The Company’s principal executive offices are located in Simsbury, Connecticut. The Company’s home office complex consists of approximately 655 thousand square feet, and is leased from a third party by Hartford Fire Insurance Company (“Hartford Fire”), a direct subsidiary of The Hartford. This is an operating lease which expires on December 31, 2007 and will be replaced by a capital lease between HLA and Hartford Fire. Expenses currently associated with these offices are allocated on a direct basis to the Company by Hartford Fire. The Company believes its properties and facilities are suitable and adequate for current operations.
Certain of the statements contained herein are forward-looking statements. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include estimates and assumptions related to economic, competitive and legislative developments. These forward-looking statements are subject to change and uncertainty which are, in many instances, beyond the Company’s control and have been made based upon management’s expectations and beliefs concerning future developments and their potential effect upon the Company. There can be no assurance that future developments will be in accordance with management’s expectations or that the effect of future developments on the Company will be those anticipated by management. Actual results could differ materially from those expected by the Company, depending on the outcome of various factors, including, but not limited to, those set forth in Part II, Item 1A, Risk Factors. These factors include: the possible occurrence of terrorist attacks; the response of reinsurance companies under reinsurance contracts and the availability, pricing and adequacy of reinsurance to protect the Company against losses; changes in financial and capital markets, including changes in interest rates, credit spreads, equity prices and foreign exchange rates; the inability to effectively mitigate the impact of equity market volatility on the Company’s financial position and results of operations arising from obligations under annuity product guarantees; the incidence and severity of catastrophes, both natural and man-made; stronger than anticipated competitive activity; unfavorable judicial or legislative developments; the potential effect of domestic and foreign regulatory developments, including those which could increase the Company’s business costs and required capital levels; the possibility of general economic and business conditions that are less favorable than anticipated; the Company’s ability to distribute its products through distribution channels, both current and future; a downgrade in the Company’s financial strength or credit ratings; the ability to recover the Company’s systems and information in the event of a disaster or other unanticipated event; potential for difficulties arising from outsourcing relationships; potential changes in federal or state tax laws, including changes impacting the availability of the separate account dividend received deduction; losses due to defaults by others; the Company’s ability to protect its intellectual property and defend against claims of infringement; and other factors described in such forward-looking statements.
The Company derives its revenues principally from: (a) fee income, including asset management fees, on separate account assets and mortality and expense fees, as well as cost of insurance charges; (b) net investment income on general account assets; (c) fully insured premiums; and (d) certain other fees. Asset management fees and mortality and expense fees are primarily generated from separate account assets, which are deposited with the Company through the sale of variable annuity and variable universal life products. Cost of insurance charges are assessed on the net amount at risk for investment-oriented life insurance products.
The profitability of the Company’s fixed annuities and other “spread-based” products depends largely on its ability to earn target spreads between earned investment rates on its general account assets and interest credited to policyholders. Profitability is also influenced by operating expense management including the benefits of economies of scale in the administration of its variable annuity businesses in particular. 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 the deferred policy acquisition costs.
For most contracts, the Company estimates gross profits over a 20 year horizon as estimated profits emerging subsequent to year 20 are immaterial. The Company uses other amortization bases for amortizing DAC, such as gross costs (net of reinsurance), as a replacement for EGPs when EGPs are expected to be negative for multiple years of the contract’s life. Actual gross profits, in a given reporting period, that vary from management’s initial estimates result in increases or decreases in the rate of amortization, commonly referred to as a “true-up”, which are recorded in the current period. The true-up recorded for the years ended December 31, 2007, 2006 and 2005 was an increase to amortization of $0, $45 and $27, respectively.
Products sold in a particular year are aggregated into cohorts. Future gross profits for each cohort are projected over the estimated lives of the underlying contracts, and are, to a large extent, a function of future account value projections for individual variable annuity products and to a lesser extent for variable universal life products. The projection of future account values requires the use of certain assumptions. The assumptions considered to be important in the projection of future account value, and hence the EGPs, include separate account fund performance, which is impacted by separate account fund mix, less fees assessed against the contract holder’s account balance, surrender and lapse rates, interest margin, mortality and hedging costs. The assumptions are developed as part of an annual process and are dependent upon the Company’s current best estimates of future events. The Company’s current separate account return assumption is approximately 8% (after fund fees, but before mortality and expense charges). Beginning in 2007, the Company estimated gross profits using the mean of EGPs derived from a set of stochastic scenarios that have been calibrated to our estimated separate account return as compared to prior years where we used a single deterministic estimation.
During the third quarter of 2007 and the fourth quarter of 2006, the Company completed an annual, comprehensive study of assumptions underlying EGPs, resulting in an “unlock”. The study covered all assumptions, including mortality, lapses, expenses, hedging costs, and separate account returns, in substantially all product lines. The new best estimate assumptions were applied to the current in-force to project future gross profits. The after-tax impact on the Company’s assets and liabilities as a result of the unlock during the third quarter of 2007 was as follows:
As a result of the unlock, death benefit reserves, in Retail, increased $294,pre-tax, offset by an increase of $279, pre-tax, in reinsurance recoverables.
The Company performs sensitivity analyses with respect to the effect certain assumptions have on EGPs and the related DAC, sales inducement, unearned revenue reserve and SOP 03-1 reserve balances. Each of the sensitivities illustrated below are estimated individually, without consideration for any correlation among the key assumptions. Therefore, it would be inappropriate to take each of the sensitivity amounts below and add them together in an attempt to estimate volatility for the respective EGP-related balances in total. The following tables depict the estimated sensitivities for variable annuities:
Capital markets assumptions can significantly change the value of the GMWB embedded derivative liability, as well as the GMIB reinsurance liability. For example, independent future decreases in equity market returns, future decreases in interest rates and future increases in equity index volatility will all have the effect of increasing the value of the GMWB embedded derivative liability and the value of the GMIB reinsurance liability as of December 31, 2007 resulting in a realized loss in net income. Furthermore, changes in policyholder behavior can also significantly change the value of the GMWB embedded derivative liability, as well as the GMIB reinsurance liability. For example, independent future increases in fund mix towards equity based funds vs. bond funds, future increases in withdrawals, future decreasing mortality, future increasing usage of the step-up feature, as applicable, and decreases in lapses will all have the effect of increasing the value of the GMWB embedded derivative liability, and decreasing the value of the GMIB reinsurance liability, as applicable, as of December 31, 2007 resulting in a realized loss in net income. Independent changes in any one of these assumptions moving in the opposite direction will have the effect of decreasing the value of the GMWB embedded derivative liability and the GMIB reinsurance liability as of December 31, 2007 resulting in a realized gain in net income. As markets change, mature and evolve and actual policyholder behavior emerges, management continually evaluates the appropriateness of its assumptions. In addition, management regularly evaluates the valuation model, incorporating emerging valuation techniques where appropriate, including drawing on the expertise of market participants and valuation experts. Upon adoption of Statement of Financial Accounting Standard No. 157, “Fair Value Measurements”, (“SFAS 157”) the Company expects to revise many of the assumptions used to value GMWB embedded derivative liability, as well as the GMIB and GMAB. See Note 1 in Notes to Consolidated Financial Statements for a discussion of SFAS 157.
Prices from third party pricing services are often unavailable for securities that are rarely traded or are traded only in privately negotiated transactions. As a result, certain of the Company’s securities are priced via independent broker quotations which utilize inputs that may be difficult to corroborate with observable market based data. A pricing matrix is used to price securities for which the Company is unable to obtain either a price from a third party pricing service or an independent broker quotation. The pricing matrix begins with current spread levels to determine the market price for the security. The credit spreads, as assigned by a nationally recognized rating agency, incorporate the issuer’s credit rating and a risk premium, if warranted, due to the issuer’s industry and the security’s time to maturity. The issuer-specific yield adjustments, which can be positive or negative, are updated twice annually, as of June 30 and December 31, by an independent third party source and are intended to adjust security prices for issuer-specific factors.
Derivative instruments are recognized on the consolidated balance sheets at fair value. As of December 31, 2007 and 2006, approximately 89% and 82% of derivatives, respectively, based upon notional values, were priced by valuation models, which utilize independent market data, while the remaining 11% and 18%, respectively, were priced by broker quotations. The derivatives are valued using mid-market level inputs that are predominantly observable in the market place. Inputs used to value derivatives include, but are not limited to, interest swaps rates, foreign currency forward and spot rates, credit spreads, interest and equity volatility and equity index levels. The Company performs a monthly analysis on the derivative valuation 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 changes in the market environment and monitoring trading volume. This discussion on derivative pricing excludes the GMWB rider and associated reinsurance contracts as well as the reinsurance contracts associated with the GMIB and GMAB products, which are discussed in the preceding paragraphs under “Living Benefits Required to be Fair Valued” section.
The evaluation of impairments is a quantitative and qualitative process, which is subject to risks and uncertainties and is intended to determine whether declines in the fair value of investments should be recognized in current period earnings. The risks and uncertainties include changes in general economic conditions, the issuer’s financial condition or near term recovery prospects, the effects of changes in interest rates or credit spreads and the recovery period. The Company has a security monitoring process overseen by a committee of investment and accounting professionals (“the committee”) that identifies securities that, due to certain characteristics, as described below, are subjected to an enhanced analysis on a quarterly basis. Based on this evaluation, for the year ended December 31, 2007, the Company concluded $339 of unrealized losses were other-than-temporarily impaired and as of December 31, 2007, the Company’s unrealized losses for fixed maturity and available-for-sale equity securities of $1.8 billion, were temporarily impaired.
For certain securitized financial assets with contractual cash flows including ABS, EITF Issue No. 99-20 requires the Company to periodically update its best estimate of cash flows over the life of the security. If the fair value of a securitized financial asset is less than its cost or amortized cost and there has been a decrease in the present value of the estimated cash flows since the last revised estimate, considering both timing and amount, an other-than-temporary impairment charge is recognized. The Company also considers its intent and ability to retain a temporarily depressed security until recovery. Estimating future cash flows is a quantitative and qualitative process that incorporates information received from third party sources along with certain internal assumptions and judgments regarding the future performance of the underlying collateral. In addition, projections of expected future cash flows may change based upon new information regarding the performance of the underlying collateral.
The Company has a quarterly monitoring process involving legal and accounting professionals. Legal personnel first identify outstanding corporate litigation and regulatory matters posing a reasonable possibility of loss. These matters are then jointly reviewed by accounting and legal personnel to evaluate the facts and changes since the last review in order to determine if a provision for loss should be recorded or adjusted, the amount that should be recorded, and the appropriate disclosure. The outcomes of certain contingencies currently being evaluated by the Company, which relate to corporate litigation and regulatory matters, are inherently difficult to predict, and the reserves that have been established for the estimated settlement amounts are subject to significant changes. In view of the uncertainties regarding the outcome of these matters, as well as the tax-deductibility of payments, it is possible that the ultimate cost to the Company of these matters could exceed the reserve by an amount that would have a material adverse effect on the Company’s consolidated results of operations or cash flows in a particular quarterly or annual period.
The DAC unlock benefit recorded in the third quarter of 2007.
Benefits, losses and loss adjustment expenses increased for the year ended December 31, 2007, as a result of the Company recording a reserve of $55, after tax, during the second quarter of 2007 for regulatory matters.
See “Investment Results” in the Investments section and the “Realized Capital Gains and Losses by Segment” table within this MD&A.
The effective tax rate for December 31, 2007, 2006 and 2005 was 19%, 12% and 19%, respectively. The principal cause of the difference between the effective tax rate and the U.S. Statutory rate of 35% for 2007, 2006 and 2005 was the separate account dividends received deduction (“DRD”).
Management believes the market for retirement products continues to expand as individuals increasingly save and plan for retirement. Demographic trends suggest that as the “baby boom” generation matures, a significant portion of the United States population will allocate a greater percentage of their disposable incomes to saving for their retirement years due to uncertainty surrounding the Social Security system and increases in average life expectancy. Competition continues to be strong in the variable annuities market as the focus on guaranteed lifetime income has caused most major variable annuity writers to upgrade their suite of living benefits. The company is committed to maintaining a competitive variable annuity product line and intends to refresh its suite of living benefits in May 2008.
The Institutional Investment Products (“IIP”) markets are highly competitive from a pricing perspective, and a small number of cases often account for a significant portion of deposits, therefore the Company may not be able to sustain the level of assets under management growth attained in 2007. The Company’s success depends in part on the level of credited interest rates and the Company’s credit rating.
Fee income is largely driven from amounts collected as a result of contractually defined percentages of assets under management on investment type contracts. These fees are generally collected on a daily basis. For individual life insurance products, fees are contractually defined as percentages based on levels of insurance, age, premiums and deposits collected and contract holder value. Life insurance fees are generally collected on a monthly basis. Therefore, the growth in assets under management either through positive net flows, or favorable equity market performance will have a favorable impact on fee income. Conversely, either negative net flows, or unfavorable equity market performance will reduce fee income generated from investment type contracts.
Increases in Retail individual variable annuity account values as of December 31, 2007 can be primarily attributed to market growth during the year and improved net flows due to an increase in sales.
Management evaluates performance of certain products based on net investment spread. These products include those that have insignificant mortality risk, such as fixed annuities, certain general account universal life contracts and certain institutional contracts. Net investment spread is determined by taking the difference between the earned rate and the related crediting rates on average assets under management. The net investment spreads shown below are for the total portfolio of relevant contracts in each segment and reflect business written at different times. When pricing products, the Company considers current investment yields and not the portfolio average. Net investment spread can be volatile period over period, which can have a significant positive or negative effect on the operating results of each segment. The volatile nature of net investment spread is driven primarily by prepayment premiums on securities and earnings on partnership investments.
Retail individual annuity, Retirement Plans, Institutional and Individual Life net investment spreads increased or remained stable, primarily due to a higher allocation of investments in higher yield / higher risk investment classes, including limited partnerships and alternative investments and relative strong performance of this asset class in 2007.
Net investment spreads were virtually unchanged in 2006 as compared to 2005 with the exception of Institutional where increased partnership income increased spread from 2005 to 2006.
There are three major categories for expenses. The first major category of expenses is benefits and losses. These include the costs of mortality in the individual life businesses, as well as other contractholder benefits to policyholders. The second major category is insurance operating costs and expenses, which is commonly expressed in a ratio of a revenue measure depending on the type of business. The third category is the amortization of deferred policy acquisition costs and the present value of future profits, which is typically expressed as a percentage of pre-tax income before the cost of this amortization (an approximation of actual gross profits). The individual annuity business within Retail accounts for the majority of the amortization of deferred policy acquisition costs and present value of future profits for the Company.
The ratio of Retail individual annuity DAC amortization over income before taxes and DAC amortization declined in 2007 primarily due to unlock charge in 2006. DAC unlock charges generally have the effect of reducing future DAC amortization rates. After an unlock charge, the DAC amortization rate will generally decline as amortization expected to occur in future years was recorded as part of the unlock charge.
Individual Life death benefits increased 4% in 2006 primarily due to a larger insurance in-force. Individual Life insurance expenses, net of deferrals increased 9% for 2006 consistent with the growth of life insurance in-force.
The increase in Retail individual annuity’s ROA, excluding realized gain (losses) and DAC unlock, was primarily due to a decline in the effective tax rate as a result of prior period true-up benefits in 2006 related to separate account DRD and FTC.
Net realized gains (losses) for the year ended December 31, 2006
Across all lines of business, impairments increased $268 in 2007, primarily due to an increase in credit related other-than-temporary impairments which were taken on ABS securities backed by sub-prime residential mortgage loans and securities in the financial services and home builders sectors. For further discussion, see the Other-Than-Temporary Impairments discussion within Investment section of the MD&A.
Retail losses on GMWB rider embedded derivatives increased $251 primarily due to liability model assumption updates and modeling refinements made in 2007, including those for dynamic lapse behavior, mortality and claims adjustments, correlations of market returns across underlying indices as well as those to reflect newly reliable market inputs for volatility.
Across all lines of business, Other net losses increased $138 primarily from the change in value of non-qualifying derivatives due to fluctuations in credit spreads, interest rates, and equity markets. The increase in net losses in 2007 compared to the prior year was primarily due to changes in value associated with credit derivatives due to credit spreads widening. Credit spreads widened primarily due to the deterioration in the U.S. housing market, tightened lending conditions, reduction of risk appetite as well as increased likelihood of a U.S. recession. For further discussion, see the “Capital Market Risk Management” section of the MD&A.
Across all lines of business, impairments were primarily recorded on corporate fixed maturities. For further discussion, see the Other-Than-Temporary Impairments section within the Investments section of the MD&A.
Other net losses, as compared to gains in the prior year period were primarily driven from the change in value of non-qualifying derivatives due to fluctuations in interest rates and foreign currency exchange rates. These losses were partially offset by a before-tax benefit of $25 received from the WorldCom security settlement.
The net losses on sales were driven by fixed maturities for the year ended December 31, 2006 and primarily the result of rising interest rates from the date of security purchase and, to a lesser extent, credit spread widening on certain issuers that were sold. For further discussion of gross gains and losses, see “Investment Results” in the Investments section of the MD&A.
Retail focuses on the savings and retirement needs of the growing number of individuals who are preparing for retirement, or have already retired, through the sale of individual variable and fixed annuities and other investment products. The Company is both a large writer and seller of individual variable annuities and a top seller of individual variable annuities throughout banks in the United States.
Net income in Retail increased for the year ended December 31, 2007, primarily driven by lower amortization of DAC resulting from the unlock benefit in the third quarter of 2007, fee income growth in the variable annuity businesses, partially offset by increased non-deferrable individual annuity asset based commissions. In addition, realized capital losses increased $294 for the year ended December 31, 2007 as compared to the prior year period. For further discussion, see Realized Capital Gains and Losses by Segment table under in this section of the MD&A. A more expanded discussion of income growth is presented below:
Fee income increased for the year ended December 31, 2007 primarily as a result of growth in variable annuity average account values. The year-over-year increase in average variable annuity account values can be attributed to market appreciation of $7.4 billion during the year. Variable annuities had net outflows of $2.7 billion in 2007. Net outflows were driven by surrender activity due to the aging of the variable annuity inforce block of business and increased sales competition, particularly competition related to guaranteed living benefits.
Net investment income has declined for the year ended December 31, 2007 due to a decrease in variable annuity fixed option account values of 11% or $635. The decrease in these account values can be attributed to a combination of transfers into separate accounts and surrender activity. Offsetting this decrease in net investment income was an increase in the returns on partnership income of $14, after-tax, for the year ended December 31, 2007.
Insurance operating costs and other expenses increased for the year ended December 31, 2007. These increases were principally driven by non-deferrable variable annuity asset based commissions which increased $67 for the year ended December 31, 2007 due to a 4% growth in assets under management, as well as an increase in the number of contracts reaching anniversaries when trail commission payments begin.
The increase in fee income in the variable annuity business for the year ended December 31, 2006 was mainly a result of growth in average account values. The year-over-year increase in average variable annuity account values can be attributed to market appreciation of $12.2 billion during 2006. Variable annuities had net outflows of $3.2 billion for the year ended December 31, 2006 compared to net outflows of $881 for the year ended December 31, 2005. Net outflows from additional surrender activity were due to increased sales competition, particularly from competitors offering variable annuity products with guaranteed living benefits.
Net income in Retirement Plans decreased for the year ended December 31, 2007 due to higher amortization of DAC as a result of the unlock expense in the third quarter of 2007, partially offset by a growth in fee income. In addition, realized capital losses increased $25 for the year ended December 31, 2007 as compared to the prior year period. For further discussion, see Realized Capital Gains and Losses by Segment table in this section of the MD&A. The following other factors contributed to the changes in income:
Fee income increased for the year ended December 31, 2007 primarily due to an increase in 401(k) average account values. This growth in 401(k) business is primarily driven by positive net flows of $1.8 billion over the past four quarters resulting from strong sales and increased ongoing deposits. Market appreciation contributed an additional $888 to assets under management over the past year.
Higher amortization of DAC resulted from the unlock expense in the third quarter of 2007 as compared to an unlock benefit in the fourth quarter of 2006. For further discussion, see Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A.
Net income in the Retirement Plans segment for the year ended December 31, 2006 increased primarily due to improved fee income combined with lower amortization of DAC resulting from the unlock during the fourth quarter of 2006. In addition, realized capital losses increased $30 for the year ended December 31, 2006 as compared to the prior year period. For further discussion, see Realized Capital Gains and Losses by Segment table in this section of the MD&A. A more expanded discussion of income growth can be found below:
Insurance operating costs and other expenses increased for the year ended December 31, 2006 primarily driven by the 401(k) business. The additional costs can be attributed to greater assets under management resulting in higher trail commissions and maintenance expenses.
The future profitability of this segment will depend on Life’s ability to increase assets under management across all businesses, achieve scale in areas with a high degree of fixed costs and maintain its investment spread earnings on the general account products sold largely in the 403(b)/457 business. As the “baby boom” generation approaches retirement, management believes these individuals, as well as younger individuals, will contribute more of their income to retirement plans due to the uncertainty of the Social Security system and the increase in average life expectancy. In 2007, Life has begun selling mutual fund based products in the 401(k) market that will increase Life’s ability to grow assets under management in the medium size 401(k) market. Life has also begun selling mutual fund based products in the 403(b) market as we look to grow assets in a highly competitive environment primarily targeted at health and education workers. Disciplined expense management will continue to be a focus; however, as Life looks to expand its reach in these markets, additional investments in service and technology will occur.
Institutional investment product account values include transfers from Retirement Plans of $413 during 2006 and from the Retail segment of $350 during 2006
Net income in Institutional decreased for the year ended December 31, 2007 primarily due to increased realized capital losses of $148 as compared to the prior year period. For further discussion, see Realized Capital Gains and Losses by Segment table under Life’s Operating Section of the MD&A. Offsetting the impact of realized capital losses, Institutional’s net income increased driven by higher assets under management in both IIP and PPLI, combined with increased returns on general account assets, primarily due to strong partnership income. The following other factors contributed to the changes in income:
Fee income increased for the year ended December 31, 2007 primarily driven by higher PPLI assets under management due to net flows and change in market appreciation of $5.1 billion and $1.7 billion, respectively. In addition, PPLI collects front-end loads, recorded in fee income, to subsidize premium tax payments. Premium taxes are recorded as an expense in insurance operating costs and other expenses. During the year ended December 31, 2007, PPLI had deposits of $5.2 billion, which resulted in an increase in fee income due to front-end loads of $107 offset by a corresponding increase in insurance operating costs and other expenses.
General account net investment spread is the main driver of net income for IIP. An increase in spread income for the year ended December 31, 2007, was driven principally by higher assets under management in IIP resulting from positive net flows of $1.5 billion during the year. Net flows for IIP were favorable primarily as a result of the Company’s funding agreement backed Investor Notes program. Investor Notes deposits for the year ended December 31, 2007 were $1.5 billion. General account net investment spread also increased for the year ended December 31, 2007 due to improved returns on partnership investments. For the year ended December 31, 2007 and 2006, partnership income was $32 and $15, after-tax, respectively.
PPLI’s income increased for the year ended December 31, 2007 primarily due to a one-time adjustment of $4, after-tax, consisting mainly of a true-up of premium tax accruals in the first quarter of 2007.
The change in income taxes for the year ended December 31, 2007 over the prior year was due to a decrease in income before income taxes primarily driven by the increase in realized capital losses.
Net investment income increased in Institutional driven by positive net flows of $2.2 billion during the year, which resulted in higher assets under management. Net flows for IIP were strong primarily as a result of the Company’s funding agreement backed Investor Notes program. Investor Note deposits for the years ended December 31, 2006 and 2005 were $2.3 billion and $2.0 billion, respectively.
Earned premiums increased as a result of two large terminal funding cases that were sold during 2006. This increase in earned premiums was offset by a corresponding increase in benefits, losses and loss adjustment expenses.
The future net income of this segment will depend on Institutional’s ability to increase assets under management across all businesses. For Institutional’s products specifically, maintenance of investment spreads and business mix are also key contributors to income. These products are highly competitive from a pricing perspective, and a small number of cases often account for a significant portion of deposits. Therefore, the Company may not be able to sustain the level of assets under management growth attained in 2007. Hartford Income Notes and other structured notes products provide the Company with continued opportunity for future growth. These products provide access to both a multi-billion dollar retail market, and a nearly trillion dollar institutional market. These markets are highly competitive and the Company’s success depends in part on the level of credited interest rates and the Company’s credit rating.
Net investment income increased for the year ended December 31, 2007 consistent with growth in general account account values. Individual Life earned additional investment income throughout 2007 associated with higher returns from partnership investments.
Benefits, losses and loss adjustment expenses increased due to life insurance in-force growth and unfavorable mortality for the year ended December 31, 2007 compared to the corresponding 2006 period.
Lower amortization of DAC resulted from the unlock benefit in the third quarter of 2007 as compared to an unlock expense in the fourth quarter of 2006. For further discussion, see Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A.
Cost of insurance charges, the largest component of fee income, increased $31 for the year ended December 31, 2006, driven by growth in the variable universal and universal life insurance in-force. Variable fee income increased, consistent with the growth in the variable universal life insurance account value. Other fee income, another component of total fee income, increased primarily due to additional amortization of deferred revenues associated with the unlock.
Benefits, losses and loss adjustment expenses increased for 2006 consistent with the growth in account values and life insurance in-force and also reflect favorable mortality experience in 2006 compared to 2005.
Amortization of DAC for the year ended December 31, 2006 increased related to the unlock expense, partially offset by revisions to prior year estimates. Excluding the impacts of the unlock expense and revisions, the amortization of DAC decreased for the year ended December 31, 2006, consistently with the mix of products and the level and mix of product profitability. For further discussion, see Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A.
Sales results for the year ended December 31, 2007 were strong across core distribution channels, including wirehouses/regional broker dealers and banks. The variable universal life mix remains strong at 45% of total sales for 2007. Future sales will be driven by the Company’s management of current distribution relationships and development of new sources of distribution while offering competitive and innovative new products and product features.
Effective November 1, 2007, Individual Life reinsured the policy liability related to statutory reserves in universal life with secondary guarantees to a captive reinsurance subsidiary. These reserves are calculated under prevailing statutory reserving requirements as promulgated under Actuarial Guideline 38, “The Application of the Valuation of Life Insurance Policies Model Regulation”. An unaffiliated standby third party letter of credit supports a portion of the statutory reserves that have been ceded to this subsidiary. The transaction released approximately $300 of statutory capital previously supporting our universal life products with secondary guarantees. The release of this capital from Individual Life will result in a decline in net investment income and increased expenses in future periods for Individual Life. The released capital is available to the Company for general corporate purposes. As its business grows, from time to time, Individual Life will evaluate the need for additional capital structures.
Benefits, losses and loss adjustment expenses increased $55, after tax for the year ended December 31, 2007, as a result of the Company recording a reserve during the second quarter of 2007 for regulatory matters.
Fluctuations in interest rates affect the Company’s return on, and the fair value of, fixed maturity investments, which comprised approximately 83% and 87% of the fair value of its invested assets as of December 31, 2007 and December 31, 2006, respectively. Other events beyond the Company’s control, including changes in credit spreads, could also adversely impact the fair value of these investments. Additionally, a downgrade of an issuer’s credit rating or default of payment by an issuer could reduce the Company’s investment return.
The primary investment objective of the Company’s general account is to maximize economic value consistent with acceptable risk parameters, including the management of the interest rate sensitivity of invested assets, while generating sufficient after-tax income to meet policyholder and corporate obligations.
Total investments increased $3.7 billion since December 31, 2006 primarily as a result of positive operating cash flows and securities lending activities, partially offset by increased unrealized losses primarily due to a significant widening of credit spreads associated with fixed maturities. The fair value of fixed maturities declined as a percentage of total investments due to the increase in unrealized losses and the decision to allocate a greater percentage of the Company’s portfolio to mortgage loans and limited partnerships and other alternative investments. The increased allocation to limited partnerships and alternative investments and mortgage loans was made primarily due to the attractive risk/return profiles and diversification opportunities of these asset classes.
The following table summarizes the Company’s limited partnerships and other alternative investments as of December 31, 2007 and 2006.
Relates to the Japanese fixed annuity product assumed from HLIKK (product and related derivative hedging instruments excluding periodic net coupon settlements).
See the Other-Than-Temporary Impairments section that follows for information on impairment losses.
Total net realized capital losses were recognized in 2006 compared to net realized capital gains in 2005 primarily as a result of a higher interest rate environment and changes in value of GMIB reinsurance. The circumstances giving rise to these components are as follows:
The net losses in 2006 related to GMIB were primarily driven by liability model refinements and assumption updates reflecting in-force demographics, actual experience, and revised future expectations. The net gains in 2005 were primarily driven by positive movements in the global bond market and the Japanese equity market.
The maximum exposure to loss does not include changes in fair value or the Company’s proportionate shares of earnings associated with limited partnerships accounted for under the equity method. The Company’s maximum exposure to loss as of December 31, 2007 and 2006 based on the carrying value was $413 and $217, respectively. The Company’s maximum exposure to loss as of December 31, 2007 and 2006 based on the Company’s initial co-investment or amortized cost basis was $402 and $211, respectively.
As of December 31, 2007 and 2006, the Company had relationships with six and four VIEs, respectively, where the Company was the primary beneficiary.
HIMCO is the collateral manager for four market value CLOs (included in the VIE discussion above) that invest in senior secured bank loans through total return swaps. For two of the CLOs, the Company has determined it is the primary beneficiary and accordingly consolidates the transactions. The maximum exposure to loss for these two consolidated CLOs, which is included in the “Collateral loan obligations and other funds” line in the table above, is $74 of which the Company has recognized a realized capital loss of $19. The Company is not the primary beneficiary for the remaining two CLOs, but maintains a significant involvement in the transactions. The maximum exposure to loss for these remaining two CLOs, included in the $100 in the preceding paragraph, is $14. The CLOs have triggers that allow the total return swap counterparty to terminate the transactions if the fair value of the aggregate referenced bank loan portfolio declines below a stated level. Due to the bank loan valuation declines in the first quarter of 2008, the CLO termination triggers were breached. The Company expects these transactions will be terminated in the first quarter of 2008 with a realized capital loss, which the Company estimates could be between $45-$70, before-tax.
The Company has a security monitoring process overseen by a committee of investment and accounting professionals that, on a quarterly basis, identifies securities that could potentially be other-than-temporarily impaired. When a security is deemed to be other-than-temporarily impaired, its cost or amortized cost is written down to current market value and a realized loss is recorded in the Company’s consolidated statements of operations. For fixed maturities, the Company accretes the new cost basis to par or to the estimated future value over the expected remaining life of the security by adjusting the security’s yield. For further discussion regarding the Company’s other-than-temporary impairment policy, see “Evaluation of Other-Than-Temporary Impairments on Available-for-Sale Securities” included in the Critical Accounting Estimates section of the MD&A and Note 1 of Notes to Consolidated Financial Statements.
For further discussion of risk factors associated with portfolio sectors with significant unrealized loss positions, see the risk factor commentary under the Consolidated Total Available-for-Sale Securities with Unrealized Loss Greater than Six Months by Type table in the Investment Credit Risk section that follows.
For the year ended December 31, 2005, other-than-temporary impairments recorded on corporate securities. Approximately $13 recorded on corporate securities related to three Canadian paper companies. These companies’ operations suffered from high energy prices and falling demand, in part due to the appreciation of the Canadian dollar in comparison to the U.S. dollar. Also included in the corporate securities was $6 recorded on securities related to two major automotive manufacturers. The market values of these securities had fallen due to a downward adjustment in earnings and cash flow guidance primarily due to sluggish sales, rising employee and retiree benefit costs and an increased debt service burden. Other-than-temporary impairments recorded on equity securities had sustained a decline in market value for an extended period of time as a result of issuer credit spread widening. During 2005 there were no significant other-than-temporary impairments (i.e., $15 or greater) recorded on any single security or issuer.
The Company is not exposed to any credit concentration risk of a single issuer greater than 10% of the Company’s stockholder’s equity other than U.S. government and certain U.S. government agencies. For further discussion of concentration of credit risk, see the “Concentration of Credit Risk” section in Note 3 of Notes to Consolidated Financial Statements.
The credit index swaps assume the credit risk of a referenced AAA rated tranche of a commercial mortgage security index. The credit index swap contracts pay or receive amounts based upon changes in the referenced index and are typically six months in duration. In February 2008, the credit index swaps were closed and resulted in an additional ($61), before-tax, net realized capital loss which will be recorded in the first quarter 2008.
Includes securities with an amortized cost and fair value of $30 and $28, respectively, as of December 31, 2007 and $8 as of December 31, 2006, which were backed by pools of loans issued to prime borrowers. Includes securities with an amortized cost and fair value of $91 and $82, respectively, as of December 31, 2007, and $26 and $25, respectively, as of December 31, 2006, which were backed by pools of loans issued to Alt-A borrowers.
As of December 31, 2007, investment sector allocations as a percentage of total fixed maturities have not significantly changed since December 31, 2006 except investments in ABS CDOs, financial services in corporate sector and municipal securities. The increase in ABS CDOs was primarily related to the investment of the cash collateral received from securities lending programs into AAA rated CLOs that have underlying bank loan collateral. The increases in the financial services and municipal securities were due to the sectors attractive risk/return profiles. The majority of the increase in the financial services sector occurred during the first nine months of the year.
Deterioration in the U.S. housing market, tightened lending conditions and the market’s flight to quality securities as well as the increased likelihood of a U.S. recession has caused credit spreads to widened considerably. The sectors most significantly impacted include residential and commercial mortgage backed investments, and other structured products, including consumer loan backed investments and lenders and monoline insurers. The follows sections illustrate the Company’s holdings and provides commentary of the sectors identified above.
The remaining structured investment products other than ABS sub-prime and consumer loans and CMBS primarily relate to ABS CDOs supported by senior secured bank loans. As of December 31, 2007, these CLOs represent 98% of ABS CDO holdings with approximately 88% rated AAA.
The Company’s exposure to second lien residential mortgages is composed primarily of loans to prime and Alt-A borrowers, of which approximately half were wrapped by monoline insurers. These securities are included in the table above and have an amortized cost and fair value of $206 and $170, respectively, as of December 31, 2007 and $118 as of December 31, 2006.
The Company’s exposure to second lien residential mortgages is composed primarily of loans to prime and Alt-A borrowers, of which approximately half were wrapped by monoline insurers. These securities are included in the table above and have an amortized cost and fair value of $145 and $118, respectively, as of December 31, 2007 and $97 and $98, respectively, as of December 31, 2006.
Approximately 90% of the portfolio is backed by adjustable rate mortgages.
Commercial real estate market cash flow fundamentals have been solid with mortgage delinquencies near all time lows. Recently, however, commercial real estate rents and property values have begun to soften. The following tables present the Company’s exposure to CMBS bonds and commercial real estate CDOs by credit quality and vintage year.
In addition to commercial mortgage-backed securities, the company has whole loan commercial real estate investments. The carrying value of mortgage loans on real estate was $4.2 billion and $2.6 billion as of December 31, 2007 and 2006, respectively. The Company’s mortgage loans are collateralized by a variety of commercial and agricultural properties. The mortgage loans are geographically dispersed throughout the United States and by property type. At December 31, 2007 and 2006, the Company held no impaired, restructured, delinquent or in-process-of-foreclosure mortgage loans and accordingly had no valuation allowance for mortgage loans at December 31, 2007 and 2006.
Approximately 15% of the exposure was issued by lenders that lend primarily to sub-prime borrowers.
The AAA rated securities include monoline insured securities with an amortized cost and fair value of $42 at December 31, 2007 and $29 at December 31, 2006. Additionally, approximately 7% of the auto consumer loan-backed securities was issued by lenders whose primary business is to sub-prime borrowers.
Monoline insurers guarantee the timely payment of principal and interest of certain securities. Municipalities will often purchase monoline insurance to “wrap” a security issuance in order to benefit from better market execution. As of December 31, 2007, the fair value of the Company’s total monoline insured securities was $1.7 billion, with the fair value of the insured municipal securities totaling $1.1 billion. At December 31, 2007, the overall credit quality of the municipal bond portfolio, including the benefits of monoline insurance, was AA+ and excluding the monoline insurance, the overall credit quality dropped to AA-. In addition to the insured municipal securities, as of December 31, 2007 the Company has other insured securities with an amortized cost and fair value of $637 and $583, respectively. These securities include the below prime mortgage-backed securities and other consumer loan receivables discussed above and corporate securities. The Company also has direct investments in monoline insurers with a fair value of approximately $80 as of December 31, 2007.
The following table identifies fixed maturities by credit quality on a consolidated basis as of December 31, 2007 and 2006. The ratings referenced below are based on the ratings of a nationally recognized rating organization or, if not rated, assigned based on the Company’s internal analysis of such securities.
The following table presents the Company’s unrealized loss aging for total fixed maturity and equity securities classified as available-for-sale, as of December 31, 2007 and 2006, by length of time the security was in an unrealized loss position.
The increase in total unrealized losses greater than six months since December 31, 2006 primarily resulted from credit spread widening, offset in part by the decreases in interest rates and other-than-temporary impairments. The sectors with the most significant concentration of unrealized losses were CMBS and corporate fixed maturities most significantly within the financial services sector. The Company’s current view of risk factors relative to these fixed maturity types is as follows:
Financial services - As of December 31, 2007, the Company held approximately 160 different securities in the financial services sector that were in an unrealized loss position for greater than six months. Substantially all of these securities are rated investment grade securities, most of which are priced at, or greater than, 90% of amortized cost as of December 31, 2007. The increase in unrealized losses was primarily due to the recent credit spread widening stemming from concerns over risks in the sub-prime mortgage and leveraged finance markets and the associated impact of issuer credit losses, earnings volatility, and access to liquidity for companies involved in those markets as well as the financial sector as a whole. Future changes in fair value of these securities are primarily dependent on the extent of future issuer credit losses, return of liquidity, and changes in general market conditions, including interest rates and credit spread movements.
RMBS - As of December 31, 2007, the Company held approximately 90 different securities that had been in an unrealized loss position for greater than six months, of which approximately 70% were rated AA and above. The remaining securities primarily consist of securities from vintage years 2005 and prior. Fundamentals impacting the RMBS market, as discussed in the “Sub-prime Residential Mortgage Loans” section above have caused a pull-back in market liquidity and repricing of risk. Future changes in fair value of these securities are primarily dependent upon sector fundamentals and credit spread movements.
The Company has a disciplined approach to managing risks associated with its capital markets and asset/liability management activities. Investment portfolio management is organized to focus investment management expertise on the specific classes of investments, while asset/liability management is the responsibility of a dedicated risk management unit supporting the Company. Derivative instruments are utilized in compliance with established Company policy and regulatory requirements and are monitored internally and reviewed by senior management. During 2007, the deterioration in the U.S. housing market, tightened lending conditions, the market’s flight to quality securities as well as increased likelihood of a U.S. recession contributed to substantial spread widening in credit derivatives and structured credit products.
The Company is exposed to market risk, primarily relating to the market price and/or cash flow variability associated with changes in interest rates, credit spreads including issuer defaults, equity prices or market indices, and foreign currency exchange rates. The Company is also exposed to credit and counterparty repayment risk.
As interest rates decline, certain securities such as MBS and CMO as well as other mortgage loans backed securities are more susceptible to paydowns and prepayments. During such periods, the Company generally will not be able to reinvest the proceeds at comparable yields, however in 2007, in general, increases in credit spreads off-set lower interest rates. 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 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.
The Company is exposed to credit risk within our investment portfolio and through derivative counterparties. Credit risk relates to the uncertainty of an obligor’s continued ability to make timely payments in accordance with the contractual terms of the instrument or contract. The Company manages credit risk through established investment credit policies which address quality of obligors and counterparties, credit concentration limits, diversification requirements and acceptable risk levels under expected and stressed scenarios. These policies are regularly reviewed and approved by senior management and by the Company’s Board of Directors.
Derivative counterparty credit risk is measured as the amount owed to the Company based upon current market conditions and potential payment obligations between the Company and its counterparties. Credit exposures are generally quantified daily, netted by counterparty for each legal entity of the Company and collateral is pledged to and held by, or on behalf of, the Company to the extent the current value of derivative instruments exceeds the exposure policy thresholds which do not exceed $10. The Company also minimizes the credit risk in derivative instruments by entering into transactions with high quality counterparties rated A2/A or better.
In addition to counterparty credit risk, the Company enters into credit derivative instruments, including credit default, index and total return swaps, in which the Company assumes credit exposure from or reduces credit exposure to a single entity, referenced index, or asset pool, in exchange for periodic payments. For further information on credit derivatives, see the “Investment Credit Risk” section.
The Company’s foreign currency exchange risk is related to non-U.S. dollar denominated investments, which primarily consist of fixed maturity investments and non-U.S. dollar denominated liability contracts, including those for assumed GMDB, GMAB, and GMIB benefits and a yen denominated individual fixed annuity product assumed from a related party. A significant portion of the Company’s foreign currency exposure is mitigated through the use of derivatives.
Foreign currency swaps exchange an initial principal amount in two currencies, agreeing to re-exchange the currencies at a future date, at an agreed upon exchange rate. There may also be a periodic exchange of payments at specified intervals calculated using the agreed upon rates and exchanged principal amounts.
The Company is responsible for maximizing economic value within acceptable risk parameters, including the management of the interest rate sensitivity of invested assets, while generating sufficient after-tax income to support policyholder and corporate obligations. The Company’s fixed maturity portfolios and certain investment contracts and insurance product liabilities have material market exposure to interest rate risk. In addition, operations are significantly influenced by changes in the equity markets. The Company’s profitability depends largely on the amount of assets under management, which is primarily driven by the level of sales, equity market appreciation and depreciation and the persistency of the in-force block of business. The Company’s foreign currency exposure is primarily related to non-U.S. dollar denominated fixed income securities, non-U.S. dollar denominated liability contracts, and certain foreign currency based individual fixed annuity contracts, and its GMDB, GMAB, and GMIB benefits associated with its Japanese variable annuities all of which are assumed from a related party.
The Company’s investment contracts and certain insurance product liabilities, other than non-guaranteed separate accounts, include asset accumulation vehicles such as fixed annuities, guaranteed investment contracts, other investment and universal life-type contracts and certain insurance products such as long-term disability.
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 duration 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 variable annuity products, credit interest to policyholders subject to market conditions and minimum interest rate guarantees. The duration of these products is short-term to intermediate-term.
The Company utilizes a variety of derivative instruments to mitigate interest rate risk. 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 the operation’s asset/liability duration matching policy. Occasionally, swaps are also used to hedge the variability in the cash flow of a forecasted purchase or sale due to changes in interest rates.
At December 31, 2007 and 2006, notional amounts pertaining to derivatives utilized to manage interest rate risk totaled $14.3 billion and $13.4 billion, respectively ($10.6 billion and $9.3 billion, respectively, related to investments and $3.7 billion and $4.1 billion, respectively, related to life liabilities). The fair value of these derivatives was $35 and $(30) as of December 31, 2007 and 2006, respectively.
The fixed liabilities included above represented approximately 69% and 66% of the Company’s general account liabilities as of December 31, 2007 and 2006, respectively. The assets supporting the fixed liabilities are monitored and managed within rigorous duration guidelines using scenario simulation techniques, and are evaluated on an annual basis, in compliance with regulatory requirements.
The after-tax change in fair value of the invested asset portfolios that support certain universal life-type contracts and other insurance contracts are shown in the following table. The cash flows associated with these liabilities are less predictable than fixed liabilities. The Company identifies the most appropriate investment strategy based upon the expected policyholder behavior and liability crediting needs. The calculation of the estimated hypothetical change in fair value below assumes a 100 basis point upward and downward parallel shift in the yield curve.
The Company’s operations are significantly influenced by changes in the equity markets, primarily in the U.S., but increasingly in Japan and other global markets due to the reinsurance of GMIB, GMAB and GMDB. The Company’s profitability in its investment products businesses depends largely on the amount of assets under management, which is primarily driven by the level of deposits, equity market appreciation and depreciation and the persistency of the in-force block of business. Prolonged and precipitous declines in the equity markets can have a significant effect on the Company’s operations, as sales of variable products may decline and surrender activity may increase, as customer sentiment towards the equity market turns negative. Lower assets under management will have a negative effect on the Company’s financial results, primarily due to lower fee income related to the Retail, Retirement Plans and Institutional and, to a lesser extent, the Individual Life segment, where a heavy concentration of equity linked products are administered and sold.
In addition, immediate and significant declines in one or more equity markets may also decrease the Company’s expectations of future gross profits in one or more product lines, which are utilized to determine the amount of DAC to be amortized in reporting product profitability in a given financial statement period. A significant decrease in the Company’s future estimated gross profits would require the Company to accelerate the amount of DAC amortization in a given period, which could potentially cause a material adverse deviation in that period’s net income. Although an acceleration of DAC amortization would have a negative effect on the Company’s earnings, it would not affect the Company’s cash flow or liquidity position.
The Company sells variable annuity contracts that offer one or more living benefits, the value of which, to the policyholder, generally increases with declines in equity markets. As is described in more detail below, the Company manages the equity market risks embedded in these guarantees through reinsurance, product design and hedging programs. The Company believes its ability to manage equity market risks by these means gives it a competitive advantage; and, in particular, its ability to create innovative product designs that allow the Company to meet identified customer needs while generating manageable amounts of equity market risk. The Company’s relative sales and variable annuity market share have generally increased during periods when it has recently introduced new products to the market. In contrast, the Company’s relative sales and market share have generally decreased when competitors introduce products that cause an issuer to assume larger amounts of equity and other market risk than the Company is confident it can prudently manage. The Company believes its long-term success in the variable annuity market will continue to be aided by successful innovation that allows the Company to offer attractive product features in tandem with prudent equity market risk management. In the absence of this innovation, the Company’s market share in one or more of its markets could decline. At times, the Company has experienced lower levels of U.S. variable annuity sales as competitors continue to introduce new equity guarantees of increasing risk and complexity. New product development is an ongoing process. Depending on the degree of consumer receptivity and competitor reaction to continuing changes in the Company’s product offerings, the Company’s future level of sales will continue to be subject to a high level of uncertainty.
The Company sells variable annuity contracts that offer various guaranteed death benefits. The Company maintains a liability, under SOP 03-1, for the death benefit costs of $531, as of December 31, 2007. Declines in the equity market may increase the Company’s net exposure to death benefits under these contracts. The majority of the contracts with the guaranteed death benefit feature are sold by the Retail segment. For certain guaranteed death benefits, the Company pays the greater of (1) the account value at death; (2) the sum of all premium payments less prior withdrawals; or (3) the maximum anniversary value of the contract, plus any premium payments since the contract anniversary, minus any withdrawals following the contract anniversary. For certain guaranteed death benefits sold with variable annuity contracts beginning in June 2003, the Retail segment pays the greater of (1) the account value at death; or (2) the maximum anniversary value; not to exceed the account value plus the greater of (a) 25% of premium payments, or (b) 25% of the maximum anniversary value of the contract. The Company currently reinsures a significant portion of these death benefit guarantees associated with its in-force block of business. Under certain of these reinsurance agreements, the reinsurers exposure is subject to an annual cap.
The Company’s total gross exposure (i.e., before reinsurance) to these guaranteed death benefits as of December 31, 2007 is $5.1 billion. Due to the fact that 81% of this amount is reinsured, the Company’s net exposure is $976. This amount is often referred to as the retained net amount at risk. However, the Company will incur these guaranteed death benefit payments in the future only if the policyholder has an in-the-money guaranteed death benefit at their time of death.
Effective September 30, 2007, HLAI entered into another reinsurance agreement where HLIKK agreed to cede and HLAI agreed to reinsure 100% of the risks associated with the in-force and prospective GMAB, GMIB and GMDB riders issued by HLIKK on certain of its variable annuity business. The reinsurance of the GMAB and GMIB riders is accounted for as a free-standing derivative in accordance with SFAS 133. Accordingly, the reinsurance of the GMAB and GMIB is recorded at fair value on the Company’s balance sheet, with prospective changes in fair value recorded in net realized capital gains (losses) in net income.
The majority of the Company’s recent variable annuities are sold with a GMWB living benefit rider, which, as described above, is accounted for under SFAS 133. Declines in the equity market may increase the Company’s exposure to benefits under the GMWB contracts. For all contracts in effect through July 6, 2003, the Company entered into a reinsurance arrangement to offset its exposure to the GMWB for the remaining lives of those contracts.
The Company continually seeks to improve its equity risk management strategies. The Company has made considerable investment in analyzing current and potential future market risk exposures arising from a number of factors, including but not limited to, product guarantees (GMDB, GMWB, GMIB and GMAB), equity market and interest rate risks (in both the U.S. and Japan) and foreign currency exchange rates. The Company evaluates these risks individually and, increasingly, in the aggregate to determine the risk profiles of all of its products and to judge their potential impacts on GAAP net income, statutory capital volatility and other metrics. Utilizing this and future analysis, the Company expects to evolve its risk management strategies over time, modifying its reinsurance, hedging and product design strategies to optimally mitigate its aggregate exposures to market-driven changes in GAAP equity, statutory capital and other economic metrics. Because these strategies could target an optimal reduction of a combination of exposures rather than targeting a single one, it is possible that volatility of GAAP net income would increase, particularly if the Company places an increased relative weight on protection of statutory surplus in future strategies.
In addition to the Company’s use of reinsurance, hedging instruments and other risk management techniques, the Company, along with its ultimate parent, The Hartford, maintains capital resources to, at a minimum, manage the statutory distributable earnings equity tail scenario risk described above. Given the level of the Company’s statutory surplus at December 31, 2007, as well as capital resources at The Hartford, management of the Company believes the risk inherent in these tail scenarios can be managed within the capital resources of the Company and The Hartford. The magnitude of the tail scenario estimate, described above, of $1 - $2 billion, subsequent changes to it and the width of the disclosed range can be significantly impacted by the following factors:
The Company’s ability to organically generate surplus in excess of that required to maintain financial strength ratings would reduce the exposure in a tail scenario.
Increases or decreases in surplus due to the impact capital market movements can have on the valuation of GMWB hedging instruments. Under statutory accounting, there is no fair value recognition of an embedded derivative; however, changes in value of the GMWB hedging instruments are recorded in capital and surplus. The tail scenario estimates described above incorporate the dynamic hedging of GMWB. Generally, increases in the value of GMWB hedging instruments will reduce the exposure in the tail scenario.
Each year, the Company writes new variable annuity business with existing or new living benefit guarantees, while older business, often without living benefit guarantees, is naturally lapsing. As a result the exposure in the tail scenario is likely to increase over time.
As of December 31, 2007 and 2006, $809 and $258 of consumer notes had been issued. As of December 31, 2007, these consumer notes have interest rates ranging from 4.75% to 6.25% for fixed notes and, for variable notes, either consumer price index plus 157 basis points to 267 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: $222 in 2008, $494 in 2009, $34 in 2010, $19 in 2011 and $40 thereafter. For the year ended December 31, 2007 and 2006, interest credited to holders of consumer notes was $11 and $2, respectively.
Estimated Life and Annuity obligations include death and disability claims, other charges associated with policyholder reserves, policy surrenders and policyholder dividends, offset by expected future deposits on in-force contracts. Estimated contractual policyholder obligations are based on mortality, morbidity and lapse assumptions comparable with the Company’s historical experience, modified for recent observed trends. The Company has also assumed market growth consistent with assumptions used in amortizing deferred acquisition costs. As the majority of the Company’s estimated obligations are recorded on the balance sheet at the current account value, as described in the Critical Accounting Policies, the Company’s recorded liability does not incorporate an expectation of future market growth. Therefore, the estimated contractual policy holder obligations presented in this table exceed the liabilities recorded on the balance sheet within reserves for future policy benefits and unpaid claims and claim adjustment expenses, other policyholder funds and benefits payable and separate account liabilities. Due to the significance of the assumptions used, the amounts presented could significantly differ from actual results.
The Company accounts for guaranty fund and other insurance assessments in accordance with Statement of Position No. 97-3, “Accounting by Insurance and Other Enterprises for Insurance-Related Assessments”. Liabilities for guaranty fund and other insurance-related assessments are accrued when an assessment is probable, when it can be reasonably estimated, and when the event obligating the Company to pay an imposed or probable assessment has occurred. Liabilities for guaranty funds and other insurance-related assessments are not discounted and are included as part of other liabilities in the Consolidated Balance Sheets. As of December 31, 2007 and 2006, the liability balance was $4 and $4, respectively. As of December 31, 2007 and 2006, $12 and $13, respectively, related to premium tax offsets were included in other assets.