(1) On November 10, 1998, the Company recaptured an in force block of corporate owned life insurance (COLI) business from MBL Life Assurance Co. of New Jersey (MBL Life). For additional information, see the COLI section as well as the MBL Recapture discussion under "Purchases of Affiliates and Other" within the Capital Resources and Liquidity section of the Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A).
(6) Pro forma effect on basic and diluted earnings per share has been given for the 1997 and 1996 periods presented for the conversion of 1,000 shares of common stock into 114 million shares of Class B Common Stock, which occurred on April 3, 1997, prior to the Company's initial public offering (IPO). For information regarding the IPO and earnings per share data, see Notes 3 and 10 of Notes to Consolidated Financial Statements, respectively.
Certain statements contained in this discussion, other than statements of historical fact, are forward-looking statements. These 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 on Hartford Life, Inc. and subsidiaries ("Hartford Life" or 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 Hartford Life will be those anticipated by management. Actual results could differ materially from those expected by the Company, depending on the outcome of certain factors, including those described in the forward-looking statements.
Hartford Life is a leading financial services and insurance company providing investment products such as variable and fixed annuities, retirement plan services and mutual funds; individual and corporate owned life insurance; and, employee benefit products such as group life and disability insurance.
Hartford Life has the following reportable segments: Investment Products, Individual Life, Employee Benefits and Corporate Owned Life Insurance (COLI). The Company reports in "Other" corporate items not directly allocable to any of its segments, principally interest expense, as well as its international operations, which are primarily located in Latin America. For information regarding the Company's reportable segments as they relate to SFAS No. 131, see Note 17 of Notes to Consolidated Financial Statements.
Total benefits, claims and expenses decreased $134 in 1997 as compared to 1996. This decrease was primarily driven by COLI, where dividends to policyholders declined $394 in 1997 due to the HIPA Act of 1996, as discussed above. Partially offsetting this decrease was an increase in benefits, claims and expenses of $215 in Employee Benefits associated with the growth in this segment. Additionally, benefits, claims and expenses increased $67 in Investment Products primarily related to individual annuity products, partially offset by declines related to GIC business.
Net income totaled $386 in 1998 as compared to $306 in 1997 and $24 in 1996. The improvement in earnings for both comparative periods was primarily driven by higher aggregate fee income earned on growth in the Company's account values due to strong sales and equity market appreciation in Investment Products and Individual Life. Additionally, the improvement in earnings for these comparative periods was impacted by strong sales and favorable mortality and morbidity experience in Employee Benefits. Also contributing to the improvement in 1997 was the reduction in losses resulting from actions taken in the third quarter of 1996 related to the Company's GIC business.
Revenues increased $503, or 50%, to $1.5 billion in 1997 from $1.0 billion in 1996. This increase was primarily driven by the individual annuity operation, whose revenues increased $253, reflecting a substantial improvement in aggregate fees earned as a result of this segment's growing account values. Average individual variable annuity account values increased $13.1 billion, or 49%, to $39.7 billion in 1997 from $26.6 billion in 1996, primarily due to strong net cash flow resulting from a high volume of sales and favorable persistency as well as significant equity market appreciation in the Company's separate accounts. In addition, within other investment products, $205 of the segment's increase in revenues was related to GIC business, which was primarily impacted by $219 of net realized capital losses primarily resulting from actions taken in the third quarter of 1996. Associated with strong sales and continued growth in this segment, benefits, claims and expenses grew $67, or 6%, over the prior year. A 27% growth in total average account value in 1997, coupled with operating efficiencies and a reduction in losses of $225 primarily as a result of actions taken in the third quarter of 1996 related to the Company's GIC business, increased net income $282 to $202 in 1997 from $(80) in 1996.
Revenues in 1998 increased $57, or 11%, to $567 from $510 in 1997, reflecting the impact of applying cost of insurance charges and variable life fees on the growing block of variable life insurance. Variable life average account values increased $562, or 67%, to $1.4 billion in 1998 from $840 in 1997 due to strong sales and equity market appreciation. In 1998, higher variable life sales of $29, or 30%, constituted the majority of increased total sales over 1997. Total benefits, claims and expenses increased $43, or 10%, to $466 in 1998 from $423 in 1997. This increase was the result of an increase in amortization of DPAC of $21 and benefits, claims and claim adjustment expenses of $18 in 1998 related to the growth in this segment. As a result of growth in account values, primarily variable life, net income increased $9, or 16%, in 1998 as compared to 1997.
Revenues increased $109, or 6%, to $1.8 billion in 1998 as compared to $1.7 billion in 1997. This increase was driven by growth in fully insured premiums, excluding buyouts, which increased $181, or 13%, in 1998. This increase was primarily due to group life and group disability, where ongoing premiums increased $69 and $55, respectively, in 1998 as compared to 1997 due to strong sales and good persistency. Sales of fully insured business, excluding buyouts, were $397 in 1998, an increase of $68, or 21%, over 1997; of which, group life and group disability business were each $148 in 1998, an increase of $26 and $23, respectively, as compared to 1997.
Revenues increased $237, or 16%, to $1.7 billion in 1997 as compared to $1.5 billion in 1996. This increase was due to growth in fully insured premiums, excluding buyouts, attributable to group disability business of $107, or 25%, and group life business of $79, or 19%, in 1997 as compared to 1996. Sales of fully insured business, excluding buyouts, increased $91, or 38%, to $329 in 1997 as compared to 1996. Included in the 1997 results are group disability and group life premiums of $89 and $16, respectively, as a result of the acquisition of a block of business from the United States branch of Confederation Life Insurance Company. The 1996 results include $78 of group disability premiums and $23 of group life premiums related to the acquisition of a block of business from North American Life Assurance Company of Toronto. Benefits, claims and expenses increased $215, or 15%, to $1.6 billion in 1997 from $1.4 billion in 1996 primarily attributable to growth in the Company's group life and group disability business. As a result of the premium growth in this segment, net income grew $13, or 29%, to $58 in 1997 from $45 in 1996.
Hartford Life is a leader in the COLI market, which includes life insurance policies purchased by a company on the lives of its employees, with the company named as the beneficiary under the policy. Until the HIPA Act of 1996, the Company sold two principal types of COLI business, leveraged and variable products. Leveraged COLI is a fixed premium life insurance policy owned by a company or a trust sponsored by a company. The HIPA Act of 1996 phased out the deductibility of interest on policy loans under leveraged COLI at the end of 1998, virtually eliminating all future sales of this product. Variable COLI continues to be a product used by employers to fund non-qualified benefits or other post-employment benefit liabilities. Products marketed in this segment also include coverage owned by employees under business sold through corporate sponsorship.
Benefits, claims and expenses increased $593, or 63%, to $1.5 billion in 1998 from $938 in 1997. The MBL Recapture resulted in an increase in benefits, claims and expenses of $624 and is comprised of $478 of benefits, claims and other expenses and $146 of dividends to policyholders. The increase in benefits, claims and expenses was also a result of the growth in the segment's variable COLI block of business, which was partially offset by a decrease in benefits, claims and expenses related to leveraged COLI.
COLI revenues decreased $380, or 28%, to $980 in 1997 from $1.4 billion in 1996. COLI expenses also declined, primarily due to a $394 decrease in dividends to policyholders. These decreases were primarily the result of the HIPA Act of 1996 discussed above. Net income of $27 in 1997 was consistent with 1996 results.
Certain proposed legislative initiatives which could impact Hartford Life are discussed in the Regulatory Initiatives and Contingencies section.
The Company's general account consists of a diversified portfolio of investments. Although all the assets of the general account support all the Company's liabilities, the Company's investment strategy group has developed separate investment portfolios for specific classes of product liabilities within the general account. The strategy group works closely with the business lines to develop specific investment guidelines, including duration targets, asset allocation and convexity constraints, asset/liability mismatch tolerances and return objectives for each product line in order to achieve each product line's individual risk and return objectives.
Invested assets in the Company's general account totaled $24.9 billion as of December 31, 1998 and were comprised of $17.7 billion of fixed maturities, $6.7 billion of policy loans and other investments of $503. As of December 31, 1997, general account invested assets totaled $21.0 billion and were comprised of $16.8 billion of fixed maturities, $3.8 billion of policy loans and other investments of $363. Policy loans, which had a weighted-average interest rate of 9.9% and 11.2%, as of December 31, 1998 and 1997,
respectively, increased primarily as a result of the MBL Recapture. These loans are secured by the cash value of the underlying life insurance policies and do not mature in a conventional sense, but expire in conjunction with the related policy liabilities.
During 1998, the Company, in executing its investment strategy, increased its allocation to municipal tax-exempt securities with the objective of increasing after-tax yields, and also increased its allocation to commercial mortgage backed securities while decreasing its allocation to asset backed securities. The increase in short-term investments as of December 31, 1998 as compared to 1997 was impacted by the settlement of the MBL Recapture in the fourth quarter 1998 (as discussed in the COLI section), which resulted in short-term investment proceeds of approximately $300.
Approximately 22.8% and 22.6% of the Company's fixed maturity portfolio was invested in private placement securities (including Rule 144A offerings) as of December 31, 1998 and 1997, respectively. Private placement securities are generally less liquid than public securities; however, covenants for private placements are designed to mitigate liquidity risk. Most of the private placement securities in the Company's portfolio are rated by nationally recognized rating organizations. For further discussion of the Company's investment credit policies, see the Capital Markets Risk Management section under "Credit Risk".
The table below summarizes Hartford Life's investment results for the past three years.
Total net investment income, before-tax, increased $419, or 27%, to $2.0 billion in 1998 from $1.5 billion in 1997, principally due to an increase in policy loan income of $364 which is primarily due to the MBL Recapture. (For additional information on the MBL Recapture, see the COLI section.) Yields on average invested assets, before-tax, increased to 7.9% in 1998 from 7.6% in 1997 primarily due to the increase in policy loan income that resulted from the MBL Recapture as well as an increase in fixed maturities rated BBB. There were no net realized capital gains or losses for the years ended December 31, 1998 and 1997. During 1998, realized capital gains from the sale of fixed maturities and equity securities were offset by realized capital losses, including $21, after-tax, related to the other than temporary impairment charge associated with asset backed securities securitized and serviced by Commercial Financial Services, Inc. (CFS). (For additional information on CFS, see Note 16, Commitments and Contingencies, of Notes to Consolidated Financial Statements.)
Total net investment income, before-tax, totaled $1.5 billion in 1997, unchanged from 1996. Total yields on average invested assets, before-tax, decreased to 7.6% in 1997 from 7.7% in 1996 primarily attributable to declining market interest rates. In 1996, net realized capital losses of $219 were primarily attributable to the writedown and sale of certain securities within the Company's GIC business.
Hartford Life has established investment credit policies that focus on the credit quality of obligors and counterparties, limit credit concentrations, encourage diversification and require frequent creditworthiness reviews. Investment activity, including setting of policy and defining acceptable risk levels, is subject to regular review and approval by senior management and frequent review by Hartford Life's Finance Committee.
As of December 31, 1998 and 1997, over 98% of the fixed maturity portfolio, including guaranteed separate accounts, was invested in investment-grade securities.
The Company also maintains credit policies regarding the financial stability and credit standing of its major derivatives' counterparties and typically requires credit enhancement provisions to further reduce its credit risk. Credit risk for derivatives contracts is limited to the amounts calculated to be due to the Company on such contracts based on current market conditions and potential payment obligations between the Company and its counterparties. Credit exposures are quantified weekly and netted, and collateral is pledged to or held by the Company to the extent the current value of derivatives exceeds exposure policy thresholds.
As described above, the Company holds a significant fixed maturity portfolio, which includes both fixed and variable rate features. The following table reflects the principal amounts of the fixed and variable rate fixed maturity portfolio, along with the respective weighted average coupons by estimated maturity year as of December 31, 1998. Comparative totals are included for December 31, 1997. Expected maturities differ from contractual maturities due to call or prepayment provisions. The weighted average coupon on variable rate securities is based on spot rates as of December 31, 1998 and 1997, and is primarily based on the London Interbank Offered Rate (LIBOR). Callable bonds and notes are distributed to either call dates or maturity, depending on which date produces the most conservative yield. Asset backed securities, collateralized mortgage obligations and mortgage backed securities are distributed to maturity year based on estimates of the rate of future prepayments of principal over the remaining life of the securities. These estimates are developed using prepayment speeds provided in broker consensus data. Such estimates are derived from prepayment speeds previously experienced at the interest rate levels projected for the underlying collateral. Actual prepayment experience may vary from these estimates. Financial instruments with certain leverage features have been included in each of the fixed maturity categories. These instruments have not been separately displayed because they were immaterial to the Company's investment portfolio.
(1) Represents company obligated mandatorily redeemable preferred securities of subsidiary trust holding solely parent junior subordinated debentures.
Asset Hedging -- To meet the various policyholder obligations and to provide cost effective prudent investment risk diversification, the Company may combine two or more financial instruments to achieve the investment characteristics of a fixed maturity security or that match an associated liability. The use of derivative instruments in this regard effectively transfers unwanted investment risks or attributes to others. The selection of the appropriate derivative instruments depends on the investment risk, the liquidity and efficiency of the market, and the asset and liability characteristics. The notional amount of asset hedges as of December 31, 1998 and 1997 was $3.8 billion and $3.2 billion, respectively.
The following tables provide information as of December 31, 1998, with comparative totals for December 31, 1997, on derivative instruments used in accordance with the aforementioned hedging strategies. For interest rate swaps, caps and floors, the tables present notional amounts with weighted average pay and received rates for swaps and weighted average strike rates for caps and floors by maturity year. For interest rate futures, the table presents contract amount and weighted average settlement price by expected maturity year.
Indexed -- Products in this category are similar to the fixed rate asset accumulation vehicles but require the Company to pay a rate that is determined by an external index. The amount and/or timing of cash flows will therefore vary based on the level of the particular index. The primary risks inherent in these products are similar to the fixed rate asset accumulation vehicles, with an additional risk that changes in the index may adversely affect profitability. Product examples include indexed-guaranteed investment contracts with an estimated duration of up to two years.
(1) Excludes net unrealized capital gains on securities, net of tax.
The Company's total capitalization, excluding net unrealized capital gains on securities, net of tax, increased $523, or 20%, in 1998 and $469, or 22%, in 1997. In 1998, the increase was primarily the result of net income of $386 and the issuance of TruPS of $250, which were partially offset by the retirement of $50 in commercial paper, dividends declared of $50 and the repurchase of treasury stock, net of reissuances, of $8. In 1997, the increase was primarily the result of net income of $306 and net proceeds from the IPO of $687, which were partially offset by a net reduction in debt of $193 and dividends of $341. As a result, both the debt to equity and debt to capitalization ratios (both exclude net unrealized capital gains on securities, net of tax) increased to 40% and 29% as of December 31, 1998, respectively, from 37% and 27% as of December 31, 1997, respectively.
For a discussion of Hartford Life's IPO, see Note 3 of Notes to Consolidated Financial Statements.
In 1998, a total of $50 in dividends was declared to holders of Class A and Class B Common Stock. See "Debt" discussion above for 1997 dividend payments made prior to the IPO.
Dividend decisions will be based on, and affected by, a number of factors, including the operating results and financial requirements of Hartford Life on a stand-alone basis and the impact of the regulatory restrictions discussed in Liquidity Requirements below.
and long-term fixed maturity investments to meet any liquidity needs. For a discussion of the Company's investment objectives and strategies, see the Investments section.
The National Association of Insurance Commissioners (NAIC) adopted regulations establishing minimum capitalization requirements based on Risk-Based Capital (RBC) formulas for life insurance companies (effective December 31, 1993). The requirements consist of formulas which identify companies that are undercapitalized and require specific regulatory actions. The RBC formula for life insurance companies establishes capital requirements relating to insurance, business, asset and interest rate risks. The RBC ratios for each of the major life insurance subsidiaries are in excess of 200% as of December 31, 1998.
During 1997, cash provided by operating activities increased from the prior year due primarily to growth in the Individual Life segment and the Employee Benefits segment. The change in cash used for investing activities primarily reflects the investment of cash from operating activities. The change in cash used for financing activities was primarily due to declines in investment-type contracts and changes in debt and dividends paid to the Company's parent, which were partially offset by proceeds from the IPO.
Although the Federal government does not directly regulate the insurance business, Federal initiatives often have an impact on the insurance industry in a variety of ways. Current and proposed Federal measures which may significantly affect the life insurance business include tax law changes affecting the tax treatment of life insurance products and its impact on the relative desirability of
various personal investment vehicles, medical testing for insurability, and proposed legislation to prohibit the use of gender in determining insurance and pension rates and benefits. In particular, President Clinton's 1999 Federal Budget Proposal currently contains certain recommendations for modifying tax rules related to the treatment of COLI by contractholders which, if enacted as described, could have a material adverse impact on the Company's sales of these products. The budget proposal also includes provisions which would result in a significant increase in the "DAC tax" on certain of the Company's products and would apply a tax to the Company's policyholder surplus account. (For further discussion on policyholder surplus accounts and related tax treatment as of December 31, 1998, see Note 14 of Notes to Consolidated Financial Statements.) It is too early to determine whether these tax proposals will ultimately be enacted by Congress. Therefore, the potential impact to the Company's financial condition or results of operations cannot be reasonably estimated at this time.
The NAIC has been developing several model laws and regulations, including a Model Investment Law and amendments to the Model Holding Company System Regulatory Act (the "Holding Act Amendments"). The Model Investment Law defines the investments which are permissible for life insurers to hold, and the Holding Act Amendments address the types of activities in which subsidiaries and affiliates may engage. The NAIC adopted these models in 1997 and 1996, but the laws have not been enacted for insurance companies domiciled in the State of Connecticut, such as Hartford Life. Even if enacted in Connecticut or other states in which Hartford Life's subsidiaries are domiciled, it is expected that these laws will neither significantly change Hartford Life's investment strategies nor have any material adverse effect on Hartford Life's liquidity or financial position.
The NAIC adopted the Codification of Statutory Accounting Principles (SAP) in March 1998. The proposed effective date for the statutory accounting guidance is January 1, 2001. It is expected that Hartford Life's domiciliary state will adopt the SAP and the Company will make the necessary changes required for implementation. These changes are not anticipated to have a material impact on the statutory financial statements of Hartford Life.
Hartford Life distributes its annuity and life insurance products through a variety of distribution channels, including broker-dealers, banks, wholesalers, its own internal sales force and other third party marketing organizations. The Company periodically negotiates provisions and renewals of these relationships and there can be no assurance that such terms will remain acceptable to the Company or such service providers. An interruption in the Company's continuing relationship with certain of these third parties could materially affect the Company's ability to market its products.
The Year 2000 issue relates to the ability or inability of computer hardware, software and other information technology (IT) systems, as well as non-IT systems, such as equipment and machinery with imbedded chips and microprocessors, to properly process information and data containing or related to dates beginning with the year 2000 and beyond. The Year 2000 issue exists because, historically, many IT and non-IT systems that are in use today were developed years ago when a year was identified using a two-digit date field rather than a four-digit date field. As information and data containing or related to the century date are introduced to date sensitive systems, these systems may recognize the year 2000 as "1900", or not at all, which may result in systems processing information incorrectly. This, in turn, may significantly and adversely affect the integrity and reliability of information databases of IT systems, may cause the malfunctioning of certain non-IT systems, and may result in a wide variety of adverse consequences to a company. In addition, Year 2000 problems that occur with third parties with which a company does business, such as suppliers, computer vendors, distributors and others, may also adversely affect any given company.
The integrity and reliability of Hartford Life's IT systems, as well as the reliability of its non-IT systems, are integral aspects of Hartford Life's business. Hartford Life issues insurance policies, annuities, mutual funds and other financial products to individual and business customers, nearly all of which contain date sensitive data, such as policy expiration dates, birth dates and premium payment dates. In addition, various IT systems support communications and other systems that integrate Hartford Life's various business segments and field offices, including Hartford Life's foreign operations. Hartford Life also has business relationships with numerous third parties that affect virtually all aspects of Hartford Life's business, including, without limitation, suppliers, computer hardware and software vendors, insurance agents and brokers, securities broker-dealers and other distributors of financial products, many of which provide date sensitive data to Hartford Life, and whose operations are important to Hartford Life's business.
Beginning in 1990, Hartford Life began working on making its IT systems Year 2000 ready, either through installing new programs or replacing systems. Since January 1998, Hartford Life's Year 2000 efforts have focused on the remaining Year 2000 issues related to IT and non-IT systems in all of Hartford Life's business segments. These Year 2000 efforts include the following five main initiatives: (1) identifying and assessing Year 2000 issues; (2) taking actions to remediate IT and non-IT systems so that they are Year 2000 ready; (3) testing IT and non-IT systems for Year 2000 readiness; (4) deploying such remediated and tested systems back into their respective production environments; and (5) conducting internal and external integrated testing of such systems. As of December 31, 1998, Hartford Life substantially completed initiatives (1) through (4) of its internal Year 2000 efforts. Hartford Life has begun initiative (5) and management currently anticipates that such activity will continue into the fourth quarter of 1999.
Hartford Life's Year 2000 efforts include assessing the potential impact on Hartford Life of third parties' Year 2000 readiness. Hartford Life's third party Year 2000 efforts include the following three main initiatives: (1) identifying third parties which have significant business relationships with Hartford Life, including, without limitation, insurance agents, brokers, third party administrators, banks and other distributors and servicers of financial products, and inquiring of such third parties regarding their Year 2000 readiness; (2) evaluating such third parties' responses to Hartford Life's inquiries; and (3) based on the evaluation of third party responses (or a third party's failure to respond) and the significance of the business relationship, conducting additional activities with respect to third parties as determined to be necessary in each case. These activities may include conducting additional inquiries, more in-depth evaluations of Year 2000 readiness and plans, and integrated IT systems testing. Hartford Life has completed the first third party initiative and, as of early 1999, had substantially completed evaluating third party responses received. Hartford Life has begun conducting the additional activities described in initiative (3) and management currently anticipates that it will continue to do so through the end of 1999. However, notwithstanding these third party Year 2000 efforts, Hartford Life does not have control over these third parties and, as a result, Hartford Life cannot currently determine to what extent future operating results may be adversely affected by the failure of these third parties to adequately address their Year 2000 issues.
The costs of Hartford Life's Year 2000 program that were incurred through the year ended December 31, 1997 were not material to Hartford Life's financial condition or results of operations. The after-tax costs of Hartford Life's Year 2000 efforts for the year ended December 31, 1998 were approximately $4. Management currently estimates that after-tax costs related to the Year 2000 program to be incurred in 1999 will be less than $10. These costs are being expensed as incurred.
Hartford Life is in the process of developing certain contingency plans so that if, despite its Year 2000 efforts, Year 2000 problems ultimately arise, the impact of such problems may be avoided or minimized. These contingency plans are being developed based on, among other things, known or reasonably anticipated circumstances and potential vulnerabilities. The contingency planning also includes assessing the dependency of Hartford Life's business on third parties and their Year 2000 readiness. Hartford Life currently anticipates that internal and external contingency plans will be substantially complete by the end of the second quarter of 1999. However, in many contexts, Year 2000 issues are dynamic, and ongoing assessments of business functions, vulnerabilities and risks must be made. As such, new contingency plans may be needed in the future and/or existing plans may need to be modified as circumstances warrant.