Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) addresses the financial condition of Hartford Life Insurance Company and its subsidiaries (“Hartford Life Insurance Company” or the “Company”) as of and for the year ended December 31, 2013 compared with the comparable 2012 periods. Management’s narrative analysis of the results of operations is presented pursuant to General Instruction I (2) (a) of Form 10-K. This discussion should be read in conjunction with the Consolidated Financial Statements and related Notes beginning on page. Certain reclassifications have been made to prior year financial information to conform to the current year presentation.
[1] Includes net realized capital gains (losses) on business dispositions of $1,561 for the year ended December 31, 2013.
December 31, 2013 compared to the year ended December 31, 2012
Hartford Life and Annuity Insurance Company, a subsidiary of the Company, has a modified coinsurance ("modco") and coinsurance with funds withheld reinsurance agreement with White River Life Reinsurance, an affiliated captive insurance company ("affiliate modco reinsurance agreement"). The affiliate modco reinsurance agreement increased earnings by $104 for the year ended December 31, 2013, and decreased earnings by $212 for 2012. The most significant fluctuations of the modco agreement were within net realized capital gains (losses) and insurance operating costs and other expenses, which are primarily due to changes in reserves and hedging costs associated with the reinsured block of business. For further discussion on the affiliate modco reinsurance agreement see Note 13 - Transactions with Affiliates of Notes to the Consolidated Financial Statements.
Net realized capital gains (losses), excluding the impacts of the affiliate modco reinsurance agreement and the net realized gains on business disposition, decreased by $219 for the year ended December 31, 2013, and increased $1,209 for the year ended December 31, 2012. For further discussion of net realized capital gains (losses), see MD&A - Net Realized Capital Gains (Losses).
The Company's effective tax rate differs from the U.S. statutory rate of 35% for the years ended December 31, 2013 and 2012 primarily due to the separate account dividends received deduction (“DRD”). For a reconciliation of the income tax provision at the U.S. Federal statutory rate to the provision for income taxes, see Note 11 - Income Taxes of Notes to Consolidated Financial Statements .
The separate account DRD is estimated for the current year using information from the most recent return, adjusted for current year equity market performance and other appropriate factors, including estimated levels of corporate dividend payments and level of policy owner equity account balances. The actual current year DRD can vary from estimates based on, but not limited to, changes in eligible dividends received in the mutual funds, amounts of distributions 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 $135 and $140 related to the separate account DRD for the years ended December 31, 2013 and 2012, respectively. These amounts included benefits (charges) related to prior years’ tax returns of $1 and $(4) in the years ended December 31, 2013 and 2012, respectively.
The Company receives a foreign tax credit for foreign taxes paid including payments from its separate account assets. This credit reduces the company’s U.S. tax liability. The separate account foreign tax credit is estimated for the current year using information from the most recent filed return, adjusted for the change in the allocation of separate account investments to the international equity markets during the current year. The actual current year foreign tax credit can vary from the estimates due to actual foreign tax credits passed through from the mutual funds. The Company recorded benefits of $7 and $9 related to separate account foreign tax credit for the years ended December 31, 2013 and 2012, respectively.
Total investments decreased since December 31, 2012, principally due to the sale of the Retirement Plans and Individual Life businesses resulting in the transfer of fixed maturities, AFS, fixed maturities, FVO, equity securities, AFS, mortgage loans, and policy loans with a total carrying value of $16.9 billion in January 2013. In addition, the sale of the U.K. variable annuity business, HLIL, in the fourth quarter of 2013 resulted in a decline in the carrying value of fixed maturities, AFS and equity securities, trading of $469 and $1.7 billion, respectively. Refer to Note 2 - Business Dispositions of Notes to Consolidated Financial Statements for further discussion of these transactions. The remaining decrease in total invested assets is primarily due to decreases in fixed maturities, AFS, short-term investments, and other investments. The decrease in fixed maturities, AFS was due to a decline in valuations due to an increase in interest rates, reductions in dollar rolls and repurchase agreements, and capital management activities. The decrease in short-term investments is primarily attributable to a decline in derivative collateral held due to decreases in derivative market values. The decline in other investments was largely due to a decline in derivative market value primarily related to the variable annuity hedge program.
The annualized net investment income yield, excluding limited partnerships and other alternative investments, has declined to 4.2% in 2013 versus 4.4% in 2012. The decline was primarily attributable to the divestiture of Individual Life and Retirement Plans businesses. The invested assets transferred associated with the divested Individual Life and Retirement Plans businesses had a carrying value of $16.9 billion and an average book yield, including the impact of associated derivatives, of approximately 5.0%. The average reinvestment rate for the year ended December 31, 2013 was approximately 3.6%, excluding treasury securities and mortgage backed securities related to dollar roll transactions which is slightly higher than the average yield of sales and maturities for the same period. For further discussion on dollar roll transactions see Note 4 - Investments and Derivative Investments of Notes to Consolidated Financial Statements. Based upon current reinvestment rates, we currently expect the portfolio yield, excluding limited partnerships and other alternative investments, for the full year 2014, to remain relatively consistent with the 2013 net investment income yield. The estimated impact on net investment income is subject to change as the composition of the portfolio changes through normal portfolio management and trading activities and changes in market conditions.
Relates to the Japanese fixed annuity products (adjustment of product liability for changes in spot currency exchange rates, related derivative hedging instruments excluding periodic net coupon settlements, and the change in value related to Japan government FVO securities).
estimated gross profits used in the valuation and amortization of assets and liabilities associated with variable annuity and other universal life type contracts;
For additional information regarding business dispositions, see Note 2 - Business Dispositions and Note 5 - Reinsurance of Notes to Consolidated Financial Statements. For additional information on DAC, see Note 6 - Deferred Policy Acquisition Costs and Present Value of Future Profits of Notes to Consolidated Financial Statements. For additional information on SIA, see Note 9 - Sales Inducements of Notes to Consolidated Financial Statements. For additional information on death and other insurance benefit reserves, see Note 8 - Separate Accounts, Death Benefits and Other Insurance Benefit Features of Notes to Consolidated Financial Statements.
The (charge) benefit to net income by asset and liability as a result of the Unlock is as follows:
For most life insurance product contracts, the Company estimates gross profits over 20 years as EGPs emerging subsequent to that timeframe are immaterial. Products sold in a particular year are aggregated into cohorts. Future gross profits for each cohort are projected over the estimated lives of the underlying contracts, based on future account value projections for variable annuity and variable universal life products. The projection of future account values requires the use of certain assumptions including: separate account returns; separate account fund mix; fees assessed against the contract holder’s account balance; surrender and lapse rates; interest margin; mortality; and the extent and duration of hedging activities and hedging costs.
In the third quarter of each year, the Company completes a comprehensive non-market related policyholder behavior assumption study and incorporates the results of those studies into its projection of future gross profits. Additionally, throughout the year, the Company evaluates various aspects of policyholder behavior and periodically revises its policyholder assumptions as credible emerging data indicates that changes are warranted. The Company will continue to evaluate our assumptions related to policyholder behavior as we begin to implement initiatives to reduce the size of the variable annuity business. Upon completion of the assumption study or evaluation of credible new information, the Company will revise its assumptions to reflect its current best estimate. These assumption revisions will change the projected account values and the related EGPs in the DAC, SIA and URR amortization models, as well as the death and other insurance benefit reserving model.
An Unlock revises EGPs, on a quarterly basis, to reflect market updates of policyholder account value and the Company’s current best estimate assumptions. Modifications to the Company’s hedging programs may impact EGPs, and correspondingly impact DAC recoverability. After each quarterly Unlock, the Company also tests the aggregate recoverability of DAC by comparing the DAC balance to the present value of future EGPs. As of December 31, 2013, the margin between the DAC balance and the present value of future EGPs for U.S. individual variable annuities was 26%. If the margin between the DAC asset and the present value of future EGPs is exhausted, then further reductions in EGPs would cause portions of DAC to be unrecoverable and the DAC asset would be written down to equal future EGPs.
The fair value of AFS securities, fixed maturities at fair value using the fair value option (“FVO”), equity securities, trading, and short-term investments in an active and orderly market (i.e., not distressed or forced liquidation) are determined by management after considering one of three primary sources of information: third-party pricing services, independent broker quotations or pricing matrices. Security pricing is applied using a “waterfall” approach whereby publicly available prices are first sought from third-party pricing services, the remaining unpriced securities are submitted to independent brokers for prices, or lastly, securities are priced using a pricing matrix. Typical inputs used by these pricing methods include, but are not limited to, reported trades, benchmark yields, issuer spreads, bids, offers, and/or estimated cash flows, prepayments speeds and default rates. Based on the typical trading volumes and the lack of quoted market prices for fixed maturities, third-party pricing services will normally derive the security prices through recent reported trades for identical or similar securities making adjustments through the reporting date based upon available market observable information as outlined above. If there are no recent reported trades, the third party pricing services and brokers may use matrix or model processes to develop a security price where future cash flow expectations are developed based upon collateral performance and discounted at an estimated market rate. Included in the pricing of asset-backed-securities ("ABS") and residential mortgage-backed securities ("RMBS") are estimates of the rate of future prepayments of principal over the remaining life of the securities. Such estimates are derived based on the characteristics of the underlying structure and prepayment speeds previously experienced at the interest rate levels projected for the underlying collateral. Actual prepayment experience may vary from these estimates. For further discussion, see the AFS Securities, Fixed Maturities, FVO, Equity Securities, Trading, and Short-Term Investments section in Note 3 - Fair Value Measurements of Notes to Consolidated Financial Statements.
In 2012, the Company wrote off $159 of goodwill associated with the Mutual Funds reporting unit including goodwill of $10 due to the sale of Woodbury Financial Services and $149 of remaining goodwill as a result of the Mutual Funds reorganization. For further discussion of the reorganization of the Mutual Funds business, see Note1 - Basis of Presentation and Significant Accounting Policies of Notes to Consolidated Financial Statements.
An increase in interest rates from current levels is generally a favorable development for the Company. Interest rate increases are expected to provide additional net investment income, reduce the cost of the variable annuity hedging program, limit the potential risk of margin erosion due to minimum guaranteed crediting rates in certain products and, if sustained, could reduce the Company’s prospective pension expense. Conversely, a rise in interest rates will reduce the fair value of the investment portfolio, increase interest expense on the Company’s variable rate debt obligations and, if long-term interest rates rise dramatically within a six to twelve month time period, certain businesses may be exposed to disintermediation risk.
The Company’s investment portfolios primarily consist of investment grade fixed maturity securities. The fair value of fixed maturity securities was $29.0 billion and $49.4 billion at December 31, 2013 and 2012, respectively. The fair value of these and other invested assets fluctuates depending on the interest rate environment and other general economic conditions. The weighted average duration of the portfolio, including fixed maturities, commercial mortgage loans, and cash equivalents, was approximately 5.2 years and 5.9 years as of December 31, 2013 and 2012, respectively. As of December 31, 2012, the weighted average duration of the portfolio, excluding the Retirement Plans and Individual Life businesses, was approximately 5.5 years.
At December 31, 2013 and 2012, notional amounts pertaining to derivatives utilized to manage interest rate risk totaled $9.1 billion and $18.0 billion, respectively ($8.9 billion and $17.8 billion, respectively, related to investments and $0.2 billion and $0.2 billion, respectively, related liabilities). The fair value of these derivatives was $(376) and $(251) as of December 31, 2013 and 2012, respectively. The decline in notional amounts related to investments of $8.9 billion primarily relates to the termination of interest rate swaptions designed to hedge the interest rate risk of the securities that were transferred related to the sale of the Retirement Plan business segment. These amounts do not include derivatives associated with the Variable Annuity Hedging Program. For further information, see the Variable Product Guarantee Risks and Risk Management section.
Included in the following table is the before-tax change in the net economic value of investment contracts (e.g., fixed annuity contracts) and certain insurance product liabilities (e.g., disability contracts) for which the payment rates are fixed at contract issuance and the investment experience is substantially absorbed by the Company’s operations, along with the corresponding invested assets. Also included in this analysis are the interest rate sensitive derivatives used by the Company to hedge its exposure to interest rate risk in the investment portfolios supporting these contracts. This analysis does not include the assets and corresponding liabilities of certain insurance products such as certain life contingent annuities. Certain financial instruments, such as limited partnerships and other alternative investments, have been omitted from the analysis due to the fact that the investments generally lack sensitivity to interest rate changes. Separate account assets and liabilities, equity securities, trading and the corresponding liabilities associated with the variable annuity products are excluded from the analysis because gains and losses in separate accounts accrue to policyholders.
The fixed liabilities included above represented approximately 51% and 52% of the Company’s general account liabilities as of December 31, 2013 and 2012, 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, not included in the table above, assuming 100 basis point upward and downward parallel shifts in the yield curve as of December 31, 2013 and 2012. 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 decline in the estimated change in fair value assuming a 100 basis point shift since 2012 is due to the sales of the Retirement Plans and Individual Life businesses in January of 2013.
Equity risk is defined as the risk of financial loss due to changes in the value of global equities or equity indices. The Company has exposure to equity risk from assets under management, embedded derivatives within the Company’s variable annuities and assets that support the Company’s pension plans. Equity Risk on the Company’s Variable Annuity products is mitigated through various hedging programs. For further information see the Variable Annuity Hedging Program Section.
The Company entered into two reinsurance transactions in connection with the sales of its Retirement Plans and Individual Life businesses in January 2013. For further discussion of these transactions, see Note 2 - Business Dispositions of Notes to the Consolidated Financial Statements.
Life insurance product reinsurance recoverables represent loss and loss adjustment expense recoverable from a number of reinsurers. The Company's reinsurance recoverables are summarized as follows:
The Company’s equity product risk is managed at the Life Operations level of The Hartford. The disclosures in the following equity product risk section are reflective of the risk management program, including reinsurance with third parties and the dynamic and macro derivative hedging programs which are structured at the parent company level. The following disclosures are also reflective of the Company’s reinsurance of the majority of variable annuities with living and death benefit riders to an affiliated captive reinsurer. For further information on the affiliate reinsurance transaction, see Note 5 - Reinsurance of Notes to the Consolidated Financial Statements.
Generally, increases in equity markets will reduce the value of the macro hedge derivative assets, resulting in realized capital losses, and will generally have the inverse impact of those listed above. For more information, see Risk Hedging - Variable Annuity Hedging Program section.
The following tables summarize the account values of the Company’s U.S. direct variable annuities with guarantee features and Japan assumed guarantee features and the NAR split between various guarantee features (retained net amount at risk does not take into consideration the effects of the variable annuity hedge programs currently in place):
Policies with a guaranteed living benefit (a GMWB in the US, or a GMIB in Japan) also have a guaranteed death benefit. The NAR for each benefit is shown; however these benefits are not additive. When a policy terminates due to death, any NAR related to GMWB or GMIB is released. Similarly, when a policy goes into benefit status on a GMWB or GMIB, its GMDB NAR is released.
[6] On December 12, 2013, the Company completed the sale of the U.K variable annuity business of Hartford Life International Limited ("HLIL"), an indirect wholly-owned subsidiary. For further discussion of the sale of the U.K. variable annuity business, HLIL in 2013, see Note 2 - Business Dispositions and Note 17 - Discontinued Operations of Notes to Consolidated Financial Statements.
For GMIB contracts, in general, the policyholder has the right to elect to annuitize benefits, beginning (for certain products) on the tenth or fifteenth anniversary year of contract commencement, receive lump sum payment of the then current account value, or remain in the variable sub-account. For GMIB contracts, if the policyholder makes the annuitization election, the policyholder is entitled to receive the original investment value over a 10- to 15- year annuitization period. If the policyholder defers this election, the policyholder has the right to revisit the election annually on the policy anniversary date. In general, GMIB contracts will first become eligible to elect annuitization beginning in 2015. Because policyholders have various contractual rights to defer their annuitization election, the period over which annuitization election can take place is subject to policyholder behavior and therefore indeterminate. In addition, upon annuitization the contractholder surrenders access to the account value and the account value is transferred to the Company’s general account where it is invested and the additional investment proceeds are used towards payment of the original investment value. If the original investment value exceeds the account value upon annuitization then the contract is “in the money”. As of December 31, 2013, approximately 80% of the Japan GMIB contracts were “out of the money”. The Company reinsures a majority of the GMIB benefits with an affiliated captive reinsurer. For additional information on the Company’s GMIB liability, see Note 8 - Separate Accounts, Death Benefits and Other Insurance Benefit Features of Notes to Consolidated Financial Statements.
In 2019 & beyond, $2.0 billion of the $3.5 billion is associated with account value that is eligible in 2021.
The Company’s variable annuity hedging is primarily focused on reducing the economic exposure to market risks associated with guaranteed benefits that are embedded in our global variable annuity contracts through the use of reinsurance and capital market derivative instruments. The variable annuity hedging also considers the potential impacts on Statutory accounting results.
Our statutory surplus is also impacted by widening credit spreads as a result of the accounting for the assets and liabilities in our fixed MVA annuities. Statutory separate account assets supporting the fixed MVA annuities are recorded at fair value. In determining the statutory reserve for the fixed MVA annuities, we are required to use current crediting rates. In many capital market scenarios, current crediting rates are highly correlated with market rates implicit in the fair value of statutory separate account assets. As a result, the change in statutory reserve from period to period will likely substantially offset the change in the fair value of the statutory separate account assets. However, in periods of volatile credit markets, such as we have experienced, actual credit spreads on investment assets may increase sharply for certain sub-sectors of the overall credit market, resulting in statutory separate account asset market value losses. As actual credit spreads are not fully reflected in the current crediting rates, the calculation of statutory reserves will not substantially offset the change in fair value of the statutory separate account assets resulting in reductions in statutory surplus and can create funding obligations to the statutory separate account.
The Company has reinsured approximately 20% of its risk associated with GMWB and 76% of its risk associated with the aggregate GMDB exposure. These reinsurance agreements serve to reduce the Company’s exposure to changes in the statutory reserves and the related capital and RBC ratios associated with changes in the equity markets. The Company also continues to explore other solutions for mitigating the capital market risk effect on surplus, such as internal and external reinsurance solutions, modifications to our hedging program, changes in product design, increasing pricing and expense management.
The company manages the market risk, including foreign currency exchange risk, associated with the guaranteed benefits related to the Japanese variable annuities through its comprehensive International Hedge Program. For more information on the International Hedge Program, including the foreign currency exchange risk sensitivity analysis, see the Variable Product Guarantee Risks and Risk Management section.
Hartford Life Insurance K.K. (“HLIKK”), a wholly-owned Japanese subsidiary of Hartford Life, Inc. (“HLI”), previously issued a yen-denominated fixed annuity product and subsequently reinsured it to the Company. During 2009, the Company 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, 2013 and 2012 the notional value of the currency swaps was $1.4 billion and $1.7 billion and the fair value was $(6) and $224, respectively. 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. Included in net realized capital gains and losses was a before-tax net gain of $6 and a net loss $(36) for the years ended December 31, 2013, and 2012, respectively, which includes the changes in value of the currency swaps, excluding net periodic coupon settlements, and the yen fixed annuity contract remeasurement.
The risk associated with the non-U.S. dollar denominated fixed maturities relates to potential decreases in value and income resulting from unfavorable changes in foreign exchange rates. The fair value of the non-U.S. dollar denominated fixed maturities, which are primarily denominated in yen, at December 31, 2013 and 2012, were approximately $1.0 billion and $1.5 billion, respectively. Included in these amounts are $0.9 billion and $1.4 billion at December 31, 2013 and 2012, respectively, related to non-U.S. dollar denominated fixed maturity securities that directly support liabilities denominated in the same currencies. At December 31, 2013 and 2012, the derivatives used to hedge currency exchange risk related to the remaining non-U.S. dollar denominated fixed maturities had a total notional amount of $125 and $161, respectively, and total fair value of $(7) and $(10), respectively.
The Company uses various derivative counterparties in executing its derivative transactions. The use of counterparties creates credit risk that the counterparty may not perform in accordance with the contractual terms of the derivative transaction. The Company has derivative counterparty exposure policies which limit the Company’s exposure to credit risk and monitors counterparty credit exposure on a monthly basis to ensure compliance with company policies and statutory limitations. The Company’s policies with respect to derivative counterparty exposure establishes market-based credit limits, favors long-term financial stability and creditworthiness of the counterparty and typically requires credit enhancement/credit risk reducing agreements. The Company minimizes the credit risk of derivative instruments by entering into transactions with high quality counterparties primarily rated A or better, which are monitored and evaluated by the Company’s risk management team and reviewed by senior management. The Company also generally requires that OTC derivative contracts, other than certain forward contracts, be governed by an International Swaps and Derivatives Association ("ISDA") Master Agreement, which is structured by legal entity and by counterparty and reduces risk by permitting the closeout and netting of transactions upon the occurrence of certain events.
For the company's domestic derivative programs, the maximum uncollateralized threshold for a derivative counterparty for a single legal entity is $10. The Company currently transacts OTC derivatives in two legal entities that have a threshold greater than zero; and therefore the maximum combined threshold for a single counterparty across all legal entities that use derivatives is $20. In addition, the Company may have exposure to multiple counterparties in a single corporate family due to a common credit support provider. As of December 31, 2013 the maximum combined threshold for all counterparties under a single credit support provider across all legal entities that use derivatives is $40. Based on the contractual terms of the collateral agreements, these thresholds may be immediately reduced due to a downgrade in either party’s credit rating. For the year ended December 31, 2013 the Company has incurred no losses on derivative instruments due to counterparty default. For further discussion, see the Derivative Commitments section of Note 12 - Commitments and Contingencies of Notes to Consolidated Financial Statements.
The movement in the overall credit quality of the Company’s portfolio was primarily attributable to the sale of the Retirement Plans and Individual Life businesses in January 2013. Refer to Note 2 - Business Dispositions of Notes to Consolidated Financial Statements for further discussion of these transactions. Excluding the impact of the sales, United States government and government agencies declined due to the sale of agency RMBS securities associated with the termination of repurchase agreements, see Note 4 - Investments and Derivative Instruments of Notes to Consolidated Financial Statements. Fixed maturities, FVO, are not included in the above table. For further discussion on fair value option securities, see Note 3 - Fair Value Measurements of Notes to Consolidated Financial Statements.
The overall decrease in AFS and FVO securities is attributed to the sales of the Retirement Plans and Individual Life businesses in January 2013. Refer to Note 2 - Business Dispositions of the Notes to Consolidated Financial Statements for further discussion of these transactions. The Company continues to invest in a diversified portfolio that is primarily comprised of investment grade securities. Due to the type of securities transferred in connection with the sold businesses, a higher percentage of securities held at December 31, 2013 were in U.S. Treasuries, and foreign and U.S. government agency securities and a lower percentage in corporates. Apart from the impact of the business sales, during 2013, the Company sold agency RMBS associated with repurchase agreements and modestly increased allocations to emerging market and high yield securities, which offer attractive risk-adjusted returns. For further information on repurchase agreements, see Note 4 - Investments and Derivative Instruments of Notes to Consolidated Financial Statements. The Company's AFS net unrealized gain position declined primarily due to an increase in interest rates and the disposition of the Retirement Plans and Individual Life businesses, as discussed above.
Fixed maturities, FVO, primarily represents Japan government securities supporting the Japan fixed annuity product, as well as securities containing an embedded credit derivative for which the Company elected the fair value option. The underlying credit risk of the securities containing credit derivatives are primarily investment grade CRE CDOs. For further discussion on fair value option securities, see Note 3 - Fair Value Measurements of Notes to Consolidated Financial Statements.
The Company manages the credit risk associated with the European securities within the investment portfolio on an on-going basis using several processes which are supported by macroeconomic analysis and issuer credit analysis. For additional details regarding the Company’s management of credit risk, see the Credit Risk section of this MD&A. The Company periodically considers alternate scenarios, including a base-case and both a positive and negative “tail” scenarios that includes a partial or full break-up of the Eurozone. The outlook for key factors is evaluated, including the economic prospects for key countries, the potential for the spread of sovereign debt contagion, and the likelihood that policymakers and politicians pursue sufficient fiscal discipline and introduce appropriate backstops. Given the inherent uncertainty in the outcome of developments in the Eurozone, however, the Company has been focused on controlling both absolute levels of exposure and the composition of that exposure through both bond and derivative transactions.
The Company has limited direct European exposure, totaling only 8% of total invested assets as of December 31, 2013. The following tables present the Company’s European securities included in the Securities by Type table above. The Company identifies exposures with the issuers’ ultimate parent country of domicile, which may not be the country of the security issuer. Certain European countries were separately listed below, specifically, Greece, Italy, Ireland, Portugal and Spain (“GIIPS”), because of the current economic strains persisting in these countries. The criteria used for identifying the countries separately listed includes countries on the iTraxx SovX Western Europe Series 6 index with credit default spreads that exceed their respective index level as of December 31, 2013, an S&P credit quality rating of BBB+ or below, and a gross domestic product ("GDP") greater than $200 billion.
The Company’s European investment exposure largely relates to corporate entities which are domiciled in or generated a significant portion of its revenue within the United Kingdom, Germany, the Netherlands and Switzerland. As of December 31, 2013 and 2012 exposure to the United Kingdom totals less than 3% of total invested assets. The majority of the European investments are U.S. dollar-denominated, and those securities that are pound and euro-denominated are hedged to U.S. dollars or support foreign-denominated liabilities. For a discussion of foreign currency risks, see the Foreign Currency Exchange Risk section of this MD&A. The Company does not hold any sovereign exposure to the higher risk countries and does not hold any exposure to issuers in Greece. As of December 31, 2013and 2012, the Company’s unfunded commitments associated with its investment portfolio was immaterial, and the weighted average credit quality of European investments was A- and A- respectively.
The Company manages the credit risk associated with emerging market securities within the investment portfolio on an on-going basis using macroeconomic analysis and issuer credit analysis subject to diversification and individual credit risk management limits. For additional details regarding the Company’s management of credit risk, see the Credit Risk section of this MD&A.
The Company also has AFS exposure to CRE CDOs with an amortized cost and fair value of $155 and $218, respectively, as of December 31, 2013 and $370 and $345, respectively, as of December 31, 2012. These securities are comprised of diversified pools of commercial mortgage loans or equity positions of other CMBS securitizations. We continue to monitor these investments as economic and market uncertainties regarding future performance impact market liquidity and security premiums.
As of December 31, 2013, $408 of the gross unrealized losses were associated with securities depressed less than 20% of cost or amortized cost.
The remaining $168 of gross unrealized losses were associated with securities depressed greater than 20%, which includes $1 associated with securities depressed over 50% for twelve months or more. The securities depressed more than 20% are primarily foreign government securities and floating rate corporate financial securities. Unrealized losses on foreign government securities are primarily due to depreciation of the Japanese yen in relation to the U.S. dollar. Corporate financial securities are primarily depressed because the securities have floating-rate coupons and/or long-dated maturities. Based on the Company’s cash flow modeling and current market and collateral performance assumptions, these securities have sufficient credit protection levels to receive contractually obligated principal and interest payments.
In addition to the credit impairments recognized in earnings, the Company recognized non-credit impairments in other comprehensive income of $9 for the year ended December 31, 2013, predominantly concentrated in CMBS and corporate securities. These non-credit impairments represent the difference between fair value and the Company’s best estimate of expected future cash flows discounted at the security’s effective yield prior to impairment, rather than at current market implied credit spreads. These non-credit impairments primarily represent increases in market liquidity premiums and credit spread widening that occurred after the securities were purchased, as well as a discount for variable-rate coupons which are paying less than at purchase date. In general, despite credit spread tightening in 2013, larger liquidity premiums and wider credit spreads are the result of deterioration of the underlying collateral performance of the securities, as well as the risk premium required to reflect future uncertainty in the real estate market.
HLAI cedes certain variable annuity contracts and their associated riders as well as certain payout annuities issued by HLAI or assumed by it to White River Life Reinsurance Company ("WRR"), an affiliate captive reinsurer. The economic purpose of the WRR arrangement is to provide the Company and its subsidiaries with a more efficient vehicle to manage risks in connection with these products. The reinsurance transaction between HLAI and WRR is mainly structured as modified coinsurance ("modco"). Accordingly, the assets and reinsured reserves remain on the books of HLAI and all insurance and investment experience is passed to WRR through modco adjustments. The reinsurance arrangement between HLAI and WRR does not impact the Company's reserving methodology or the amount of required regulatory capital associated with the reinsured business. In the first half of 2014, The Hartford expects to dissolve WRR and recapture all reinsured risks to HLAI. The Hartford will take appropriate action to ensure that its life insurance subsidiaries are adequately capitalized. This transaction is subject to regulatory approvals.
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, 2013, was $844. Of this $844 the legal entities have posted collateral of $945 in the normal course of business. In addition, the Company has posted collateral of $44 associated with a customized GMWB derivative. Based on derivative market values as of December 31, 2013, a downgrade of one level below the current financial strength ratings by either Moody’s or S&P could require approximately an additional $5 to be posted as collateral. Based on derivative market values as of December 31, 2013, a downgrade of two levels below the current financial strength ratings by either Moody’s or S&P would not require additional 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 would post, if required, would be primarily in the form of U.S. Treasury bills, U.S. Treasury notes and government agency securities.
As December 31, 2013, there were no derivative relationships that could be subject to immediate termination in the event of rating agency downgrades to either BBB+ or Baa1, or both BBB+ and Baa1.
In the event customers elect to surrender separate account assets, the Company will use the proceeds from the sale of the assets to fund the surrender and the Company’s liquidity position will not be impacted. In many instances the Company will receive a percentage of the surrender amount as compensation for early surrender (surrender charge), increasing the Company’s liquidity position. In addition, a surrender of variable annuity separate account or general account assets will decrease the Company’s obligation for payments on guaranteed living and death benefits.
The Company may from time to time retire or repurchase its funding agreement backed notes through cash repurchases, in the open market, privately negotiated transactions or otherwise. Such repurchases, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. In 2013, the Company did not repurchase any funding agreements. The amounts of any future repurchases may be material.
As of December 31, 2013, the Company’s cash and short-term investments of $2.4 billion, included $171 of collateral received from, and held on behalf of, derivative counterparties and $40 of collateral pledged to derivative counterparties. The Company also held $1.7 billion of treasury securities, of which $380 had been pledged to derivative counterparties and $2.0 billion of government agency securities of which $445 had been pledged to derivative counterparties.
The Company is a member of the Federal Home Loan Bank of Boston (“FHLBB”). Membership allows the Company access to collateralized advances, which may be used to support various spread-based business and enhance liquidity management. The Connecticut Department of Insurance (“CTDOI”) will permit the Company to pledge up to $1.25 billion in qualifying assets to secure FHLBB advances for 2014. The amount of advances that can be taken are dependent on the asset types pledged to secure the advances. The pledge limit is recalculated annually based on statutory admitted assets and capital and surplus. The Company would need to seek the prior approval of the CTDOI if there were a desire to exceed these limits. As of December 31, 2013, the Company had no advances outstanding under the FHLBB facility.
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 the Company’s liquidity requirements.
As of December 31, 2013, these consumer notes have interest rates ranging from 4% to 6% for fixed notes and, for variable notes, based on December 31, 2013 rates, either consumer price index plus 102 to 247 basis points, or indexed to the S&P 500, Dow Jones Industrials, or the Nikkei 225. The aggregate maturities of Consumer Notes are as follows: $14 in 2014, $32 in 2015, $18 in 2016, $12 in 2017 and $8 thereafter. For 2013, 2012 and 2011, interest credited to holders of consumer notes was $6, $10, and $15, respectively.
The following table identifies the Company’s contractual obligations as of December 31, 2013:
Includes future minimum lease payments on operating lease agreements. See Note 12 - Commitments and Contingencies of Notes to Consolidated Financial Statements for additional discussion on lease commitments.
Consumer notes include principal payments, contractual interest for fixed rate notes and, interest based on current rates for floating rate notes. See Note 10 - Debt of Notes to Consolidated Financial Statements for additional discussion of consumer notes.
Included in purchase obligations is $77 relating to contractual commitments to purchase various goods and services such as maintenance and information technology 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.
The Company’s subsidiaries are permitted to pay up to a maximum of approximately $1 billion in dividends in 2014 without prior approval from the applicable insurance commissioner. With respect to dividends to its parent, the Company’s dividend limitation under the holding company laws of Connecticut is $919 in 2014. However, because the Company’s earned surplus is negative as of December 31, 2013, the Company will not be permitted to pay any dividends to its parent in 2014 without prior approval from the Connecticut
On February 5, 2013 the Company received approval from the State of Connecticut Insurance Department to receive a $1.1 billion extraordinary dividend from its Connecticut domiciled life insurance subsidiaries, and to pay a $1.2 billion extraordinary dividend to its parent company. These dividends were received and paid on February 22, 2013.
Net cash provided by financing activities in 2013 relates to a return of capital to the parent of $1.2 billion, net outflows on investment and universal life-type contracts of $1.6 billion, decrease in securities loaned or sold of $1.6 billion, and fee repayment to recapture affiliate reinsurance of $347. Net cash used for financing activities in 2012 primarily relates to net increase in securities loaned or sold of $1.6 billion, partially offset by net outflows on investment and universal life-type contracts of $1.4 billion and repayments of consumer notes of $153.
The Company’s stockholder’s equity, as prepared using U.S. GAAP, was $8.2 billion as of December 31, 2013. The Company’s estimated aggregate statutory capital and surplus, as prepared in accordance with the National Association of Insurance Commissioners’ Accounting Practices and Procedures Manual (“U.S. STAT”), was $5 billion as of December 31, 2013.
Costs incurred by the Company to acquire insurance policies are deferred under US GAAP while those costs are expensed immediately under US STAT.
Temporary differences between the book and tax basis of an asset or liability which are recorded as deferred tax assets are evaluated for recoverability under US GAAP while those amounts deferred are subject to limitations under US STAT.
The assumptions used in the determination of 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.
The difference between the amortized cost and fair value of fixed maturity and other investments, net of tax, is recorded as an increase or decrease to the carrying value of the related asset and to equity under US GAAP, while US STAT only records certain securities at fair value, such as equity securities and certain lower rated bonds required by the NAIC to be recorded at the lower of amortized cost or fair value. In the case of the Company’s market value adjusted (MVA) fixed annuity products, invested assets are marked to fair value (including the impact of audit spreads) and liabilities are marked to fair value (but generally excluding the impacts of credit spreads) for statutory purposes only. In the case of the Company’s market value adjusted (MVA) fixed annuity products, invested assets are marked to fair value (but generally actual credit spreads are not fully reflected) for statutory purposes only.
For further information on other contingencies, see Note 12 - Commitments and Contingencies of Notes to Consolidated Financial Statements.