixed assets, are non-admitted (recorded at zero value and charged against surplus) under US STAT. U.S. GAAP generally evaluates assets based on their recoverability.
A company’s risk-based statutory surplus is calculated by applying factors and performing calculations relating to various asset, premium, claim, expense and reserve items. Regulators can then measure the adequacy of a company’s statutory surplus by comparing it to the risk-based capital (“RBC”). Under RBC requirements, regulatory compliance is determined by the ratio of a company’s total adjusted capital, as defined by the insurance regulators, to its company action level of RBC (known as the RBC ratio), also as defined by insurance regulators. In addition, the rating agencies view RBC ratios along with their proprietary models as key factors in making ratings determinations.
As the value of certain fixed-income and equity securities in our investment portfolio decreases, due in part to credit spread widening, statutory surplus and RBC ratios may decrease.
Life’s exposure to foreign currency exchange risk exists with respect to non-U.S. dollar denominated assets and liabilities. Assets and liabilities denominated in foreign currencies are accounted for at their U.S. dollar equivalent values using exchange rates at the balance sheet date. As foreign currency exchange rates strengthen in comparison to the U.S. dollar, the remeasured value of those non-dollar denominated assets or liabilities will increase causing an increase or decrease to statutory surplus, respectively.
Our statutory surplus is also impacted by widening credit spreads as a result of the accounting for the assets and liabilities in our fixed market value adjusted (“MVA”) annuities. Statutory separate account assets supporting the fixed MVA annuities are recorded at fair value. In determining the statutory reserve for the fixed MVA annuities, we are required to use current crediting rates in the U.S. and Japanese LIBOR in Japan. In many capital market scenarios, current crediting rates in the U.S. are highly correlated with market rates implicit in the fair value of statutory separate account assets. As a result, the change in statutory reserve from period to period will likely substantially offset the change in the fair value of the statutory separate account assets. However, in periods of volatile credit markets, such as we are now experiencing, actual credit spreads on investment assets may increase sharply for certain sub-sectors of the overall credit market, resulting in statutory separate account asset market value losses. As actual credit spreads are not fully reflected in the current crediting rates in the U.S. or Japanese LIBOR in Japan, the calculation of statutory reserves will not substantially offset the change in fair value of the statutory separate account assets resulting in reductions in statutory surplus and create funding obligations to the statutory separate account.
In addition, the Company can access the $500 Glen Meadow trust contingent capital facility, maintains the ability to access $1.9 billion of capacity under its revolving credit facility and has been approved by the U.S. Office of Thrift Supervision to acquire Federal Trust Bank which may provide access, if granted, to funds under the U.S. Treasury’s Capital Purchase Program.