Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) addresses the financial condition of The Hartford Financial Services Group, Inc. and its subsidiaries (collectively, “The Hartford” or the “Company”) as of December 31, 2010, compared with December 31, 2009, and its results of operations for each of the three years in the period ended December 31, 2010. This discussion should be read in conjunction with the Consolidated Financial Statements and related Notes beginning on page. The Hartford made changes to its reporting segments in 2010 to reflect the manner in which the Company is currently organized for purposes of making operating decisions and assessing performance. Accordingly, segment data for prior reporting periods has been adjusted to reflect the new segment reporting, see Note 3 of the Notes to Consolidated Financial Statement for further discussion. Additionally, certain reclassifications have been made to prior year financial information to conform to the current year presentation. The Hartford defines increases or decreases greater than or equal to 200%, or changes from a net gain to a net loss position, or vice versa, as “NM” or not meaningful.
The change from consolidated net loss to consolidated net income was primarily due to a DAC Unlock charge of $1.0 billion, after-tax, in 2009 compared to a benefit of $111, after-tax, in 2010, net realized capital losses of $1.7 billion, after-tax, in 2009 compared to losses of $184, after-tax, in 2010, partially offset by a goodwill impairment of approximately $32, after-tax, in 2009, compared to approximately $100, after-tax, in 2010.
Excluding the after-tax impacts of net realized capital losses, DAC Unlocks and goodwill impairments, earnings decreased $46 from 2009 to 2010. See the segment sections of the MD&A for a discussion on their respective performances.
The decrease in consolidated net loss was primarily due to a decrease in net realized losses, which included other-than-temporary impairments of $1.5 billion in 2009 compared to $4.0 billion in 2008, and gains on the variable annuity hedge program of $631 in 2009 compared to losses of $639 in 2008. Partially offsetting the decrease in realized losses was approximately $300 in net realized capital losses in 2009 related to the settlement of a contingent obligation to Allianz SE (“Allianz”). Goodwill impairments of $32, after-tax, in 2009 compared to impairments of $597, after-tax, in 2008 also contributed to the decrease in net loss.
Excluding the after-tax impacts of net realized capital losses and goodwill impairments, earnings decreased $608 from 2008 to 2009 driven by decreases in fee income due to lower average assets under management primarily in Global Annuity, lower net investment income on available-for-sale and other securities primarily due to lower income on fixed maturities, and restructuring costs. See the segment sections of the MD&A for a discussion on their respective performances.
The effective tax rates for 2010, 2009 and 2008 were 26%, 49%, and 40%, respectively. The principal causes of the differences between the effective rate and the U.S. statutory rate of 35% for 2010, 2009 and 2008 were tax-exempt interest earned on invested assets and the separate account dividends received deduction (“DRD”). This caused a decrease in the tax expense on the 2010 pre-tax income and an increase in the tax benefit on the 2009 and 2008 pre-tax losses. The effective tax rate for 2010 also includes the effect of an increase in the valuation allowance on the deferred tax asset and the effective tax rate for 2009 includes the tax effect of a non-deductible expense related to the settlement of a contingent obligation to Allianz. For additional information, see Note 13 of the Notes to Consolidated Financial Statements.
The separate account DRD is estimated for the current year using information from the prior year-end, adjusted for current year equity market performance and other appropriate factors, including estimated levels of corporate dividend payments. The actual current year DRD can vary from estimates based on, but not limited to, changes in eligible dividends received by the mutual funds, amounts of distribution from these mutual funds, amounts of short-term capital gains at the mutual fund level and the Company’s taxable income before the DRD. The Company recorded benefits of $145, $181 and $176 related to the separate account DRD in the years ended December 31, 2010, 2009 and 2008, respectively. These amounts included benefits (charges) related to prior years’ tax returns of $(3), $29 and $9 in 2010, 2009 and 2008, respectively.
Commercial Markets will continue to focus on growth through market-differentiated products and services while maintaining a disciplined underwriting approach. In the Property & Casualty Commercial insurance marketplace, improving market conditions are expected to allow for moderate price increases, while a slowly-recovering economy will result in an increase in insurance exposures. Within Property & Casualty Commercial, the Company expects low to mid single-digit written premium growth in 2011, due to an increase in pricing, higher new business premium and an increase in premium retention. Additionally, Property & Casualty Commercial is expected to continue to grow policy counts, particularly for our small commercial business, led by an increase in workers’ compensation in force. This growth potential reflects the combination of our current market position, a broadening of underwriting expertise focused on selected industries, a leveraging of the payroll model, and numerous initiatives launched in the past several years. Initiatives include programs aimed at improving policy count retention, the rollout of new product offerings and the introduction of ease of doing business technology for our small commercial business. The Property & Casualty Commercial combined ratio before catastrophes and prior accident year development is expected to be slightly higher in 2011 than the 93.4 achieved in 2010 as pricing increases are expected to largely offset loss cost changes. In the Group Benefits, the economic downturn, combined with the potential for employees to lessen spending on the Company’s products and the overall competitive environment, reduced premium levels in 2010. Premium levels are expected to remain relatively flat in 2011, or until there is economic expansion with lower unemployment rates compared to 2010 levels. Over time, 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 continued opportunities for our products and services. The Company experienced higher disability loss ratios in 2010. The Company anticipates loss ratios to remain essentially flat in 2011.
In 2011, Consumer Markets expects to increase its business written with AARP members and enter into new affinity relationships. Management expects new business will primarily be generated from continued direct marketing to AARP members, marketing to households associated with other affinity groups, expanding the sale of the Open Road Advantage auto product through independent agents and introducing an enhanced homeowners product called Hartford Home Advantage. The Company distributes its discounted AARP Open Road Advantage auto product through those independent agents who are authorized to offer the AARP product and, beginning in 2011, will distribute its Hartford Home Advantage product on a discounted basis through those same authorized agents. The Company expects non-AARP member Agency earned premium to decline in 2011 as the result of continued pricing and underwriting actions to improve profitability, including efforts to reposition the book into more business for insureds aged 40+. As of December 31, 2010, the Open Road Advantage auto product was available in 33 states and the Company expects the product to be available to authorized agents in 42 states by the end of the second quarter of 2011. The Company began rolling out its Hartford Home Advantage product during the first quarter of 2011 and expects the product to be available in 39 states by the end of 2011. Management expects that the combined ratio before catastrophes and prior accident year development will improve in 2011, driven by earned pricing increases, slightly improving claim frequency and modest claim severity in both auto and home as the Company expects to benefit from a continued shift to a more preferred mix of business.
Reserve estimates can also change over time because of changes in internal Company operations. Potential internal factors include (1) periodic changes in claims handling procedures; (2) growth in new lines of business where exposure and loss development patterns are not well established; or (3) changes in the quality of risk selection in the underwriting process. In the case of assumed reinsurance, all of the above risks apply. In addition, changes in ceding company case reserving and reporting patterns can create additional factors that need to be considered in estimating the reserves. Due to the inherent complexity of the assumptions used, final claim settlements may vary significantly from the present estimates, particularly when those settlements may not occur until well into the future.
The Company provides an allowance for uncollectible reinsurance, reflecting management’s best estimate of reinsurance cessions that may be uncollectible in the future due to reinsurers’ unwillingness or inability to pay. The Company analyzes recent developments in commutation activity between reinsurers and cedants, recent trends in arbitration and litigation outcomes in disputes between reinsurers and cedants and the overall credit quality of the Company’s reinsurers. Where its contracts permit, the Company secures future claim obligations with various forms of collateral, including irrevocable letters of credit, secured trusts, funds held accounts and group-wide offsets. The allowance for uncollectible reinsurance was $290 as of December 31, 2010, including $79 related to Property & Casualty Commercial and $211 related to Other Operations.
The following table shows loss and loss adjustment expense reserves by line of business as of December 31, 2010, net of reinsurance:
An expected loss ratio is used in initially recording the reserves for both short-tail and long-tail lines of business. This expected loss ratio is determined through a review of prior accident years’ loss ratios and expected changes to earned pricing, loss costs, mix of business, ceded reinsurance and other factors that are expected to impact the loss ratio for the current accident year. For short-tail lines, IBNR for the current accident year is initially recorded as the product of the expected loss ratio for the period, earned premium for the period and the proportion of losses expected to be reported in future calendar periods for the current accident period. For long-tailed lines, IBNR reserves for the current accident year are initially recorded as the product of the expected loss ratio for the period and the earned premium for the period, less reported losses for the period.
As of December 31, 2010 and 2009, net property and casualty insurance product reserves for losses and loss adjustment expenses reported under accounting principles generally accepted in the United States of America (“U.S. GAAP”) were approximately equal to net reserves reported on a statutory basis. Under U.S. GAAP, liabilities for unpaid losses for permanently disabled workers’ compensation claimants are discounted at rates that are no higher than risk-free interest rates and which generally exceed the statutory discount rates set by regulators, such that workers’ compensation reserves for statutory reporting are higher than the reserves for U.S. GAAP reporting. Largely offsetting the effect of the difference in discounting is that a portion of the U.S. GAAP provision for uncollectible reinsurance is not recognized under statutory accounting. Most of the Company’s property and casualty insurance product reserves are not discounted. However, the Company has discounted liabilities funded through structured settlements and has discounted certain reserves for indemnity payments due to permanently disabled claimants under workers’ compensation policies.
Workers’ Compensation. Workers’ compensation is the Company’s single largest reserve line of business so a wide range of methods are reviewed in the reserve analysis. Methods performed include paid and reported development, variations on expected loss ratio methods, and an in-depth analysis on the largest states. Historically, paid development patterns in the Company’s workers’ compensation business have been stable, so paid techniques are preferred for older accident periods. For more recent periods, paid techniques are less predictive of the ultimate liability since such a low percentage of ultimate losses are paid in early periods of development. Accordingly, for more recent accident periods, the Company generally relies more heavily on a state-by-state analysis and the expected loss ratio approach.
Assumed Reinsurance and All Other. For these lines, management tends to rely on the reported development techniques. In assumed reinsurance, assumptions are influenced by information gained from claim and underwriting audits.
The following discussion includes disclosure of possible variation from current estimates of loss reserves due to a change in certain key indicators of potential losses. Each of the impacts described below is estimated individually, without consideration for any correlation among key indicators or among lines of business. Therefore, it would be inappropriate to take each of the amounts described below and add them together in an attempt to estimate volatility for the Company’s reserves in total. The estimated variation in reserves due to changes in key indicators is a reasonable estimate of possible variation that may occur in the future, likely over a period of several calendar years. It is important to note that the variation discussed is not meant to be a worst-case scenario, and therefore, it is possible that future variation may be more than the amounts discussed below.
Recorded reserves for workers’ compensation, net of reinsurance, are $6.7 billion. Loss development patterns are a key indicator for this line of business, particularly for more mature accident years. Historically, loss development patterns have been impacted by, among other things, medical cost inflation. The Company has reviewed the historical variation in reported loss development patterns. If the reported loss development patterns change by 3%, the estimated net reserve need would change by $400, in either direction. A 3% change in reported loss development patterns is within the Company’s historical variation, as measured by the variation around the average development factors as reported in statutory accident year reports.
Recorded reserves for general liability, net of reinsurance, are $2.8 billion. Loss development patterns are a key indicator for this line of business, particularly for more mature accident years. Historically, loss development patterns have been impacted by, among other things, emergence of new types of claims (e.g., construction defect claims) or a shift in the mixture between smaller, more routine claims and larger, more complex claims. The Company has reviewed the historical variation in reported loss development patterns. If the reported loss development patterns change by 9%, the estimated net reserve need would change by $200, in either direction. A 9% change in reported loss development patterns is within the Company’s historical variation, as measured by the variation around the average development factors as reported in statutory accident year reports.
A number of factors affect the variability of estimates for asbestos and environmental reserves including assumptions with respect to the frequency of claims, the average severity of those claims settled with payment, the dismissal rate of claims with no payment and the expense to indemnity ratio. The uncertainty with respect to the underlying reserve assumptions for asbestos and environmental adds a greater degree of variability to these reserve estimates than reserve estimates for more traditional exposures. While this variability is reflected in part in the size of the range of reserves developed by the Company, that range may still not be indicative of the potential variance between the ultimate outcome and the recorded reserves. The recorded net reserves as of December 31, 2010 of $2.14 billion ($1.80 billion and $339 for asbestos and environmental, respectively) is within an estimated range, unadjusted for covariance, of $1.67 billion to $2.44 billion. The process of estimating asbestos and environmental reserves remains subject to a wide variety of uncertainties, which are detailed in Note 12 of Notes to Consolidated Financial Statements. The Company believes that its current asbestos and environmental reserves are appropriate. However, analyses of future developments could cause the Company to change its estimates and ranges of its asbestos and environmental reserves, and the effect of these changes could be material to the Company’s consolidated operating results, financial condition and liquidity. Consistent with the Company’s long-standing reserving practices, the Company will continue to review and monitor its reserves in Other Operations regularly and, where future developments indicate, make appropriate adjustments to the reserves.
Based on the results of the quarterly reserve review process, the Company determines the appropriate reserve adjustments, if any, to record. Recorded reserve estimates are changed after consideration of numerous factors, including but not limited to, the magnitude of the difference between the actuarial indication and the recorded reserves, improvement or deterioration of actuarial indications in the period, the maturity of the accident year, trends observed over the recent past and the level of volatility within a particular line of business. In general, adjustments are made more quickly to more mature accident years and less volatile lines of business. Such adjustments of reserves are referred to as “reserve development”. Reserve development that increases previous estimates of ultimate cost is called “reserve strengthening”. Reserve development that decreases previous estimates of ultimate cost is called “reserve releases”. Reserve development can influence the comparability of year over year underwriting results and is set forth in the paragraphs and tables that follow.
Included within prior accident years development for the year ended December 31, 2010 were the following reserve strengthenings (releases):
During 2010, the Company’s re-estimates of prior accident years reserves included the following significant reserve changes:
Released reserves for personal auto liability claims. Favorable trends in reported severity have persisted, most notably for accident years 2008 and 2009. As these accident years develop, the uncertainty around the ultimate losses is reduced and management places more weight on the emerged experience. The reserve releases impact accident years 2004 through 2009, as some of the older years are also showing improvements in reported severity.
Released reserves for workers’ compensation business, primarily related to accident years 2006 and 2007. Management updated reviews of state reforms affecting these accident years and determined impacts to be more favorable than previously estimated. Accordingly, management reduced reserve estimates for these years.
Released reserves for general liability claims, primarily related to accident years 2005 through 2008. Claim emergence for these accident years continues to be lower than anticipated. Management now believes this lower level of claim activity will continue into the future and has reduced its reserve estimate in response to these favorable trends. Partially offsetting this reserve release is strengthening on loss adjustment expense reserves during the second quarter of 2010 due to higher than expected allocated loss expenses for claims in accident years 2000 and prior.
Refer to the Other Operations Claims section for further discussion concerning the Company’s annual evaluations of net environmental and net asbestos reserves, and related reinsurance.
Strengthened reserves for surety business, primarily related to accident years 2004 to 2007. The net strengthening consisted of $55 strengthening of reserves for customs bonds, partially offset by a $27 release of reserves for contract surety claims. During 2008, the Company became aware that there were a large number of late reported surety claims related to customs bonds. Continued high volume of late reported claims during 2009 caused the Company to strengthen the reserves. Because the pattern of claim reporting for customs bonds has not been similar to the reporting pattern of other surety bonds, future claim activity is difficult to predict. It is possible that as additional claim activity emerges, our estimate of both the number of future claims and the cost of those claims could change substantially.
The Company reviewed its allowance for uncollectible reinsurance for Property & Casualty Commercial in the second quarter of 2009 and reduced its allowance for Property & Casualty Commercial driven, in part, by a reduction in gross ceded loss recoverables.
Released reserves for professional liability claims for accident years 2003 to 2006. During 2008, the Company updated its analysis of certain professional liability claims and the new analysis showed that claim severity for directors and officers losses in the 2003 to 2006 accident years were favorable to previous expectations, resulting in a reduction of reserves. The analysis also showed favorable emergence of claim severity on errors and omission policy claims for the 2004 and 2005 accident years, resulting in a release of reserves.
Strengthened reserves for allocated loss adjustment expenses on national account general liability claims. Allocated loss adjustment expense reserves on general liability excess and umbrella claims were strengthened for accident years 2004 and prior as the Company observed that the cost of settling these claims has exceeded previous expectations.
Reserves and reserve activity in the Other Operations operating segment, within Corporate and Other, are categorized and reported as asbestos, environmental, or “all other”. The “all other” category of reserves covers a wide range of insurance and assumed reinsurance coverages, including, but not limited to, potential liability for construction defects, lead paint, silica, pharmaceutical products, molestation and other long-tail liabilities.
Gross of reinsurance, asbestos and environmental reserves, including liabilities in Property & Casualty Commercial and Commercial Markets, were $2,308 and $378, respectively, as of December 31, 2010; $2,484 and $367, respectively, as of December 31, 2009; and $2,498 and $309, respectively, as of December 31, 2008.
The following table sets forth, for the years ended December 31, 2010, 2009 and 2008, paid and incurred loss activity by the three categories of claims for asbestos and environmental.
The three year average gross paid amount for total environmental claims is $56, resulting in a three year gross survival ratio of 6.8.
During the second quarters of 2010, 2009 and 2008, the Company completed its annual ground-up asbestos reserve evaluations. As part of these evaluations, the Company reviewed all of its open direct domestic insurance accounts exposed to asbestos liability, as well as assumed reinsurance accounts and its London Market exposures for both direct insurance and assumed reinsurance. Based on this evaluation, the Company increased its net asbestos reserves by $169 in second quarter 2010. During 2010 and 2009, for certain direct policyholders, the Company experienced increases in claim severity and expense. Increases in severity and expense were driven by litigation in certain jurisdictions and, to a lesser extent, development on primarily peripheral accounts. The Company also experienced unfavorable development on its assumed reinsurance accounts driven largely by the same factors experienced by the direct policyholders. The net effect of these changes in 2009 resulted in a $138 increase in net asbestos reserves. 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. The Company currently expects to continue to perform an evaluation of its asbestos liabilities annually.
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. During the second quarters of 2010, 2009 and 2008, the Company completed its annual evaluations of the collectability of the reinsurance recoverables and the adequacy of the allowance for uncollectible reinsurance associated with older, long-term casualty liabilities reported in the Other Operations segment. In conducting this evaluation, the Company used its most recent detailed evaluations of ceded liabilities reported in the segment. The Company analyzed the overall credit quality of the Company’s reinsurers, recent trends in arbitration and litigation outcomes in disputes between cedants and reinsurers, and recent developments in commutation activity between reinsurers and cedants. The evaluation in the second quarter of 2010 resulted in no addition to the allowance for uncollectible reinsurance. As of December 31, 2010, the allowance for uncollectible reinsurance for Other Operations totals $211. As a result of the second quarter of 2009 evaluation, the Company reduced its allowance for uncollectible reinsurance by $20 principally to reflect decreased reinsurance recoverable dispute exposure and favorable activity since the last evaluation. The evaluation in the second quarter of 2008 resulted in no addition to the allowance for uncollectible reinsurance. The Company currently expects to perform its regular comprehensive review of Other Operations reinsurance recoverables annually. Due to the inherent uncertainties as to collection and the length of time before reinsurance recoverables become due, particularly for older, long-term casualty liabilities, it is possible that future adjustments to the Company’s reinsurance recoverables, net of the allowance, could be required.
The table above shows the cumulative deficiency (redundancy) of the Company’s reserves, net of reinsurance, as now estimated with the benefit of additional information. Those amounts are comprised of changes in estimates of gross losses and changes in estimates of related reinsurance recoveries.
During the 2007 calendar year, the Company refined its processes for allocating incurred but not reported (“IBNR”) reserves by accident year, resulting in a reclassification of $347 of IBNR reserves from the 2003 to 2006 accident years to the 2002 and prior accident years. This reclassification of reserves by accident year had no effect on total recorded reserves within any segment or on total recorded reserves for any line of business within a segment.
The largest impacts of net reserve re-estimates are shown in the “2000 & Prior” accident years. Reserve deterioration was related to calendar years, driven, in part, by deterioration of reserves for assumed casualty reinsurance and workers’ compensation claims. Numerous actuarial assumptions on assumed casualty reinsurance turned out to be low, including loss cost trends, particularly on excess of loss business, and the impact of deteriorating terms and conditions. Workers’ compensation reserves also deteriorated, as medical inflation trends were above initial expectations.
The reserve re-estimates in calendar year 2003 include an increase in reserves of $2.6 billion related to reserve strengthening based on the Company’s evaluation of its asbestos reserves. The reserve evaluation that led to the strengthening in calendar year 2003 confirmed the Company’s view of the existence of a substantial long-term deterioration in the asbestos litigation environment. The reserve re-estimates in calendar years 2004 and 2006 were largely attributable to reductions in the reinsurance recoverable asset associated with older, long-term casualty liabilities.
Beginning with the second quarter of 2009, the Company now determines EGPs from a single deterministic reversion to mean (“RTM”) separate account return projection which is an estimation technique commonly used by insurance entities to project future separate account returns. Through this estimation technique, the Company’s DAC model is adjusted to reflect actual account values at the end of each quarter. Through consideration of recent market returns, the Company will unlock, or adjust, projected returns over a future period so that the account value returns to the long-term expected rate of return, providing that those projected returns do not exceed certain caps or floors. This DAC Unlock for future separate account returns is determined each quarter. Under RTM, the expected long term weighted average rate of return is 8.3% and 5.9% for U.S. and Japan, respectively.
The after-tax impact on the Company’s assets and liabilities as a result of the Unlocks for years ended 2010, 2009 and 2008, were:
Includes $(49) related to DAC recoverability impairment associated with the decision to suspend sales in the U.K variable annuity business.
The most significant contributors to the Unlock was a result of actual separate account returns being significantly below our aggregated estimated return for the first quarter of 2009, partially offset by actual returns being greater than our aggregated estimated return for the period from April 1, 2009 to December 31, 2009.
Evaluation of Other-Than-Temporary Impairments on Available-for-Sale Securities and Valuation Allowances on Investments
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 Wealth Management 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.
A reporting unit is defined as an operating segment or one level below an operating segment. Most of the Company’s reporting units, for which goodwill has been allocated, are equivalent to the Company’s operating segments as there is no discrete financial information available for the separate components of the segment or all of the components of the segment have similar economic characteristics. In 2010, The Hartford has changed its reporting segments with no change to reporting units. The homeowners and automobile components of Consumer Markets have been aggregated into one reporting unit; the variable life, universal life and term life components within Life Insurance have been aggregated into one reporting unit of Individual Life; the 401(k), 457 and 403(b) components of Retirement Plans have been aggregated into one reporting unit; the retail mutual funds component of Mutual Funds has been aggregated into one reporting unit; and the group disability and group life components of Group Benefits have been aggregated into one reporting unit. In circumstances where the components of an operating segment constitute a business for which discrete financial information is available and segment management regularly reviews the operating results of that component such as Hartford Financial Products, the Company has classified those components as reporting units. Goodwill associated with the June 30, 2000 buyback of Hartford Life, Inc. was allocated to each of Hartford Life’s reporting units based on the reporting units’ fair value of in-force business at the time of the buyback. Although this goodwill was allocated to each reporting unit, it is held in Corporate and Other for segment reporting. In addition Federal Trust Corporation is an immaterial operating segment where the goodwill has been included in the Corporate and Other.
The Company completed its annual goodwill assessment for the individual reporting units within Wealth Management and Corporate and Other, except for the Federal Trust Corporation reporting unit, as of January 1, 2010, which resulted in no write-downs of goodwill in 2010. The reporting units passed the first step of their annual impairment tests with a significant margin with the exception of the Individual Life reporting unit within Life Insurance.
Individual Life completed the second step of the annual goodwill impairment test resulting in an implied goodwill value that was in excess of its carrying value. Even though the fair value of the reporting unit was lower than its carrying value, the implied level of goodwill in Individual Life exceeded the carrying amount of goodwill. In the implied purchase accounting required by the step two goodwill impairment test, the implied present value of future profits was substantially lower than that of the DAC asset removed in purchase accounting. A higher discount rate was used for calculating the present value of future profits as compared to that used for calculating the present value of estimated gross profits for DAC. As a result, in the implied purchase accounting, implied goodwill exceeded the carrying amount of goodwill. The fair value of the Individual Life reporting unit within Life Insurance is based on discounted cash flows using earnings projections on in force business and future business growth. There could be a positive or negative impact on the result of step one in future periods if actual earnings or business growth assumptions emerge differently than those used in determining fair value for the first step of the annual goodwill impairment test.
The annual goodwill assessment for the reporting units within Property & Casualty Commercial and Consumer Markets was completed during the fourth quarter of 2010, which resulted in no write-downs of goodwill for the year ended December 31, 2010. Consumer Markets passed the first step of its annual impairment test with a significant margin while the Hartford Financial Products reporting unit within Property & Casualty Commercial passed the first step of its annual impairment test with less than a 5% margin. The fair value of the Hartford Financial Products reporting unit is based on discounted cash flows using earnings projections on existing business and future business growth. To the extent that actual earnings or business growth assumptions emerge differently than those used in determining fair value for the first step of the annual goodwill impairment test, it could have a positive or negative impact on the results of step one in future periods.
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. Excluding embedded and reinsurance related derivatives, as of December 31, 2010 and 2009, 97% of derivatives 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 that are predominantly observable in the market with the exception of the customized swap contracts that hedge guaranteed minimum withdrawal benefits (“GMWB”) liabilities. Inputs used to value derivatives include, but are not limited to, swap interest 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.
As of December 31, 2010, a 25 basis point increase/decrease in the discount rate would decrease/increase the pension and other postretirement obligations by $137 and $9, respectively.
The Company determines the expected long-term rate of return assumption based on an analysis of the Plan portfolio’s historical compound rates of return since 1979 (the earliest date for which comparable portfolio data is available) and over 5 year and 10 year periods. The Company selected these periods, as well as shorter durations, to assess the portfolio’s volatility, duration and total returns as they relate to pension obligation characteristics, which are influenced by the Company’s workforce demographics. In addition, the Company also applies long-term market return assumptions to an investment mix that generally anticipates 60% fixed income securities, 20% equity securities and 20% alternative assets to derive an expected long-term rate of return. Based upon these analyses, management maintained the long-term rate of return assumption at 7.30% as of December 31, 2010. This assumption will be used to determine the Company’s 2011 expense. The long-term rate of return assumption at December 31, 2009, that was used to determine the Company’s 2010 expense, was 7.30%.
The Company uses a five-year averaging method to determine the market-related value of Plan assets, which is used to determine the expected return component of pension expense. Under this methodology, asset gains/losses that result from returns that differ from the Company’s long-term rate of return assumption are recognized in the market-related value of assets on a level basis over a five year period. The difference between actual asset returns for the plans of $434 and $184 for the years ended December 31, 2010 and 2009, respectively, as compared to expected returns of $286 and $276 for the years ended December 31, 2010 and 2009, respectively, will be fully reflected in the market-related value of plan assets over the next five years using the methodology described above. The level of actuarial net loss continues to exceed the allowable amortization corridor. Based on the 5.50% discount rate selected as of December 31, 2010 and taking into account estimated future minimum funding, the difference between actual and expected performance in 2010 will decrease annual pension expense in future years. The decrease in pension expense will be approximately $7 in 2011 and will increase ratably to a decrease of approximately $50 in 2016.
The profitability of fixed annuities and other “spread-based” products depends largely on the Company’s ability to earn target spreads between earned investment rates on its general account assets and interest credited to policyholders. In addition, the size and persistency of gross profits from these businesses is an important driver of earnings as it affects the rate of amortization of deferred policy acquisition costs.
DAC amortization ratio, excluding realized gains (losses) and DAC Unlock, is a non-GAAP financial measure that the Company uses to evaluate, and believes is an important measure of, certain of the segment’s operating performance. DAC amortization ratio is the most directly comparable U.S. GAAP measure. The Hartford believes that the measure DAC amortization ratio, excluding realized gains (losses) and DAC Unlock, provides investors with a valuable measure of the performance of certain of the Company’s on-going businesses because it reveals trends in our businesses that may be obscured by the effect of realized gains (losses) or quarterly DAC Unlocks. Some realized capital gains and losses are primarily driven by investment decisions and external economic developments, the nature and timing of which are unrelated to insurance aspects of our businesses. Accordingly, these non-GAAP measures exclude the effect of all realized gains and losses that tend to be highly variable from period to period based on capital market conditions. The Hartford believes, however, that some realized capital gains and losses are integrally related to our insurance operations, so amortization of deferred policy acquisition costs and the present value of future profits (DAC amortization ratio), which is typically expressed as a percentage of pre-tax income before the cost of this amortization (an approximation of actual gross profits) and excludes the effects of realized capital gains and losses and DAC Unlock, however should include net realized gains and losses on net periodic settlements on the Japan fixed annuity cross-currency swap. These net realized gains and losses are directly related to an offsetting item included in the statement of operations such as net investment income. DAC Unlocks occur when the Company determines based on actual experience or other evidence, that estimates of future gross profits should be revised. As the DAC Unlock is a reflection of the Company’s new best estimates of future gross profits, the result and its impact on the DAC amortization ratio is meaningful; however, it does distort the trend of DAC amortization ratio. DAC amortization ratio, excluding realized gains (losses) and DAC Unlock, should not be considered as a substitute for DAC amortization ratio and does not reflect the overall profitability of our businesses. Therefore, the Company believes it is important for investors to evaluate both DAC amortization ratio, excluding realized gains (losses) and DAC Unlock, and DAC amortization ratio when reviewing the Company’s performance. For additional information regarding the DAC Unlock, see Critical Accounting Estimates within the MD&A.
The loss and loss adjustment expense ratio is a measure of the cost of claims incurred in the calendar year divided by earned premium and includes losses incurred for both the current and prior accident years, as well as the costs of mortality and morbidity and other contractholder benefits to policyholders. Since Group Benefits occasionally buys a block of claims for a stated premium amount, the Company excludes this buyout from the loss ratio used for evaluating the underwriting results of the business as buyouts may distort the loss ratio. Among other factors, the loss and loss adjustment expense ratio needed for the Company to achieve its targeted return on equity fluctuates from year to year based on changes in the expected investment yield over the claim settlement period, the timing of expected claim settlements and the targeted returns set by management based on the competitive environment.
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, renewal earned pricing increases (decreases) lag renewal written pricing increases (decreases) by 6 to 12 months.
ROA, excluding realized gains (losses) and DAC Unlock, is a non-GAAP financial measure that the Company uses to evaluate, and believes is an important measure of, certain of the segment’s operating performance. ROA is the most directly comparable U.S. GAAP measure. The Hartford believes that the measure ROA, excluding realized gains (losses) and DAC Unlock, provides investors with a valuable measure of the performance of certain of the Company’s on-going businesses because it reveals trends in our businesses that may be obscured by the effect of realized gains (losses) or quarterly DAC Unlocks. Some realized capital gains and losses are primarily driven by investment decisions and external economic developments, the nature and timing of which are unrelated to insurance aspects of our businesses. Accordingly, this non-GAAP measures exclude the effect of all realized gains and losses that tend to be highly variable from period to period based on capital market conditions. The Hartford believes, however, that some realized capital gains and losses are integrally related to our insurance operations, so ROA, excluding the realized gains (losses) and DAC Unlock, should include net realized gains and losses on net periodic settlements on the Japan fixed annuity cross-currency swap. These net realized gains and losses are directly related to an offsetting item included in the statement of operations, such as net investment income. DAC Unlocks occur when the Company determines based on actual experience or other evidence, that estimates of future gross profits should be revised. As the DAC Unlock is a reflection of the Company’s new best estimates of future gross profits, the result and its impact on the DAC amortization ratio is meaningful; however, it does distort the trend of ROA. ROA, excluding realized gains (losses) and DAC Unlock, should not be considered as a substitute for ROA and does not reflect the overall profitability of our businesses. Therefore, the Company believes it is important for investors to evaluate both ROA, excluding realized gains (losses) and DAC Unlock, and ROA when reviewing the Company’s performance. ROA is calculated by dividing the earnings measures described above by a two-point average AUM.
The Hartford considers several measures and ratios to be the key performance indicators for its businesses. The following discussions include the more significant ratios and measures of profitability for the years ended December 31, 2010, 2009 and 2008. Management believes that these ratios and measures are useful in understanding the underlying trends in The Hartford’s businesses. However, these key performance indicators should only be used in conjunction with, and not in lieu of, the results presented in the segment discussions that follow in this MD&A. These ratios and measures may not be comparable to other performance measures used by the Company’s competitors.
Property & Casualty Commercial’s combined ratio before catastrophes and prior year development increased primarily due to higher severity on package business and workers’ compensation, as well as an increased ratio for specialty casualty, and to a lesser extent an increase in the expense ratio due to increased expenses for taxes, licenses and fees.
Property & Casualty Commercial’s combined ratio before catastrophes and prior year development for the year increased, primarily due a decrease in earned premium and an increase in the current accident year loss and loss adjustment expense ratio before catastrophes. The increase in the current accident year loss and loss adjustment expense ratio before catastrophes was primarily due to a higher loss and loss adjustment expense ratio on workers’ compensation, package business and general liability, partially offset by lower non-catastrophe losses on property and marine business driven by favorable claim frequency and severity.
Retirement Plans’ ROA, excluding realized losses and DAC Unlock, increased primarily due to improved performance on limited partnerships and other alternative investments in 2010, and was driven by improvement in the equity markets, which led to increased account values and increased deposit activity.
Global Annuity’s ROA, excluding realized losses and DAC Unlock, increased primarily due to the impact of the write off of goodwill in 2008 of $274, after-tax, partially offset by higher DAC amortization and lower investment spread in 2009. In addition, Global Annuity’s ROA, excluding realized losses and DAC Unlock, for the year ended December 31, 2009 improved due to lower 3 Win related charges in 2009 versus 2008 of $40 and $152, after-tax, respectively.
Retirement Plans’ ROA, excluding realized losses and DAC Unlock, decreased primarily due to lower returns on fixed maturities and a full year of activity from the business acquired in 2008, which had produced a lower ROA.
Life Insurance’s after-tax margin, excluding realized gains (losses) and DAC Unlock, increase was primarily due to lower DAC amortization, favorable operating expenses and investment margin, partially offset by higher mortality.
Life Insurance’s after-tax margin, excluding realized gains (losses) and DAC Unlock, decrease was primarily due to a higher DAC amortization, partially offset by a lower effective rate and lower operating expenses.
Group Benefits after-tax margin (excluding buyouts), excluding realized gains (losses), decrease was primarily due to the unfavorable loss ratio that resulted from unfavorable morbidity experience, which was primarily due to unfavorable reserve development from the 2008 incurral loss year and higher new incurred long-term disability claims in 2009.
Total net investment income decreased largely due to equity securities, trading, resulting primarily from declines in market performance of the underlying investment funds supporting the Japanese variable annuity product. Total net investment income, excluding equity securities, trading, increased primarily due to improved performance of limited partnerships and other alternative investments primarily within real estate and private equity funds, partially offset by lower income on fixed maturities resulting from a decline in average short-term interest rates and lower reinvestment rates. The Company’s expectation, based on the current interest rate and credit environment, is that upcoming maturities will be reinvested at a similar rate. Therefore, the Company expects the 2011 portfolio yield, excluding limited partnership investments, to be relatively consistent with the 2010 portfolio yield excluding limited partnerships.
Gross gains and losses on sales for the year ended December 31, 2010 were predominantly from sales of investment grade corporate securities in order to take advantage of attractive market opportunities, as well as, sales of U.S. Treasuries related to tactical repositioning of the portfolio.
Gross gains and losses on sales for the year ended December 31, 2009 were predominantly within corporate, government and structured securities. Also included were gains of $360 related to the sale of Verisk/ISO securities. Gross gains and losses on sales primarily resulted from efforts to reduce portfolio risk through sales of subordinated financials and real estate related securities and from sales of U.S. Treasuries to manage liquidity.
Gross gains and losses on sales for the year ended December 31, 2008 primarily resulted from the decision to reallocate the portfolio to securities with more favorable risk/return profiles. Also included was a gain of $141 from the sale of a synthetic CDO.
For the year ended December 31, 2009, the gain on GMWB derivatives, net, was primarily due to liability model assumption updates related to favorable policyholder experience of $566, the relative outperformance of the underlying actively managed funds as compared to their respective indices of $550, and the impact of the Company’s own credit standing of $154. Additional net gains of $56 resulted from lower implied market volatility and a general increase in long-term interest rates, partially offset by rising equity markets. Increasing equity markets resulted in a loss of $895 related to the Company’s macro hedge program. Total gains related to GMWB hedging in 2009 were $1.5 billion. For further information, see Note 4a of the Notes to Consolidated Financial Statements. In addition, see the Company’s variable annuity hedging program sensitivity disclosures within Capital Markets Risk Management section of the MD&A.
For the year ended December 31, 2008, the loss on GMWB derivatives, net, was primarily due to losses of $904 related to market-base hedge ineffectiveness due to extremely volatile capital markets and $355 related to the relative outperformance of the underlying actively managed funds as compared to their respective indices, partially offset by gains of $470 in the fourth quarter related to liability model assumption updates for lapse rates.
Other, net losses for the year ended December 31, 2009 primarily resulted in net losses of $463 on credit derivatives where the Company purchased credit protection due to credit spread tightening and approximately $300 from contingent obligations associated with the Allianz transaction. These losses were partially offset by gains of $155 on credit derivatives that assume credit risk due to credit spread tightening, as well as $140 from a change in spot rates related to transactional foreign currency predominately on the internal reinsurance of the Japan variable annuity business, which is offset in AOCI.
Insurance operating costs and expenses increased in 2010, driven by an increase in taxes, licenses and fees of $19, which included a $5 increase in reserve strengthening for other state funds and taxes and a $7 reduction in TWIA assessments recognized in 2009 related to hurricane Ike. Also contributing to the increase were higher IT costs. The increased expenses were partially offset by a decrease of $5 in dividends payable primarily for workers’ compensation policyholders, and lower compensation-related costs. Amortization of deferred policy acquisition costs decreased, largely due to the decrease in earned premiums.
The effective tax rate, in both periods, differs from the U.S. Federal statutory rate primarily due to permanent differences related to investments in tax exempt securities. For further discussion, see Income Taxes within Note 13 of the Notes to Consolidated Financial Statements.
Net income increased significantly in 2009, compared to 2008, driven by an increase in underwriting results coupled with improvements in net realized capital losses. Underwriting results increased primarily due to lower losses and loss adjustment expenses for the current accident year before catastrophes, lower current accident year catastrophe losses, and more favorable prior accident year development, partially offset by decreases in earned premiums.
New business written premium increased, primarily driven by the increase in workers’ compensation and package business, partially offset by a decrease in new business for professional liability, marine, general liability and commercial auto. Despite continued pricing competition, the Company has increased new business for workers’ compensation by targeting business in selected industries and regions of the country where attractive new business opportunities remain. For standard commercial lines, earned pricing decreased, primarily driven by decreases in workers’ compensation, commercial auto, general liability, property and marine, partially offset by an increase in package business. The earned pricing changes were primarily a reflection of written pricing changes over the last two years. A number of carriers have continued to compete aggressively on price, particularly on larger accounts. In addition to the effect of written pricing decreases in workers’ compensation, average premium per policy has declined due to a reduction in the payrolls of workers’ compensation insureds and the effect of declining endorsements.
Also, for standard commercial lines, policy count retention decreased slightly as the effects of the downturn in the economy caused business closures and increased shopping of policies by businesses seeking lower premiums. The number of policies in-force increased in 2009, as the growth in policies in-force does not correspond directly with the change in earned premiums due to the effect of changes in earned pricing and changes in the average premium per policy.
Net favorable prior accident year reserve development, in both periods, included reserve releases in the following: workers’ compensation, general liability, including umbrella and high hazard liability, professional liability and auto liability. Reserve development in 2009 also included strengthening in both package business and fidelity and surety, and releases in uncollectible reinsurance and catastrophes, while reserve development in 2008 also included strengthening in general liability, including product liability and national accounts. For a discussion on prior accident year reserve development, see the Property and Casualty Insurance Product Reserves, Net of Reinsurance section within Critical Accounting Estimates.
Insurance operating costs and expenses decreased primarily due to a $37 decrease in the estimated amount of dividends payable to certain workers’ compensation policyholders and a decrease in TWIA assessments of $17, partially offset by increase in taxes, license and fees of $23 and higher compensation-related costs. The increase in taxes, license and fees included, a $6 increase in the assessment for a second injury fund and $9 reserve strengthening for other state funds and taxes. Amortization of deferred policy acquisition costs decreased largely due to the decrease in earned premiums.
Net realized capital gains (losses) improved significantly in 2009. The improvements were driven primarily by lower impairments in 2009 compared to 2008. Net investment income decreased in 2009, primarily due to lower income on fixed maturities resulting from a decline in average rates, partially offset by decreased losses on limited partnerships and other alternative investments. For additional information, see the Investment Results section within Key Performance Measures and Ratios.
The effective tax rate, in both periods, differs from the U.S. Federal statutory rate. In 2009, this is primarily due to permanent differences related to investments in tax exempt securities. In 2008, there was a net income tax benefit despite having pre-tax income due to an income tax benefit on realized capital losses that was greater than the income tax expense on all other components of pre-tax income. For further discussion, see Income Taxes within Note 13 of the Notes to Consolidated Financial Statements.
Group Benefits has a block of financial institution business that is experience rated. This business comprised approximately 9% to 10% of the segment’s 2010, 2009 and 2008 premiums and other considerations (excluding buyouts). With respect to the segment’s net income (loss), excluding net realized capital gains (losses), the financial institution business comprised 6% for 2010, and on average, 2% to 4% for 2009 and 2008, excluding the commission accrual adjustment in 2009 discussed below.
Net income decreased as compared to prior year, as a decrease in premiums and other considerations and higher claim costs offset the improvements in net realized capital gains (losses) and net investment income. Premiums and other considerations decreased due to a 3% decline in fully insured ongoing premiums which was driven by lower sales due to the competitive marketplace, and the pace of the economic recovery. The loss ratio, excluding buyouts, increased compared to the prior year, particularly in group disability, primarily due to unfavorable morbidity experience from higher incidence and lower claim terminations.
The expense ratio increased due largely to an $8 increase in legal settlement costs in 2010 and higher amortization of acquisition costs on AARP business, partially offset by lower direct marketing spend for consumer direct business. Also contributing to the increase in the expense ratio was a $7 reduction of TWIA hurricane assessments in 2009 largely offset by an $8 increase in reserves for other state funds and taxes in 2009.
Net income increased as a result of lower net realized capital losses, partially offset by a decrease in underwriting results and lower net investment income.
Earned premiums grew in 2009, as a result of an increase in auto, while homeowners remained flat. The increase in auto earned premiums was primarily due to the effect of an increase in new business, largely offset by a decrease in average renewal premium per policy. Homeowners’ earned premiums were flat as the effect of an increase in new business was largely offset by a decrease in policy count retention.
The increases in renewal earned pricing during 2009 were primarily a reflection of written pricing in the second half of 2008 and first half of 2009. Renewal written pricing in 2009 increased in auto due to rate increases and the effect of policyholders purchasing newer vehicle models in place of older models. Homeowners’ renewal written pricing increased due to rate increases and increased coverage amounts reflecting higher rebuilding costs. For both auto and home, the Company has increased rates in certain states for certain classes of business to maintain profitability in the face of rising loss costs. While the Company recognized higher renewal earned pricing in 2009, driven by higher rates and an increase in the amount of insurance per exposure unit, average renewal premium per policy decreased for auto and was flat for home. For both auto and home, average renewal premium was impacted by a shift to more preferred market segment business and growth in states and territories with lower average premium. In addition, average renewal premium was affected by the impact of the economic downturn on consumer behavior. Among other actions, in 2009 insureds reduced their premiums by raising deductibles, reducing limits, dropping coverage and reducing mileage.
Current accident year losses and loss adjustment expenses before catastrophes increased, primarily due to an increase in the current accident year loss and loss adjustment expense ratio before catastrophes, driven by a 3.3 point increase for auto and a 4.2 point increase for home. The increase for auto was due to an increase in expected liability loss costs, an increase in physical damage frequency and a decline in average premium. After a historically low claim frequency in 2008, auto claim frequency increased in 2009, mostly in bodily injury coverage, driven by an increase in miles driven. The increase for home was driven by increasing frequency and severity coupled with a decline in average premium.
Net favorable reserve development was lower in 2009 than in 2008. Net favorable reserve development in 2009 included a release of personal auto liability reserves, partially offset by a strengthening of reserves for homeowners’ claims. Net favorable reserve development in 2008 included a release of personal auto liability reserves. For additional information on prior accident year reserve development, see the Property and Casualty Insurance Product Reserves, Net of Reinsurance section within Critical Accounting Estimates.
The expense ratio increased due largely to higher amortization of deferred acquisition costs and an increase in other non-deferrable costs, partially offset by a decrease in TWIA assessments of $17. Also contributing to the increase in the expense ratio was an $8 increase in reserves for other state funds and taxes in 2009. Amortization of acquisition costs increased due to an increase in direct marketing costs.
Net realized capital gains (losses) improved significantly in 2009. The improvements were primarily driven by lower impairments in 2009 compared to 2008. Net investment income decreased in 2009, primarily as a result of lower returns on taxable fixed maturities due to declining interest rates. For additional information, see the Investment Results section within Key Performance Measures and Ratios.
The effective tax rate, in both periods, differs from the U.S. Federal statutory rate. In 2009, this is primarily due to permanent differences related to investments in tax exempt securities. In 2008, there was an income tax benefit on realized capital losses that partially offset the income tax expense on all other components of pre-tax income. For further discussion, see Income Taxes within Note 13 of the Notes to Consolidated Financial Statements.
Canadian and Offshore businesses were transferred from Mutual Funds to Global Annuity, effective January 1, 2009. Canadian mutual funds were transferred from Global Annuity to Mutual Funds effective January 1, 2010.
Global Annuity’s net income in 2010 compared to a net loss in 2009 is primarily due to significant improvements in the equity markets, which resulted in an Unlock benefit in 2010 as compared to an Unlock charge in 2009, as well as continued market value appreciation in account value resulting in increased fee income, and due to continued expense reduction efforts in 2010. Additionally, 2009 includes a charge of $60, pre-tax, related to 3 Wins within benefits, losses and loss adjustment expenses. Partially offsetting these improvements were higher net realized capital losses.
The Unlock benefit was $65, after-tax, in 2010 as compared to an Unlock charge of $924, after-tax, in 2009. The benefit in 2010 was primarily due to equity market improvements that were greater than expectations for the year ended December 31, 2010, while 2009’s charge was primarily the result of equity market performance significantly below expectations for the first quarter of 2009. The Unlock resulted in decreases to both benefits, losses and loss adjustment expenses and amortization of DAC. For further discussion of the Unlock see the Critical Accounting Estimates within the MD&A.
Insurance operating costs and other expenses have continued to decline as a result of lower operating and wholesaling expenses driven by management’s active efforts to reduce operating expenses and management’s efforts to match distribution costs with the Company’s current lower sales levels. These efforts have also resulted in a decline in the general insurance expense ratio, primarily associated with the U.S. annuity product and the restructuring and active expense management of Japan’s operations, which have been partially offset by an increase in the average asset base from continued improvements in equity markets.
The higher net realized capital losses in 2010 were primarily due to losses on the variable annuity hedging program compared to gains in 2009, partially offset by lower impairment losses in 2010 and net realized gains on sales of securities in 2010 compared to net realized losses in 2009. The variable annuity hedging program losses were $451 in 2010 compared with gains of $631 in 2009. For further discussion on the results of the variable annuity hedging program see Investment Results, Net Realized Capital Gains (Losses) within Key Performance Measures and Ratios of the MD&A.
Management’s decision to suspend sales of structured settlements and terminal funding products resulted in decreased earned premiums in 2010 as compared to 2009 with a corresponding decrease in benefits, losses and loss adjustment expenses. In addition, benefits, losses and loss adjustment expenses were lower for institutional investment products driven by the Company’s execution on its call and buyback strategy associated with stable value products, which reduced the related liabilities.
Net investment income on securities available-for-sale and other decreased slightly in 2010 as compared to the comparable prior year primarily as a result of significant net outflow activity since 2009 and declines on returns from fixed maturity securities driven by a lower interest rate environment, partially offset by improving investments results on limited partnership and other alternative investments.
Net investment spread improved in 2010 compared to 2009 primarily due to improved performance on limited partnership and other alternative investments of 48 bps, partially offset by a decline in yields on fixed maturity assets of 15 bps, along with lower earnings on other investing activities of 6 bps. The decline in fixed maturity returns was primarily related to a lower interest rate environment.
Net loss improved in 2009 as compared to 2008 primarily due to lower net realized capital losses, goodwill impairment in 2008 and lower insurance operating and other expenses, partially offset by decreases in fee income and other, earned premiums and net investment income on securities available-for-sale and other, as well as a higher Unlock charge in 2009.
The net realized capital losses declined significantly in 2009 primarily due to gains of $631 on the variable annuity hedging program compared to losses of $639 in 2008, realized losses recorded in 2008 of $650 related to the fair value measurement transition impact, and lower impairment losses in 2009 compared to 2008. For further discussion on these results see Investment Results, Net Realized Capital Gains (Losses) within Key Performance Measures and Ratios of the MD&A.
Insurance operating costs and other expenses have decreased as compared to 2008 as a result of lower asset based trail commissions due to equity market declines, as well as management’s active efforts to reduce operating expenses including the restructuring of international operations. These efforts have also resulted in a decline in the general insurance expense ratio.
Fee income and other decreased in 2009 primarily due to a decline in average account values of variable annuities driven by significant declines in market value during 2008, continued net outflows in 2009 and the decision in the second quarter of 2009 to suspend new sales in Japan and European operations.
Net investment spread declined in 2009 compared to 2008 primarily due to the decrease in earnings on fixed maturities, including the impact of interest rate hedges. Partnership earnings and other investing activities also declined lowering total spread by 7 bps. The decline in fixed maturity returns was primarily related to a higher percentage of fixed maturities being held in short-term investments and an overall decline in interest rates. Partially offsetting these declines in spread were decreases in crediting rates.
Global Annuity’s effective tax rate differs from the statutory rate of 35% primarily due to permanent differences for the separate account DRD on U.S. annuity products, as well as varying tax rates by country, and the valuation allowance on deferred tax benefits related to certain realized losses on securities that back certain institutional investment products. Income taxes include separate account DRD benefits of $142 in 2009 compared to $130 in 2008. For further discussion, see Note 13 of the Notes to Consolidated Financial Statements.
Life Insurance’s net realized gains in 2010 compared to net realized capital losses in 2009 were primarily due to lower losses from impairments. For further discussion on impairments, see Other-Than-Temporary Impairments within the Investment Credit Risk section of the MD&A.
The Unlock benefit was $28, after-tax, in 2010 as compared to an Unlock charge of $51, after-tax, in 2009. The benefit in 2010 was primarily due to assumption updates related to lapse rates, investment margin and mortality, partially offset by persistency, while 2009’s charge was primarily the result of assumption updates related to investment margin and expenses, as well as equity market performance significantly below expectations in 2009, partially offset by assumption updates on lapse rates. The Unlock primarily resulted in decreases to amortization of DAC and fee income and other. For further discussion of the Unlock see the Critical Accounting Estimates within the MD&A.
Life Insurance’s individual life business increased driven by improvements in net investment income primarily related to improved performance of limited partnerships and other alternative investment and earnings on a higher average invested asset base in 2010 compared to 2009, partially offset by lower yields on fixed maturity investments. Net investment spread for individual life’s variable universal life and universal life products increased primarily due to the improved performance of limited partnerships and other alternative investments for the year ended December 31, 2010.
Life Insurance’s effective tax rate differs from the statutory rate of 35% primarily due to permanent differences for the separate account DRD, partially offset by a valuation allowance on deferred tax benefits related to certain realized losses in 2010. Income taxes include separate account DRD benefits of $19 in 2010 compared to $24 in 2009. For further discussion, see Note 13 of the Notes to Consolidated Financial Statements.
Fee income and other increased primarily due to the impact of the amortization of unearned revenue reserves of $83 within the 2009 Unlock and increased cost of insurance charges of $38 for individual life products, as a result of growth in guaranteed universal life insurance in-force, partially offset by lower variable life fees as a result of equity market declines.
Life Insurance’s net realized losses decreased in 2009 compared to net realized losses in 2008 primarily due to lower impairments. For further discussion on impairments, see Other-Than-Temporary Impairments within the Investment Credit Risk section of the MD&A.
The DAC Unlock benefit was $18, after-tax, in 2010 as compared to a DAC Unlock charge of $56, after-tax, in 2009. The benefit in 2010 was primarily due to assumption changes based on actual experience and to a lesser extent from the market performance variance to expectations for the year ended December 31, 2010, while 2009’s charge was primarily the result assumption changes based on actual experience and equity market performance significantly below expectations. The DAC Unlock primarily resulted in a decrease to amortization of DAC. For further discussion of DAC Unlock see the Critical Accounting Estimates within the MD&A.
Net realized capital losses increased primarily as a result of realized losses of $56 on non-qualifying derivatives in 2009 compared with $14 of gains in 2008 and mortgage valuation allowances of $38 in 2009, partially offset by OTTI impairment losses of $178 in 2009 compared with $243 in 2008.
Net investment income decreased primarily as a result of lower yields on fixed maturity investments, partially offset by an increase in derivative income. Net investment spread’s decline is attributable to lower fixed maturity returns of 34 bps and lower returns on limited partnerships and other alternative investments of 3 bps, partially offset by a reduction in credited rates of 10 bps.
Insurance operating costs and other expenses increased primarily due to a full year of operating expenses associated with the businesses acquired in 2008 and lower deferrable acquisition expenses due to low sales levels, partially offset by expense management initiatives.
The DAC Unlock charge was $56, after-tax, in 2009 as compared to a DAC Unlock charge of $49, after-tax, in 2008. The charges in both periods primarily related to assumption changes based on actual experience and the variance in market performance compared to expectations. The DAC Unlock primarily resulted in a decrease to amortization of DAC and an increase in net realized capital losses. For further discussion of DAC Unlock see the Critical Accounting Estimates within the MD&A. Additionally, amortization of DAC decreased as a result of lower gross profits in 2009 than in 2008.
Change in market value and other in 2010 includes the sale of Canadian mutual fund assets of approximately $1.8 billion.
Net income increased in 2010 compared to 2009 primarily due to net realized gain on the sale of Canadian mutual fund operations of $69, pre-tax, and higher overall account balances attributed to the improved equity markets, and positive net flows on non-proprietary and Canadian mutual fund assets, resulting in higher fee income, partially offset by higher trail commissions, as well as capital infusions to the money market funds. Also contributing to the net income in 2010 is the increase in scale of the reporting segment’s businesses.
The change to net realized capital gains, from net realized capital losses was due to impairments on investment securities recorded in 2009. In addition, 2009 included a net realized capital loss of approximately $300 as a result of a contingency payment made to Allianz due to the Company’s participation in the Capital Purchase Program. See Note 21 of the Notes to Consolidated Financial Statements for a further discussion on Allianz.
Goodwill impairments were recorded for Federal Trust Corporation goodwill in 2010 of $100, after-tax, in 2010 compared to impairments for the Institutional reporting unit in 2009 of $32, after-tax, see Note 8 of the Notes to Consolidated Financial Statements for additional information regarding goodwill impairments.
The effective tax rate in 2009 differed from the U.S. Federal statutory rate due to nondeductible costs associated with the contingency payment to Allianz and goodwill impairments.
The net loss in Corporate and Other increased primarily due to higher net realized capital losses and increases in interest expense and benefits, losses and loss adjustment expenses, partially offset by a decrease in goodwill impairments.
The net realized capital loss increased primarily due to approximately $300 in net realized losses a result of a contingency payment made to Allianz due to the Company’s participation in the Capital Purchase Program. Additionally, 2008 included realized gains of $110 on the change in fair value of the liability related to warrants issued to Allianz. See Note 21 of the Notes to Consolidated Financial Statements for a further discussion on Allianz.
Benefits, losses and loss adjustment expenses increased as the unfavorable prior year loss development in 2009 was higher than 2008. The 2009 reserve development included asbestos and environmental reserve strengthening of $138 and $75, respectively, while the 2008 reserve development included asbestos and environmental reserve strengthening of $50 and $53, respectively.
The effective tax rate differs from the U.S. Federal statutory rate due to nondeductible costs associated with the contingency payment to Allianz in 2009, and with goodwill impairments in both 2009 and 2008. Also 2008 included tax exemption for the realized gains on the change in fair value of the liability related to warrants issued to Allianz.
The Hartford has a robust set of enterprise risk management processes and controls around the management of insurance risks that are integrated into such core activities as underwriting, pricing, reinsurance, claims management, and capital management. In addition, to manage aggregations of insurance risk across the portfolio, The Hartford has policies and processes to manage risk related to natural catastrophes, such as hurricanes and earthquakes and pandemics, as well as man-made disasters such as terrorism. The Hartford’s risk management processes include, but are not limited to, disciplined underwriting protocols, exposure controls, sophisticated risk modeling, risk transfer, and capital management strategies. In managing risk, The Hartford’s management processes involve establishing underwriting guidelines for both individual risks, including individual policy limits, and in aggregate, including aggregate exposure limits by geographic zone and peril. The Company establishes risk limits and actively monitors risk exposures as a percent of statutory surplus.
For natural catastrophe perils, the Company generally limits its estimated loss to natural catastrophes from a single 250-year event prior to reinsurance to less than 30% of statutory surplus of the property and casualty operations and its estimated loss to natural catastrophes from a single 250-year event after reinsurance to less than 15% of statutory surplus of the property and casualty operations. The Company uses third-party models to estimate the potential loss resulting from various catastrophe events and the potential financial impact those events would have on the Company’s financial position and results of operations. The Company’s modeled loss estimates are derived by averaging 21 modeled loss events representing a 250-year return period loss. For the peril of earthquake, the 21 events averaged to determine the modeled loss estimate include events occurring in California as well as the Northwestern, Northeastern, Southeastern and Midwestern regions of the United States with associated magnitudes ranging from 6.1 to 7.9 on the Moment Magnitude scale. For the peril of hurricane, the 21 events averaged to determine the modeled loss estimate include category 3, 4 and 5 events in Florida, as well as other Southeastern and Northeastern region landfalls.
While Enterprise Risk Management has a process to track and manage these limits, from time to time, the estimated loss to natural catastrophes from a single 250-year event prior to reinsurance may fluctuate above or below these limits due to changes in modeled loss estimates, exposures, or statutory surplus. Currently, the Company’s estimated pre-tax loss to a single 250-year natural catastrophe event prior to reinsurance is less than 30% of the statutory surplus of the property and casualty insurance subsidiaries and the Company’s estimated pre-tax loss net of reinsurance is less than 15% of statutory surplus of the property and casualty operations. The estimated 250 year pre-tax probable maximum losses from hurricane events are estimated to be $1.5 billion and $582 before and after reinsurance, respectively. The estimated 250 year pre-tax probable maximum loss from earthquake events are estimated to be $666 before reinsurance and $434 net of reinsurance. The loss estimates represent total property losses for hurricane events and property and workers’ compensation losses for earthquake events resulting from a single event. The estimates provided are based on 250-year return period loss estimates, which have a 0.4% likelihood of being exceeded in any single year.
The net loss estimates provided above assume that the Company is able to recover all losses ceded to reinsurers under its reinsurance programs. There are various methodologies used in the industry to estimate the potential property and workers’ compensation losses that would arise from various catastrophe events and companies may use different models and assumptions in their estimates. Therefore, the Company’s estimates of gross and net losses arising from a 250-year hurricane or earthquake event may not be comparable to estimates provided by other companies. Furthermore, the Company’s estimates are subject to significant uncertainty and could vary materially from the actual losses that would arise from these events and the loss estimates provided by other Companies. The company also manages natural catastrophe risk for group life, group disability, and individual life insurance, which in combination with property and workers compensation loss estimates, are subject to separate enterprise risk management net aggregate loss limits as a percent of enterprise surplus.
The Company is exposed to losses from terrorist attacks, including losses caused by single-site and multi-site conventional attacks, as well as the potential for attacks using nuclear, biological, chemical or radiological weapons (“NBCR”) attacks. For terrorism, the Company monitors aggregations of exposure around key landmarks primarily in major metropolitan areas that span the Company’s insurance portfolio. Enterprise limits for terrorism apply to aggregations of risk across property-casualty, group benefits, life insurance and specific asset portfolios and are defined based on a deterministic, single-site conventional terrorism attack scenario. The Company manages its potential estimated loss from this terrorism loss scenario to less than $1.3 billion. Among the landmark locations specifically monitored by the Company as of December 31, 2010, the largest estimated modeled loss arising from a single event is approximately $1.1 billion. The Company monitors exposures monthly and employs both internally developed and vendor-licensed loss modeling tools as part of its risk management discipline. The risk of terrorism presents unique challenges to any insurance company given the fact that the frequency and severity of terrorist attacks are highly uncertain and potentially unknowable. As such, modeled terrorism losses could differ materially from scenarios employed to manage the Company’s overall terrorism risk loss exposure.
Pandemic risk is the exposure to loss in the Company’s market value, earnings or surplus arising from widespread influenza or other pathogens or bacterial infections that create an aggregation of loss across the Company’s insurance or asset portfolios. Consistent with industry practice, The Hartford assesses exposure to pandemics by analyzing the potential impact from a variety of pandemic scenarios based on conditions consistent with earlier outbreaks of flu-like viruses, including the “Severe” 1918 Spanish Flu, the Asian flu in 1957, the Hong Kong flu in 1968, and the 2009 outbreak of swine flu. In evaluating these scenarios, The Hartford assesses the impact on group and individual life policies, short-term and long-term disability, annuities, COLI, property & casualty claims, and losses in the investment portfolio associated market declines in the event of a widespread pandemic. Given the evolving science around the risk of pandemics, the Company has not adopted formal limits for pandemic but continues to manage the risk of pandemic exposures within acceptable management tolerances.
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 to transfer certain risks to reinsurance companies based on specific geographic or risk concentrations. All reinsurance processes are aligned under a single enterprise reinsurance governance policy with treaty purchases administered by a centralized function within Commercial and Consumer Markets and Wealth Management to support a consistent strategy and to ensure that the reinsurance activities are fully integrated into the organization’s risk management processes.
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 February 18, 2011:
In addition, the Company also purchased an industrial accident only WC coverage for the 7/1/2010 to 7/1/2011 treaty year providing reinsurance of 80% of $30 of per occurrence limit in excess of $20.
In addition to the reinsurance protection provided by The Hartford’s traditional property catastrophe reinsurance program described above, the Company has fully collateralized reinsurance coverages from Foundation Re III for losses sustained from qualifying hurricane loss events. Under the terms of the treaties, the Company is reimbursed for losses from hurricanes using customized industry index contracts designed to replicate The Hartford’s own catastrophe losses, with a provision that the actual losses incurred by the Company for covered events, net of reinsurance recoveries, cannot be less than zero.
The following table summarizes the terms of the reinsurance treaties with Foundation Re III that were in place as of February 21, 2011:
As of February 21, 2011, there have been no events that are expected to trigger a recovery under the Foundation Re III reinsurance program and, accordingly, the Company has not recorded any recoveries from the associated reinsurance treaty.
For the risk of terrorism, private sector catastrophe reinsurance capacity is generally limited and largely 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 TRIPRA. On December 26, 2007, the President signed TRIPRA extending the Terrorism Risk Insurance Act of 2002 (“TRIA”) through the end of 2014. TRIPRA provides a backstop for insurance-related losses resulting from any “act of terrorism” certified by the Secretary of the Treasury, in concurrence with the Secretary of State and Attorney General, that result in industry losses in excess of $100. In addition, TRIPRA revised the TRIA definition of a certified “act of terrorism” by removing the requirement that an act be committed “on behalf of any foreign person or foreign interest.” As a result, domestic acts of terrorism can now be certified as “acts of terrorism” under the program, subject to the other requirements of TRIPRA. Under the program, in any one calendar year, the federal government would pay 85% of covered losses from a certified act of terrorism after an insurer’s losses exceed 20% of the company’s eligible direct commercial earned premiums of the prior calendar year, up to a combined annual aggregate limit for the federal government and all insurers of $100 billion. If an act of terrorism or acts of terrorism result in covered losses exceeding the $100 billion annual industry aggregate limit, a future Congress would be responsible for determining how additional losses in excess of $100 billion will be paid.
Among other items, TRIPRA required that the President’s Working Group on Financial Markets (“PWG”) continue to perform an analysis regarding the long-term availability and affordability of insurance for terrorism risk. Among the findings detailed in the PWG’s initial report, released October 2, 2006, were that the high level of uncertainty associated with predicting the frequency of terrorist attacks, coupled with the unwillingness of some insurance policyholders to purchase insurance coverage, makes predicting long-term development of the terrorism risk market difficult, and that there is likely little potential for future market development for NBCR coverage. The January 2011 PWG report notes some improvements in capacity and modeling, but also noted that take-up rates for terrorism coverage remained relatively flat over the past three years and that insurers remain uncertain about the ability of models to predict the frequency and severity of terrorist attacks. With respect to NBCR coverage, a December 2008 study by the U.S. Government Accountability Office (“GAO”) found that property and casualty insurers still generally seek to exclude NBCR coverage from their commercial policies when permitted. However, while nuclear, pollution and contamination exclusions are contained in many property and liability insurance policies, the GAO report concluded that such exclusions may be subject to challenges in court because they were not specifically drafted to address terrorist attacks. Furthermore, workers’ compensation policies generally have no exclusions or limitations. The GAO found that commercial property and casualty policyholders, including companies that own high-value properties in large cities, generally reported that they could not obtain NBCR coverage. Commercial property and casualty insurers generally remain unwilling to offer NBCR coverage because of uncertainties about the risk and the potential for catastrophic losses.
In all states, insurers licensed to transact certain classes of insurance are required to become members of a guaranty fund. In most states, in the event of the insolvency of an insurer writing any such class of insurance in the state, members of the funds are assessed to pay certain claims of the insolvent insurer. A particular state’s fund assesses its members based on their respective written premiums in the state for the classes of insurance in which the insolvent insurer was engaged. Assessments are generally limited for any year to one or two percent of the premiums written per year depending on the state. The amount and timing of assessments related to past insolvencies is unpredictable.
Investment credit risk is viewed by the Company as the set of credit risks that can impair the value of the investment portfolio. This includes default risk, credit transition risk, systemic credit risk, idiosyncratic risk, and counterparty risk. Default risk is the risk of loss of principal and/or interest income stemming from a debt issuer’s failure to meet their contractual obligations. Credit transition risk is the risk that an investment declines in creditworthiness after purchase. Typically, the decline in creditworthiness is associated with an increase in credit spreads associated with the investment, potentially resulting in increases in other-than -temporary impairments and the increased probability of a realized loss. Counterparty credit risk is the risk that the financial institution, clearing exchange, or other party with whom the Company has entered into a financial contract will default on the obligation and fail to meet their contractual obligations. This is a significant risk in over-the-counter derivatives trading, and futures trading.
Counterparty credit risk is mitigated both through the practice of entering into contracts only with highly creditworthy institutions, but also through the practice of holding and posting of collateral, and including collateral short-falls in the exposure calculations. Systemic credit risk is mitigated through the construction of a high-quality, diverse portfolio of investments that are subject to regular underwriting of the risks. Additional limits on investment activity, including setting of policy and defining acceptable risk levels, is subject to regular review and approval by Enterprise Risk Management and senior management.
In addition to counterparty credit risk, the Company enters into credit default swaps to manage credit exposure. 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 risk, will typically only make a payment if there is a credit event as defined in the contract and such payment will be typically 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.
The Company uses credit derivatives to purchase credit protection and assume credit risk with respect to a single entity, referenced index, or asset pool. The Company purchases credit protection through credit default swaps to economically hedge and manage credit risk of certain fixed maturity investments across multiple sectors of the investment portfolio. The Company also enters into credit default swaps that assume credit risk as part of replication transactions. Replication transactions are used as an economical means to synthetically replicate the characteristics and performance of assets that would otherwise be permissible investments under the Company’s investment policies. These swaps reference investment grade single corporate issuers and baskets, which include customized diversified portfolios of corporate issuers, which are established within sector concentration limits and may be divided into tranches which possess different credit ratings.
As of December 31, 2010 and 2009, the notional amount related to credit derivatives that purchase credit protection was $2.6 billion, while the fair value was $(9) and $(50), respectively. As of December 31, 2010 and 2009, the notional amount related to credit derivatives that assume credit risk was $2.6 and $1.2 billion, respectively, while the fair value was $(434) and $(240), respectively. For further information on credit derivatives, see the Capital Markets Risk Management section of the MD&A and Note 5 of the Notes to Consolidated Financial Statements.
The movement in the overall credit quality of the Company’s portfolio was primarily attributable to purchases of U.S. Treasuries and investment grade corporate securities. This was partially offset by rating agency downgrades primarily associated with commercial real estate (“CRE”) collateralized debt obligations (“CDOs”), commercial mortgage-backed securities (“CMBS”) and securities in the financial services sector. Fixed maturities, FVO, are not included in the above table as of December 31, 2010. For further discussion on the election of fair value option, see Note 4 of the Notes to Consolidated Financial Statements.
Gross unrealized gains (losses) exclude the fair value of bifurcated embedded derivative features of certain securities. Subsequent changes in value will be recorded in net realized capital gains (losses).
The Company continues to rebalance its AFS investment portfolio to securities with more favorable risk/return profiles, in particular investment grade corporate securities, while reducing its exposure to real estate related securities. The Company’s AFS net unrealized position improved primarily as a result of improved security valuations largely due to a decline in interest rates and, to a lesser extent, credit spread tightening. Fixed maturities, FVO, represents securities containing an embedded credit derivative for which the Company elected the fair value option. The underlying credit risk of these securities is primarily high quality corporate bonds and CRE CDOs. For further discussion on the election of fair value option, see Note 4 of the Notes to Consolidated Financial Statements. The following sections highlight the Company’s significant investment sectors.
The vintage year represents the year the pool of loans was originated.
Since December 31, 2009, the Company significantly reduced its exposure to B-Note participations and mezzanine loans by $1.1 billion primarily through sales. As of December 31, 2010, the Company had mortgage loans held-for-sale with a carrying value and valuation allowance of $87 and $7, respectively.
Credit impairments were primarily concentrated in structured securities associated with commercial and residential real estate which were impaired primarily due to continued property-specific deterioration of the underlying collateral and increased delinquencies. The Company calculated these impairments utilizing both a top down modeling approach and, for certain commercial real estate backed securities, a loan by loan collateral review. The top down modeling approach used discounted cash flow models that considered losses under current and expected future economic conditions. Assumptions used over the current period included macroeconomic factors, such as a high unemployment rate, as well as sector specific factors such as property value declines, commercial real estate delinquency levels and changes in net operating income. Those assumptions included CMBS peak-to-trough property value declines, on average, of 36% and RMBS peak-to-trough property value declines, on average, of 35%. The macroeconomic assumptions considered by the Company did not materially change from the previous several quarters and, as such, the credit impairments recognized for the year ended December 31, 2010 were largely driven by actual or expected collateral deterioration, largely as a result of the Company’s loan-by-loan collateral review.
Impairments on securities for which the Company had the intent to sell were primarily on CMBS bonds in order to take advantage of price appreciation. Impairments on equity securities were primarily on below investment grade securities that have been depressed 20% for more than six months.
For the year ended December 31, 2010, additions of $157 primarily related to anticipated, and since executed, B-Note participant and mezzanine loan sales. Also included were additions for expected credit losses due to borrower financial difficulty and/or collateral deterioration. Recent improvements in commercial real estate property valuations will positively impact future loss development, with future impairments driven by idiosyncratic security specific risk.
A decline in interest rates results in certain mortgage-backed securities being more susceptible to paydowns and prepayments. During such periods, the Company generally will not be able to reinvest the proceeds at comparable yields. Lower interest rates will also likely result in lower net investment income, increased hedging cost associated with variable annuities and, if declines are sustained for a long period of time, it may subject the Company to reinvestment risks, higher pension costs expense and possibly reduced profit margins associated with guaranteed crediting rates on certain Wealth Management products. Conversely, the fair value of the investment portfolio will increase when interest rates decline and the Company’s interest expense will be lower on its variable rate debt obligations.
Asset accumulation vehicles primarily require a fixed rate payment, often for a specified period of time. Product examples include fixed rate annuities with a market value adjustment feature and fixed rate guaranteed investment contracts. The term to maturity of these contracts generally range from less than one year to ten years. In addition, certain products such as universal life contracts and the general account portion of Wealth Management’s variable annuity products, credit interest to policyholders subject to market conditions and minimum interest rate guarantees. The term to maturity of the asset portfolio supporting these products may range from short to intermediate.
The Company also manages the risk of certain insurance liabilities similarly to investment type products due to the relative predictability of the aggregate cash flow payment streams. Products in this category may contain significant reliance upon actuarial (including mortality and morbidity) pricing assumptions and do have some element of cash flow uncertainty. Product examples include structured settlement contracts, on-benefit annuities (i.e., the annuitant is currently receiving benefits thereon) and short-term and long-term disability contracts. The cash outflows associated with these policy liabilities are not interest rate sensitive but do vary based on the timing and amount of benefit payments. The primary risks associated with these products are that the benefits will exceed expected actuarial pricing and/or that the actual timing of the cash flows will differ from those anticipated, or interest rate levels may deviate from those assumed in product pricing, ultimately resulting in an investment return lower than that assumed in pricing. The average duration of the liability cash flow payments can range from less than one year to in excess of fifteen years.
The Company utilizes a variety of derivative instruments to mitigate interest rate risk associated with its investment portfolio. Interest rate swaps are primarily used to convert interest receipts or payments to a fixed or variable rate. The use of such swaps enables the Company to customize contract terms and conditions to customer objectives and satisfies its asset/liability duration matching policy. Interest rate swaps are also used to hedge the variability in the cash flow of a forecasted purchase or sale of fixed rate securities due to changes in interest rates. Forward rate agreements are used to convert interest receipts on floating-rate securities to fixed rates. These derivatives are used to lock in the forward interest rate curve and reduce income volatility that results from changes in interest rates. Interest rate caps, floors, swaptions, and futures may be used to manage portfolio duration.
At December 31, 2010 and 2009, notional amounts pertaining to derivatives utilized to manage interest rate risk totaled $19.3 billion and $21.3 billion, respectively ($18.9 billion and $19.7 billion, respectively, related to investments and $0.4 billion and $1.6 billion, respectively, related to Wealth Management liabilities). The fair value of these derivatives was $(372) and $18 as of December 31, 2010 and 2009, respectively.
The fixed liabilities included above represented approximately 47% and 63% of the Company’s general account liabilities as of December 31, 2010 and 2009, respectively. The assets supporting the fixed liabilities are monitored and managed within set duration guidelines, and are evaluated on a daily basis, as well as annually using scenario simulation techniques in compliance with regulatory requirements.
The following table provides an analysis showing the estimated before-tax change in the fair value of the Company’s fixed maturity investments and related derivatives, assuming 100 basis point upward and downward parallel shifts in the yield curve as of December 31, 2010 and 2009. Certain financial instruments, such as limited partnerships and other alternative investments, 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.
The Company’s primary exposure to equity risk relates to the potential for lower earnings associated with certain of the Wealth Management’s businesses such as variable annuities where fee income is earned based upon the fair value of the assets under management. For further discussion of equity risk, see the Variable Product Equity Risk section below. In addition, Wealth Management offers certain guaranteed benefits, primarily associated with variable annuity products, which increases the Company’s potential benefit exposure as the equity markets decline.
The Company’s variable products are significantly influenced by the U.S., Japanese, and other global equity markets. Increases or declines in equity markets impact certain assets and liabilities related to the Company’s variable products and the Company’s earnings derived from those products. The Company’s variable products include variable annuity contracts, mutual funds, and variable life insurance.
Generally, increases in equity markets will reduce the value of derivative assets used to provide a macro hedge on statutory surplus, resulting in realized capital losses during periods of market appreciation.
The following table represents the timing of account values eligible for annuitization under the Japan GMIB as of December 31, 2010, as well as the retained net amount at risk. The account values reflect 100% annuitization at the earliest point allowed by the contract and no adjustments for future market returns and policyholder behaviors. Future market returns, changes in the value of the Japanese yen and policyholder behaviors will impact account values eligible for annuitization in the years presented.
As described below, the Company’s macro hedging program is not designed to provide protection against any one variable annuity guarantee program, but rather is a broad based hedge designed to provide protection against multiple guarantees and market risks, primarily focused on statutory liability and surplus volatility.
The Company maintains derivative hedging strategies for its product guarantee risk to meet multiple, and in some cases, competing risk management objectives, including providing protection against tail scenario market events, providing resources to pay product guarantee claims, and minimizing U.S. GAAP earnings volatility, statutory surplus volatility and other economic metrics.
The Company’s dynamic hedging program uses derivative instruments to provide protection against the risks associated with the GMWB variable annuity product guarantees including equity market declines, equity implied volatility, and declines in interest rates (See Market Risk on Statutory Capital below). 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. During the year, the Company added additional volatility protection. 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, divergence between the performance of the underlying funds and the hedging indices, changes in hedging positions and the relative emphasis placed on various risk management objectives.
Based on the construction of the Company’s derivative hedging program (both dynamic and macro hedge), which can change based on capital market conditions, and changes in the hedging program, underlying exposures and other factors, an independent change in the following capital market factors is likely to have the following impacts. These sensitivities do not capture the impact of elapsed time on liabilities or hedge assets. Each of the sensitivities set forth below is estimated individually under the indicated level of market movement and from the market levels at September 30, 2010 and December 31, 2010, and without consideration of any correlation among the key assumptions. In addition, there are other factors, including changes to the underlying hedging program, policyholder behavior and variation in underlying fund performance relative to the hedged index, which could materially impact the GMWB liability. As a result, these sensitivities do not necessarily reflect the financial impact from large shifts in the underlying indices or when multiple risk factors are impacted. Actual net changes in the value of the GMWB liability, the related dynamic hedging program derivative assets and the macro hedge program derivative assets may vary materially from those calculated using only the sensitivities disclosed below:
Represents the aggregate net impact of a 1% increase or decrease in broadly traded global equity indices.
Represents the aggregate net impact of a 1% increase or decrease in blended implied volatility that is generally skewed towards longer durations for broadly traded global equity indices. The decrease in volatility sensitivity was primarily due to additional purchases of volatility coverage in our dynamic hedge program.
Represents the aggregate net impact of a 1 basis point parallel shift on the global LIBOR yield curve. The increase in interest rate sensitivity in the macro hedge program was primarily due to additional purchases of interest rate coverage during the quarter.
The yen based fixed annuity product was written by Hartford Life Insurance K.K. (“HLIKK”), a wholly-owned Japanese subsidiary of Hartford Life, Inc. (“HLI”), and subsequently reinsured to Hartford Life Insurance Company, a U.S. dollar based wholly-owned indirect subsidiary of HLI. During 2009, the Company has since suspended new sales of the Japan business. The underlying investment involves investing in U.S. securities markets, which offer favorable credit spreads. The yen denominated fixed annuity product (“yen fixed annuities”) is recorded in the consolidated balance sheets with invested assets denominated in dollars while policyholder liabilities are denominated in yen and converted to U.S. dollars based upon the December 31, yen to U.S. dollar spot rate. The difference between U.S. dollar denominated investments and yen denominated liabilities exposes the Company to currency risk. The Company manages this currency risk associated with the yen fixed annuities primarily with pay variable U.S. dollar and receive fixed yen currency swaps. As of December 31, 2010 and 2009, the notional value of the currency swaps was $2.1 billion and $2.3 billion and the fair value was $608 and $316, respectively. Although economically an effective hedge, a divergence between the yen denominated fixed annuity product liability and the currency swaps exists primarily due to the difference in the basis of accounting between the liability and the derivative instruments (i.e. historical cost versus fair value). The yen denominated fixed annuity product liabilities are recorded on a historical cost basis and are only adjusted for changes in foreign spot rates and accrued income. The currency swaps are recorded at fair value, incorporating changes in value due to changes in forward foreign exchange rates, interest rates and accrued income. A before-tax net gain of $27 and $47 for the years ended December 31, 2010 and 2009, respectively, which includes the changes in value of the currency swaps, excluding net periodic coupon settlements, and the yen fixed annuity contract remeasurement, was recorded in net realized capital gains and losses.
In addition, in 2010 The Hartford entered into an intercompany liquidity agreement that allows for short-term advances of funds among the HFSG Holding Company and certain affiliates of up to $2.0 billion for liquidity and other general corporate purposes. The Connecticut Insurance Department granted approval for the Connecticut domiciled insurance companies that are parties to the agreement to treat receivables from a parent, including the HFSG Holding Company, as admitted assets for statutory accounting purposes.
HFSG Holding Company’s debt maturities over the next twelve months include $400 aggregate principal amount of its 5.25% senior notes that mature in October 2011.
For additional information regarding debt, see Note 14 of the Notes to Consolidated Financial Statements.
On February 2, 2011, The Hartford’s Board of Directors declared a quarterly dividend of $0.10 per common share payable on April 1, 2011 to common shareholders of record as of March 1, 2011.
On February 24, 2011, The Hartford’s Board of Directors declared a dividend of $18.125 on each share of Series F preferred stock payable on April 1, 2011 to shareholders of record as of March 15, 2011.
Dividends to the HFSG Holding Company from its insurance subsidiaries are restricted. The payment of dividends by Connecticut-domiciled insurers is limited under the insurance holding company laws of Connecticut. These laws require notice to and approval by the state insurance commissioner for the declaration or payment of any dividend, which, together with other dividends or distributions made within the preceding twelve months, exceeds the greater of (i) 10% of the insurer’s policyholder surplus as of December 31 of the preceding year or (ii) net income (or net gain from operations, if such company is a life insurance company) for the twelve-month period ending on the thirty-first day of December last preceding, in each case determined under statutory insurance accounting principles. In addition, if any dividend of a Connecticut-domiciled insurer exceeds the insurer’s earned surplus, it requires the prior approval of the Connecticut Insurance Commissioner. The insurance holding company laws of the other jurisdictions in which The Hartford’s insurance subsidiaries are incorporated (or deemed commercially domiciled) generally contain similar (although in certain instances somewhat more restrictive) limitations on the payment of dividends. Dividends paid to HFSG Holding Company by its insurance subsidiaries are further dependent on cash requirements of HLI and other factors. The Company’s property-casualty insurance subsidiaries are permitted to pay up to a maximum of approximately $1.5 billion in dividends to HFSG Holding Company in 2011 without prior approval from the applicable insurance commissioner. The Company’s life insurance subsidiaries are permitted to pay up to a maximum of approximately $83 in dividends to HLI in 2011 without prior approval from the applicable insurance commissioner. The aggregate of these amounts, net of amounts required by HLI, is the maximum the insurance subsidiaries could pay to HFSG Holding Company in 2011. In 2010, HFSG Holding Company and HLI received no dividends from the life insurance subsidiaries, and HFSG Holding Company received $1.0 billion in dividends from its property-casualty insurance subsidiaries.
On March 31, 2010, the Company repurchased all 3.4 million shares of Series E Preferred Stock issued to the U.S. Department of the Treasury (the “Treasury”) for an aggregate purchase price of $3.4 billion. The Hartford used approximately $425 of the net proceeds from the debt issuance, $1.6 billion from the common stock issuance, $556 from the preferred stock issuance together with available funds at the HFSG Holding Company to repurchase the Series E Preferred Stock. The Company recorded a $440 charge to retained earnings representing the acceleration of the accretion of the remaining discount on the preferred stock.
On September 27, 2010, the Treasury sold its warrants to purchase approximately 52 million shares of The Hartford’s common stock in a secondary public offering for net proceeds of approximately $706. The Hartford did not receive any proceeds from this sale. The warrants are exercisable, in whole or in part, at any time and from time to time until June 26, 2019 at an initial exercise price of $9.79. The exercise price will be paid by the withholding by The Hartford of a number of shares of common stock issuable upon exercise of the warrants equal to the value of the aggregate exercise price of the warrants so exercised determined by reference to the closing price of The Hartford’s common stock on the trading day on which the warrants are exercised and notice is delivered to the warrant agent. The Hartford did not purchase any of the warrants sold by the Treasury.
During the Company’s participation in the Capital Purchase Program (“CPP”), the Company was subject to numerous additional regulations, including restrictions on the ability to increase the common stock dividend, limitations on the compensation arrangements for senior executives and additional corporate governance standards. As a result of the redemption of Series E Preferred Stock, the Company is no longer subject to these regulations other than certain reporting and certification obligations to U.S. regulatory agencies.
On August 4, 2010, The Hartford filed with the Securities and Exchange Commission (the “SEC”) an automatic shelf registration statement (Registration No. 333-168532) for the potential offering and sale of debt and equity securities. The registration statement allows for the following types of securities to be offered: debt securities, junior subordinated debt securities, preferred stock, common stock, depositary shares, warrants, stock purchase contracts, and stock purchase units. 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 of December 31, 2010, The Hartford has not exercised its right to require ABC Trust to purchase the Notes. As a result, the Notes remain a source of capital for the HFSG Holding Company.
Certain of the Company’s derivative agreements contain provisions that are tied to the financial strength ratings of the individual legal entity that entered into the derivative agreement as set by nationally recognized statistical rating agencies. If the legal entity’s financial strength were to fall below certain ratings, the counterparties to the derivative agreements could demand immediate and ongoing full collateralization and in certain instances demand immediate settlement of all outstanding derivative positions traded under each impacted bilateral agreement. The settlement amount is determined by netting the derivative positions transacted under each agreement. If the termination rights were to be exercised by the counterparties, it could impact the legal entity’s ability to conduct hedging activities by increasing the associated costs and decreasing the willingness of counterparties to transact with the legal entity. The aggregate fair value of all derivative instruments with credit-risk-related contingent features that are in a net liability position as of December 31, 2010, is $557. Of this $557 the legal entities have posted collateral of $530 in the normal course of business. Based on derivative market values as of December 31, 2010, a downgrade of one level below the current financial strength ratings by either Moody’s or S&P could require approximately an additional $29 to be posted as collateral. Based on derivative market values as of December 31, 2010, a downgrade by either Moody’s or S&P of two levels below the legal entities’ current financial strength ratings could require approximately an additional $56 of assets to be posted as collateral. These collateral amounts could change as derivative market values change, as a result of changes in our hedging activities or to the extent changes in contractual terms are negotiated. The nature of the collateral that we may be required to post is primarily in the form of U.S. Treasury bills and U.S. Treasury notes.
Current and expected patterns of claim frequency and severity or surrenders may change from period to period but continue to be within historical norms and, therefore, the Company’s insurance operations’ current liquidity position is considered to be sufficient to meet anticipated demands over the next twelve months, including any obligations related to the Company’s restructuring activities. For a discussion and tabular presentation of the Company’s current contractual obligations by period, refer to Off-Balance Sheet Arrangements and Aggregate Contractual Obligations within the Capital Resources and Liquidity section of the MD&A.
The principal sources of operating funds are premiums, fees earned from assets under management and investment income, while investing cash flows originate from maturities and sales of invested assets. The primary uses of funds are to pay claims, claim adjustment expenses, commissions and other underwriting expenses, to purchase new investments and to make dividend payments to the HFSG Holding Company.
The following table summarizes Property & Casualty Operation’s fixed maturities, short-term investments, and cash, as of December 31, 2010:
Liquidity requirements that are unable to be funded by Property & Casualty Operation’s short-term investments would be satisfied with current operating funds, including premiums received or through the sale of invested assets. A sale of invested assets could result in significant realized losses.
The following table summarizes Life Operation’s fixed maturities, short-term investments, and cash, as of December 31, 2010:
In the event customers elect to surrender separate account assets or international statutory separate accounts, Life Operations will use the proceeds from the sale of the assets to fund the surrender, and Life Operation’s liquidity position will not be impacted. In many instances Life Operations will receive a percentage of the surrender amount as compensation for early surrender (surrender charge), increasing Life Operation’s liquidity position. In addition, a surrender of variable annuity separate account or general account assets (see below) will decrease Life Operation’s obligation for payments on guaranteed living and death benefits.
Relates to contracts such as payout annuities or institutional notes, other than guaranteed investment products with an MVA feature (discussed below) or surrenders of term life, group benefit contracts or death and living benefit reserves for which surrenders will have no current effect on Life Operation’s liquidity requirements.
Relates to annuities that are held in a statutory separate account, but under U.S. GAAP are recorded in the general account as Fixed MVA annuity contract holders are subject to the Company’s credit risk. In the statutory separate account, Life Operation is required to maintain invested assets with a fair value equal to the MVA surrender value of the Fixed MVA contract. In the event assets decline in value at a greater rate than the MVA surrender value of the Fixed MVA contract, Life Operation is required to contribute additional capital to the statutory separate account. Life Operation will fund these required contributions with operating cash flows or short-term investments. In the event that operating cash flows or short-term investments are not sufficient to fund required contributions, the Company may have to sell other invested assets at a loss, potentially resulting in a decrease in statutory surplus. As the fair value of invested assets in the statutory separate account are generally equal to the MVA surrender value of the Fixed MVA contract, surrender of Fixed MVA annuities will have an insignificant impact on the liquidity requirements of Life Operation.
GICs are subject to discontinuance provisions which allow the policyholders to terminate their contracts prior to scheduled maturity at the lesser of the book value or market value. Generally, the market value adjustment reflects changes in interest rates and credit spreads. As a result, the market value adjustment feature in the GIC serves to protect the Company from interest rate risks and limit Life Operation’s liquidity requirements in the event of a surrender.
The Company does not have any off-balance sheet arrangements that are reasonably likely to have a material effect on the financial condition, results of operations, liquidity, or capital resources of the Company, except for the contingent capital facility described above and the following:
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, 2010, the total property and casualty reserves in the above table are gross of a reserve discount of $524.
Includes contractual principal and interest payments. All long-term debt obligations have fixed rates of interest. See Note 14 of Notes to Consolidated Financial Statements for additional discussion of long-term debt obligations.
Also included in purchase obligations is $642 relating to contractual commitments to purchase various goods and services such as maintenance, human resources, information technology, and transportation in the normal course of business. Purchase obligations exclude contracts that are cancelable without penalty or contracts that do not specify minimum levels of goods or services to be purchased.
Includes cash collateral of $1.1 billion which the Company has accepted in connection with the Company’s 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.
Includes deposits and bank advances that were acquired through the purchase of Federal Trust Corporation in the second quarter of 2009.
Does not include estimated voluntary contribution of $200 to the Company’s pension plan in 2011.
The capital structure of The Hartford as of December 31, 2010 and December 31, 2009 consisted of debt and stockholders’ equity, summarized as follows:
Total debt of the Company excludes $382 and $1.1 billion of consumer notes as of December 31, 2010 and December 31, 2009, respectively, and $25 and $78 of Federal Home Loan Bank advances recorded in other liabilities as of December 31, 2010 and December 31, 2009, respectively.
AOCI, net of tax, improved primarily due to increases in net unrealized available-for-sale securities of $2.0 billion primarily as a result of improved security valuations due to declining interest rates and an increase of $128 in cash flow hedging instruments.
The increase in cash provided by operating activities, compared to the prior year period, was primarily the result of increases in fee income. Cash used for investing activities in 2010 primarily relates to net purchases of available-for-sale securities of $1.5 billion and net payments on derivatives of $338, partially offset by net proceeds from sales of mortgage loans of $1.4 billion. Cash used for investing activities in 2009 consisted of net outflows of $2.9 billion from changes in payables on securities lending, net purchases of available-for-sale securities and $561 of net payments on derivatives, partially offset by net proceeds from sales of mortgage loans of $396.
Cash provided by (used for) financing activities decreased primarily due to the redemption of preferred stock issued to the U.S. Treasury of $3.4 billion, repayments of consumer notes of $754 in 2010, repayment of $275 in senior notes in June 2010 and net outflows on investment and universal life-type contracts in 2010. Partially offsetting the decreases were proceeds from the issuance of $1.1 billion in aggregate senior notes, issuance of common stock under a public offering of $1.6 billion and issuance of mandatory convertible preferred stock of $556.
The decrease in cash provided by operating activities compared to the prior year period was primarily the result of lower premiums, lower fee income and lower net investment income. Net derivative settlements and pay down of collateral under securities lending account for the majority of cash used for investing activities. Cash provided by financing activities decreased primarily due to net flows decrease in investment and universal life-type contracts of $5.5 billion partially offset by issuances of preferred stock and warrants to the U.S. Treasury for $3.4 billion and issuance of common stock through a discretionary equity issuance plan of $887 in 2009 and treasury stock acquired in 2008, partially offset by issuance of long-term debt and consumer notes in 2008 and repayments of commercial paper in 2009.
Operating cash flows in each of the last three years have been adequate to meet liquidity requirements.
The table below sets forth statutory surplus for the Company’s insurance companies. The statutory surplus amount as of December 31, 2009 in the table below is based on actual statutory filings with the applicable U.S. regulatory authorities. The statutory surplus amount as of December 31, 2010 is an estimate, as the respective 2010 statutory filings have not yet been made.
Total statutory capital and surplus increased by $764 primarily due statutory net income, after tax, for property and casualty subsidiaries of $1.5 billion, offset by statutory net losses of $140 in our life insurance subsidiaries, including domestic captive insurance subsidiaries and dividends to the HFSG Holding Company of $1.0 billion.
The Company also holds regulatory capital and surplus for its operations in Japan. Using the investment in subsidiary accounting requirements defined in the U.S. National Association of Insurance Commissioners Statements of Statutory Accounting Practices, the Company’s statutory capital and surplus attributed to the Japan operations was $1.2 billion and $1.3 billion as of December 31, 2010 and December 31, 2009, respectively. However, under the accounting practices and procedures governed by Japanese regulatory authorities, the Company’s statutory capital and surplus was $1.3 billion and $1.1 billion as of December 31, 2010 and 2009, respectively.
The Company’s stockholders’ equity, as prepared using U.S. generally accepted accounting principles (“US GAAP”) was $20.3 billion as of December 31, 2010. The Company’s estimated aggregate statutory capital and surplus, as prepared in accordance with the National Association of Insurance Commissioners’ Accounting Practices and Procedures Manual (“US STAT”) was $15.5 billion as of December 31, 2010. Significant differences between US GAAP stockholders’ equity and aggregate statutory capital and surplus prepared in accordance with US STAT include the following:
The assumptions used in the determination of Life benefit reserves is prescribed under US STAT, while the assumptions used under US GAAP are generally the Company’s best estimates. The methodologies for determining life insurance reserve amounts may also be different. For example, reserving for living benefit reserves under US STAT is generally addressed by the Commissioners’ Annuity Reserving Valuation Methodology and the related Actuarial Guidelines, while under US GAAP, those same living benefits may be considered embedded derivatives and recorded at fair value or they may be considered SOP 03-1 reserves. The sensitivity of these life insurance reserves to changes in equity markets, as applicable, will be different between US GAAP and US STAT.
In any particular year, statutory surplus amounts and RBC ratios may increase or decrease depending upon a variety of factors. The amount of change in the statutory surplus or RBC ratios can vary based on individual factors and may be compounded in extreme scenarios or if multiple factors occur at the same time. At times the impact of changes in certain market factors or a combination of multiple factors on RBC ratios can be counterintuitive. For further discussion on the factors see the Market Risk on Statutory Capital section within Capital Markets Risk Management of the MD&A.
For a discussion of terrorism reinsurance legislation and how it affects The Hartford, see “Terrorism” under the Property and Casualty Underwriting Risk Management section of the MD&A.
In particular, the Dodd-Frank Act vests a newly created Financial Services Oversight Council with the power to designate “systemically important” institutions, which will be subject to special regulatory supervision and other provisions intended to prevent, or mitigate the impact of, future disruptions in the U.S. financial system. Systemically important institutions are limited to nonbank financial companies that are so important that their potential failure could “pose a threat to the financial stability of the United States.” If we are designated as a systemically important institution, we could be subject to higher capital requirements and additional regulatory oversight imposed by The Federal Reserve, as well as to post-event assessments imposed by the Federal Deposit Insurance Corporation (“FDIC”) to recoup the costs associated with the orderly resolution of other systemically important institutions in the event one or more such institutions fails. Further, the FDIC is authorized to petition a state court to commence an insolvency proceeding to liquidate an insurance company that fails in the event the insurer’s state regulator fails to act. Other provisions will require central clearing of, and/or impose new margin and capital requirements on, derivatives transactions, which we expect will increase the costs of our hedging program.
A number of provisions of the Dodd-Frank Act affect us solely due to our status as a savings & loan holding company. For example, under the Dodd-Frank Act, the OTS will be dissolved. The Federal Reserve will regulate us as a holding company, and the OCC will regulate our thrift subsidiary, Federal Trust Bank. Because of our status as a savings and loan holding company or if we are designated a systemically important institution, the Dodd-Frank Act may also restrict us from sponsoring and investing in private equity and hedge funds, which would limit our discretion in managing our general account. The Dodd-Frank Act will also impose new minimum capital standards on a consolidated basis for holding companies that, like us, control insured depository institutions.
Other provisions in the Dodd-Frank Act that may impact us, irrespective of whether or not we are a savings and loan holding company include: the possibility that regulators could break up firms that are considered “too big to fail;” a new “Federal Insurance Office” within Treasury to, among other things, conduct a study of how to improve insurance regulation in the United States; new means for regulators to limit the activities of financial firms; discretionary authority for the SEC to impose a harmonized standard of care for investment advisers and broker-dealers who provide personalized advice about securities to retail customers; additional regulation of compensation in the financial services industry; and enhancements to corporate governance, especially regarding risk management.
On February 15, 2011, the Obama Administration released its “FY 2012, Budget of the United States Government” (the “Budget”). Although the Administration has not released proposed statutory language, the Budget includes proposals which if enacted, would affect the taxation of life insurance companies and certain life insurance products. In particular, the proposals would affect the treatment of corporate owned life insurance (“COLI”) policies by limiting the availability of certain interest deductions for companies that purchase those policies. The proposals would also change the method used to determine the amount of dividend income received by a life insurance company on assets held in separate accounts used to support products, including variable life insurance and variable annuity contracts, that are eligible for the dividends received deduction (“DRD”). The DRD reduces the amount of dividend income subject to tax and is a significant component of the difference between the Company’s actual tax expense and expected amount determined using the federal statutory tax rate of 35%. If proposals of this type were enacted, the Company’s sale of COLI, variable annuities, and variable life products could be adversely affected and the Company’s actual tax expense could increase, reducing earnings. The Budget also included a proposal to levy a $30 billion “Financial Crisis Responsibility Fee,” in the aggregate, on large financial institutions, including The Hartford.