Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) addresses the financial condition of Hartford Life, Inc. and its subsidiaries (“Hartford Life”, “Life” or the “Company”) as of December 31, 2005, compared with December 31, 2004, and its results of operations for each of the three years in the period ended December 31, 2005. This discussion should be read in conjunction with the Consolidated Financial Statements and related Notes beginning on page. Certain reclassifications have been made to prior year financial information to conform to the current year presentation.
The Company has six reportable operating segments: Retail Products Group (“Retail”), Retirement Plans, Institutional Solutions Group (“Institutional”), Individual Life, Group Benefits and International. The Company provides investment and retirement products, such as variable and fixed annuities, mutual funds and retirement plan services and other institutional investment products, such as structured settlements; private placement life insurance; individual and private-placement life insurance (“PPLI”) and products including variable universal life, universal life, interest sensitive whole life and term life; and group benefit products, such as group life and group disability insurance.
The Company’s profitability in its variable annuity, mutual fund and to a lesser extent, variable universal life businesses depends largely on the amount of the contract holder account value or assets under management on which it earns fees and the level of fees charged. Changes in account value or assets under management are driven by two main factors: net flows, which measure the success of the Company’s asset gathering and retention efforts, and the market return of the funds, which is heavily influenced by the return realized in the equity markets. Net flows are comprised of new sales and other deposits less surrenders, death benefits, policy charges and annuitizations of investment type contracts, such as: variable annuity contracts. In the mutual fund business, net flows are known as net sales. Net sales are comprised of new sales less redemptions by mutual fund customers. The Company uses the average daily value of the Standard & Poor’s 500 Index (“S&P 500”) as an indicator for evaluating market returns of the underlying account portfolios in the United States. Relative profitability of variable products is highly correlated to the growth in account values or assets under management since these products generally earn fee income on a daily basis. Thus, a prolonged downturn in the financial markets could reduce revenues and potentially raise the possibility of a charge against deferred policy acquisition costs.
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 United States 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.
The 2005 increase in U.S. variable annuity account values can be attributed to market growth over the past four quarters.
Japan annuity account values and net flows continue to grow as a result of strong sales and significant market growth in 2005.
Certain investment type contracts such as fixed annuities and other spread-based contracts generate deposits that the Company collects and invests to earn investment income. These investment type contracts use this investment income to credit the contract holder an amount of interest specified in the respective contract; therefore, management evaluates performance of these products based on the spread between net investment income and interest credited. Net investment income and interest credited 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 income is driven primarily by prepayments on securities and earnings on partnership investments. In addition, insurance type contracts such as those sold by Group Benefits (discussed below) collect and invest premiums for protection from losses specified in the particular insurance contract and those sold by Institutional collect and invest premiums for certain life contingent benefits.
Net investment income and interest credited on general account assets in Retail declined for the year ended December 31, 2005 due to lower assets under management from surrenders on market value adjusted (“MVA”) fixed annuity products at the end of their guarantee period. The increase for the year ended December 31, 2004 was largely due to the adoption of Statement of Position 03-1: Accounting & Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts (“SOP 03-1”).
The persistency rate represents the employer markets group life and disability business, which accounts for, on average, 75% of inforce premiums
There are three major categories for expenses. The first major category of expenses is benefits and claims. These include the costs of mortality and morbidity, particularly in the group benefits, and mortality in the individual life businesses, as well as other contract-holder benefits to policyholders. In addition, traditional insurance type products generally use a loss ratio which is expressed as the amount of benefits incurred during a particular period divided by total premiums and other considerations, as a key indicator of underwriting performance. Since Group Benefits occasionally buys a block of claims for a stated premium amount, the Company excludes this buyout from the loss ratio used for evaluating the underwriting results of the business as buyouts may distort the loss ratio.
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. 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 individual annuity DAC amortization over income before taxes and DAC amortization declined for the year ended December 31, 2005 as a result of higher gross profits and a lower amount of additional deposits received on existing business.
The Group Benefits loss ratio, excluding buyouts, for the year ended December 31, 2005 decreased due to favorable morbidity and mortality experience.
increased fees including GMWB rider fees without a corresponding increase in expenses; while the increase in fixed annuity general account spread resulted from fixed annuity contracts that were repriced upon the contract reaching maturity. Also, contributing to a higher ROA in 2005 is an increase in the separate account dividends received deduction (“DRD”) tax benefit compared to 2004.
In June 2004, The Hartford received a subpoena from the New York Attorney General’s Office in connection with its inquiry into compensation arrangements between brokers and carriers. In mid-September 2004 and subsequently, The Hartford has received additional subpoenas from the New York Attorney General’s Office, which relate more specifically to possible anti-competitive activity among brokers and insurers. Since the beginning of October 2004, The Hartford has received subpoenas or other information requests from Attorneys General and regulatory agencies in more than a dozen jurisdictions regarding broker compensation and possible anti-competitive activity. The Hartford may receive additional subpoenas and other information requests from Attorneys General or other regulatory agencies regarding similar issues. In addition, The Hartford has received a request for information from the New York Attorney General’s Office concerning The Hartford’s compensation arrangements in connection with the administration of workers compensation plans. The Hartford intends to continue cooperating fully with these investigations, and is conducting an internal review, with the assistance of outside counsel, regarding broker compensation issues in its Group Benefits operations.
On October 14, 2004, the New York Attorney General’s Office filed a civil complaint against Marsh & McLennan Companies, Inc., and Marsh, Inc. (collectively, “Marsh”). The complaint alleges, among other things, that certain insurance companies, including The Hartford, participated with Marsh in arrangements to submit inflated bids for business insurance and paid contingent commissions to ensure that Marsh would direct business to them. The Hartford was not joined as a defendant in the action, which has since settled. Although no regulatory action has been initiated against The Hartford in connection with the allegations described in the civil complaint, it is possible that the New York Attorney General’s Office or one or more other regulatory agencies may pursue action against The Hartford or one or more of its employees in the future. The potential timing of any such action is difficult to predict. If such an action is brought, it could have a material adverse effect on The Hartford.
On May 24, 2005, The Hartford received a subpoena from the Connecticut Attorney General’s Office seeking information about The Hartford’s participation in finite reinsurance transactions in which there was no substantial transfer of risk between the parties. The Hartford is cooperating fully with the Connecticut Attorney General’s Office in this matter.
On July 14, 2005, The Hartford received an additional subpoena from the Connecticut Attorney General’s Office concerning The Hartford’s structured settlement business. This subpoena requests information about The Hartford’s sale of annuity products for structured settlements, and about the ways in which brokers are compensated in connection with the sale of these products. The Hartford is cooperating fully with the New York Attorney General’s Office and the Connecticut Attorney General’s Office in these matters.
The Hartford has received a request for information from the New York Attorney General’s Office about issues relating to the reporting of workers’ compensation premium. The Hartford is cooperating fully with the New York Attorney General’s Office in this matter.
Life Deferred Policy Acquisition Costs and Present Value of Future Profits Associated with Variable Annuity and Other Universal Life-Type Contracts
Life policy acquisition costs include commissions and certain other expenses that vary with and are primarily associated with acquiring business. Present value of future profits is an intangible asset recorded upon applying purchase accounting in an acquisition of a life insurance company. Deferred policy acquisition costs and the present value of future profits intangible asset are amortized in the same way. Both are amortized over the estimated life of the contracts acquired, generally 20 years. Within the following discussion, deferred policy acquisition costs and the present value of future profits intangible asset will be referred to as “DAC”. At December 31, 2005 and 2004, the carrying value of the Company’s Life DAC asset was $8.6 billion and $7.4 billion, respectively. Of those amounts, $4.5 billion and $4.4 billion related to individual variable annuities sold in the U.S., $1.2 billion and $0.8 billion related to individual variable annuities sold in Japan and $2.0 billion and $1.8 billion related to universal life-type contracts sold by Individual Life.
revised unless the EGPs in the DAC amortization model fall outside of a reasonable range. In the event that the Company was to revise assumptions used for prior year cohorts, thereby changing its estimate of projected account value, and the related EGPs, in the DAC amortization model, the cumulative DAC amortization would be adjusted to reflect such changes, in the period the revision was determined to be necessary, a process known as “unlocking”.
The Company has estimated that the present value of the EGPs is likely to remain within the statistical range for its U.S. individual variable annuity business if account values were to decline (due to declining separate account return performance, increased lapses or increased mortality) by 17% or less over the next twelve months or increase (due to increasing separate account return performance, decreasing lapses or decreased mortality) by 20% or less over the next twelve months.
Aside from absolute levels and timing of market performance, additional factors that will influence this unlock determination include the degree of volatility in separate account fund performance and shifts in asset allocation within the separate account made by policyholders. The overall return generated by the separate account is dependent on several factors, including the relative mix of the underlying sub-accounts among bond funds and equity funds as well as equity sector weightings. The Company’s overall U.S. separate account fund performance has been reasonably correlated to the overall performance of the S&P 500 Index (which closed at 1,248 on December 31, 2005), although no assurance can be provided that this correlation will continue in the future.
The Company offers certain variable annuity products with a guaranteed minimum withdrawal benefit (“GMWB”) rider. The fair value of the GMWB obligation is calculated based on actuarial and capital market assumptions related to the projected cash flows, including benefits and related contract charges, over the lives of the contracts, incorporating expectations concerning policyholder behavior. Because of the dynamic and complex nature of these cash flows, stochastic techniques under a variety of market return scenarios and other best estimate assumptions are used. Estimating these cash flows involves numerous estimates and subjective judgments including those regarding expected market rates of return, market volatility, correlations of market returns and discount rates. At each valuation date, the Company assumes expected returns based on risk-free rates as represented by the current LIBOR forward curve rates; market volatility assumptions for each underlying index based on a blend of observed market “implied volatility” data and annualized standard deviations of monthly returns using the most recent 20 years of observed market performance; correlations of market returns across underlying indices based on actual observed market returns and relationships over the ten years preceding the valuation date; and current risk-free spot rates as represented by the current LIBOR spot curve to determine the present value of expected future cash flows produced in the stochastic projection process. Changes in capital market assumptions can significantly change the value of the GMWB obligation. For example, independent decreases in equity market returns, decreases in interest rates and increases in equity index volatility will all have the effect of decreasing the GMWB asset resulting in a realized loss in net income. Furthermore, changes in policyholder behavior can also significantly change the value of the GMWB obligation. For example, independent increases in fund mix towards equity based funds vs. bond funds, increases in withdrawals, increasing mortality, increasing usage of the step-up feature and decreases in lapses will all have the effect of decreasing the GMWB asset 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 increasing the GMWB asset resulting in a realized gain in net income. During the 4th quarter of 2005, the Company reflected a newly reliable market input for volatility on Standard and Poor’s (“S&P”) 500 index options. The impact of reflecting the newly reliable market input for the S&P 500 index volatility resulted in a decrease to the GMWB asset of $83. The impact to net income including other changes in assumptions, after DAC amortization and taxes was a loss of $18.
For certain securitized financial assets with contractual cash flows (including asset-backed securities), (“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. 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. As a result, actual results may differ from current estimates. In addition, projections of expected future cash flows may change based upon new information regarding the performance of the underlying collateral.
Management follows the requirements of SFAS No. 5 “Accounting for Contingencies”. This statement requires management to evaluate each contingent matter separately. A loss is recorded if probable and reasonably estimable. Management establishes reserves for these contingencies at its “best estimate”, or, if no one number within the range of possible losses is more probable than any other, the Company records an estimated reserve at the low end of the range of losses.
For the year ended December 31, 2004, represents the cumulative impact of the Company’s adoption of SOP 03-1.
Group Benefits provides employers, associations, affinity groups and financial institutions with group life, accident and disability coverage, along with other products and services, including voluntary benefits, group retiree health, and medical stop loss.
Life includes in an Other category its leveraged PPLI product line of business; corporate items not directly allocated to any of its reportable operating segments; net realized capital gains and losses on sales generated from movements in interest rates, less amortization of those gains or losses back to the reportable segments; net realized capital gains and losses generated from credit related events, less a credit risk fee charged to the reportable segments; net realized capital gains and losses from non-qualifying derivative strategies (including embedded derivatives) other than the net periodic coupon settlements on credit derivatives and the net periodic coupon settlements on the cross currency swap used to economically hedge currency and interest rate risk generated from sales of the Company’s yen based fixed annuity, which are allocated to the reportable segments; the mark-to-market adjustment for the equity securities held for trading reported in net investment income and the related change in interest credited reported as a component of benefits, claims and claim adjustment expenses since these items are not considered by the Company’s chief operating decision maker in evaluating the International results of operations; and intersegment eliminations.
2005 Compared to 2004 - Life’s net income for the year ended December 31, 2005 decreased compared to the prior year due to higher income tax expense. Income tax expense increased for the year ended December 31, 2005 due to the absence of a tax benefit of $190 recorded in 2004 to reflect the impact of the Internal Revenue Service (“IRS”) audit settlement on tax years prior to 2004.
Life recorded an after tax charge of $102 for the year ended December 31, 2005 to establish reserves for regulatory matters for investigations related to market timing by the SEC and New York Attorney General’s Office, directed brokerage by the SEC, and single premium group annuities by the New York Attorney General’s Office and the Connecticut Attorney General’s Office.
The effective tax rate was 20% for Life operations for the current year as compared to an effective tax rate of 11% for Life operations for the respective prior year period. The 2005 higher effective tax rate was attributed to the absence of the 2004 tax benefit of $190 (as mentioned above) offset by an increase in the DRD tax benefit of $50.
2004 Compared to 2003 - Life’s net income increased in 2004 due primarily to business growth in virtually all lines of business as discussed below, a lower effective income tax rate, and higher net realized capital gains. (See the Investments section for further discussion of investment results and related realized capital gains). Life recorded in the third quarter of 2004 a tax benefit of $190, consisting primarily of a change in estimate of the dividends-received deduction (“DRD”) tax benefit reported during 2003 and prior years and interest, and changed the estimate of the after-tax benefit for the DRD benefit related to the 2004 tax year. Additional contributing factors to the increase in net income can be found below.
Net income in International increased over the prior year primarily driven by the increase in assets under management of the Japan annuity business. Japan’s assets under management have grown to $14.6 billion at December 31, 2004 from $6.2 billion at December 31, 2003. Also during 2004, Life introduced market value adjusted fixed annuity products to provide a diversified product portfolio to customers in Japan.
The effective tax rate was 11% for Life operations for the current year as compared to an effective tax rate of 19% for Life operations for the respective prior year period. The lower effective tax rate was attributed to tax related items, as discussed above, of $190 and a 2004 tax year DRD benefit of $132, as compared to tax related items of $30 and a 2003 tax year DRD benefit of $87 reported for the years ended December 31, 2004 and 2003, respectively.
Retail recorded lower spread income on market value adjusted (“MVA”) fixed annuities due to the adoption of SOP 03-1 in 2004.
Includes policyholders balances for investment contracts and reserve for future policy benefits for insurance contracts.
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, mutual funds and other investment products. The Company is both a leading writer of individual variable annuities and a top seller of individual variable annuities through banks in the United States.
There was higher amortization of DAC, due to higher gross profits and increased subsequent deposit activity, primarily in individual annuity.
Lower income from the fixed annuity business, due to lower investment spread from the market value adjusted (“MVA”) product caused by the cumulative effect of accounting change from the Company’s adoption of SOP 03-1. With the adoption of SOP 03-1, the Company includes the investment return from the fixed annuity product in net investment income and includes interest credited to contract holders in the benefits, claims and claim adjustment expenses. In prior years, the market value spread was reported as guaranteed separate account income in fee income and other.
The growth and profitability of the individual annuity and mutual fund businesses is dependent to a large degree on the performance of the equity markets. In periods of favorable equity market performance, Life may experience stronger sales and higher net flows, which will increase assets under management and thus increase fee income earned on those assets. In addition, higher equity market levels will generally reduce certain costs to Life of individual annuities, such as guaranteed minimum death benefit (“GMDB”) and GMWB benefits. Conversely, weak equity markets may dampen sales activity and increase surrender activity causing declines in assets under management and lower fee income. Such declines in the equity markets will also increase the cost to Life of GMDB and GMWB benefits associated with individual annuities. Life attempts to mitigate some of the volatility associated with the GMDB and GMWB benefits using reinsurance or other risk management strategies, such as hedging. Future net income for Life will be affected by the effectiveness of the risk management strategies Life has implemented to mitigate the net income volatility associated with the GMDB and GMWB benefits of variable annuity contracts. For spread-based products sold in the Retail segment, the future growth will depend on the ability to earn targeted returns on new business given competition, retention of account values in the fixed annuity business when the contract holder’s rate guarantee expires and the future interest rate environment.
General account spread decreased for both 401(k) and Governmental businesses for the year ended December 31, 2005 compared to prior year. The decrease is attributable to a decrease in the net investment income earned rate for both businesses. Average general account assets for the Retirement Plans segment increased approximately 7% in 2005 compared to 2004, while net investment income increased 2% compared to the prior year. Benefits and claims expense, which mainly consists of interest credited, increased 5% for the year ended December 31, 2005 compared to prior year, which was driven by a 7% increase in Governmental’s general account business.
2004 Compared to 2003 - Net income for the year ended December 31, 2004 increased primarily due to higher fee income related to the 401(k) business compared to the prior year:
Net investment income increased a moderate $2 for the year ended December 31, 2005 as compared to the prior year due to increased general account assets from business growth, partially offset by lower interest rates on new investments and reduced prepayments on bonds in 2005.
Benefits, claims and claim adjustment expenses decreased for the year ended December 31, 2005 as compared to the prior year.
Fee income increased for the year ended December 31, 2004 as compared to the prior year primarily due to increased cost of insurance charges as life insurance inforce grew and aged and variable universal life account values increased driven by
favorable equity markets and new sales. Account values and life insurance inforce grew 9% and 7% from 2003 to 2004, respectively.
Net investment income increased for the year ended December 31, 2004 as compared to the prior year primarily due to the adoption of SOP 03-1, growth in general account values and prepayments on bonds. The adoption of SOP 03-1 also resulted in increases in benefits, claims and claim adjustment expenses and a decrease to fee income and other for the year ended December 31, 2004 as compared to the prior year period for the segment’s Modified Guarantee Life Insurance product, which was formerly classified as a separate account product.
The Group Benefits segment provides employers, associations, affinity groups and financial institutions with group life, accident and disability coverage, along with other products and services, including voluntary benefits, group retiree health, and medical stop loss. The Company also offers disability underwriting, administration, claims processing services and reinsurance to other insurers and self-funded employer plans.
Group Benefits has a block of financial institution business that is experience rated. This business comprised approximately 9% of the segment’s 2005 and 2004 premiums and other considerations (excluding buyouts) and, on average, 5% of the segment’s 2005 and 2004 net income. In 2003, this business comprised 2% of both the segment’s premiums and other considerations (excluding buyouts) and net income. Under the terms of this business, the loss experience will inversely affect the commission expenses incurred.
2005 Compared to 2004 - Net income of $272 included a non-recurring tax benefit of $9 related to the CNA Acquisition. Excluding this tax benefit, net income increased 15% to $263 for the year ended December 31, 2005 as compared to $229 for the prior year due primarily to higher earned premiums and net investment income as well as a favorable loss ratio. The following factors contributed to the earnings increase:
The segment’s loss ratio (defined as benefits, claims and claim adjustment expenses as a percentage of premiums and other considerations excluding buyouts) was 73.1% for the year ended December 31, 2005, down from 74.0% in the prior year due to improved morbidity experience as well as favorable mortality experience. Excluding financial institutions, the loss ratio was 77.3%, down from 78.7% in the prior year.
2004 Compared to 2003 - Net income increased for the year ended December 31, 2004 as compared to the prior year due to earned premium growth and net investment income growth as the result of the CNA Acquisition as well as a favorable loss ratio. The following factors contributed to the earnings increase:
The segment’s ratio of insurance operating costs and other expenses to premiums and other considerations (excluding buyouts) increased to 27.7% for the year ended December 31, 2004, from 24.6% for prior year. The increase in expense ratio was primarily attributed to lower losses, which resulted in increased commissions, on a larger block of experience rated financial institution business. Excluding the financial institution business, the 2004 expense ratio was 23.6% for the year ended December 31, 2004, down from 23.8% for the prior year.
International, with operations in Japan, Brazil, Ireland and the United Kingdom, focuses on the savings and retirement needs of the growing number of individuals outside the United States who are preparing for retirement, or have already retired, through the sale of variable annuities, fixed annuities and other insurance and savings products. The Company’s Japan operation, which began selling variable annuities at the end of 2000, has grown significantly to become the largest distributor of variable annuities in Japan and the largest component of International.
2005 Compared to 2004 - Net income increased significantly for the year ending December 31, 2005, principally driven by higher fee income and investment spread in Japan derived from a 78% increase in the assets under management. A more expanded discussion of earnings growth can be found below:
The increase in fee income in 2005 was mainly a result of growth in Japan’s variable annuity assets under management. As of December 31, 2005, Japan’s variable annuity assets under management were $24.6 billion, a 74% increase from the prior year. The increase in assets under management was driven by positive net flow of $9.8 billion and favorable market appreciation of $3.4 billion, partially offset by a ($2.6) billion impact of foreign currency exchange.
DAC amortization was higher in the current year as compared to the prior year due to higher EGP’s consistent with the growth in the Japan operation.
Tax rates increased in 2005 primarily due to a deferred tax valuation allowance established for losses on the United Kingdom operation.
At the end of the third quarter of 2004, the MVA fixed annuity product was introduced to provided a diversified product portfolio to customers in Japan. Japan fixed annuity sales and assets under management for the year ending December 31, 2004 were $521 and $502, respectively.
Management is optimistic about growth potential of the retirement savings market in Japan. Several trends such as an aging population, longer life expectancies, declining birth rate leading to a smaller number of younger workers to support each retiree, and under funded pension systems have resulted in greater need for an individual to plan and adequately fund retirement savings.
2005 Compared to 2004 - Net income decreased for the year ended December 31, 2005. The following factors contributed to the change in earnings:
Other than the impact of Japan interest credited, benefits, claims, and claim adjustment expenses increased for the year ended December 31, 2005 primarily due to the establishment of a $102 after-tax reserve for investigations related to market timing by the SEC and the New York Attorney General’s Office, directed brokerage by the SEC and single premium group annuities by the New York Attorney General’s Office and the Connecticut Attorney General’s Office.
Income tax benefit increased for the year ended December 31, 2004 due to a $190 tax benefit recorded during 2004.
HIMCO’s security selection process is a multi-dimensional approach that combines independent internal credit research along with a macro-economic outlook of technical trends (e.g. interest rates, slope of the yield curve and credit spreads) and market pricing to identify valuation inefficiencies and relative value buying and selling opportunities. Security selection and monitoring is performed by asset class specialists working within dedicated portfolio management teams.
Return on general account invested assets is an important element of the Company’s financial results. Significant fluctuations in the fixed income or equity markets could weaken the Company’s financial condition or its results of operations. Additionally, changes in market interest rates may impact the period of time over which certain investments, such as mortgage-backed securities (“MBS”), are repaid and whether certain investments are called by the issuers. Such changes may, in turn, impact the yield on these investments and also may result in re-investment of funds received from calls and prepayments at rates below the average portfolio yield. Net investment income and net realized capital gains and losses accounted for approximately 45%, 34% and 26% of the Company’s consolidated revenues for the years ended December 31, 2005, 2004 and 2003, respectively. The increase in the percentage of consolidated revenues for 2005, as compared to the prior years, is primarily due to an increase in the value of equity securities held for trading.
Fluctuations in interest rates affect the Company’s return on, and the fair value of, fixed maturity investments, which comprised approximately 64% and 74% of the fair value of its invested assets as of December 31, 2005 and 2004, respectively. Other events beyond the Company’s control could also adversely impact the fair value of these investments. Specifically, a downgrade of an issuer’s credit rating or default of payment by an issuer could reduce the Company’s investment return.
A decrease in the fair value of any investment that is deemed other-than-temporary would result in the Company’s recognition of a net realized capital loss in its financial results prior to the actual sale of the investment. For a further discussion of the evaluation of other-than-temporary impairments, see the Critical Accounting Estimates section of the MD&A under “Evaluation of Other-Than-Temporary Impairments on Available-for-Sale Securities”.
The following table identifies the fair value of fixed maturity securities by pricing source as of December 31, 2005 and 2004.
Derivative instruments are reported at fair value based upon either pricing valuation models, which utilize independent third party data as inputs, or broker quotations. Other than the GMWB rider and the associated reinsurance contracts, which are discussed in the Critical Accounting Estimates section of the MD&A under “Valuation of Guaranteed Minimum Withdrawal Benefit Derivatives”, approximately 85% and 72% of derivatives, based upon notional values, were priced via valuation models, while the remaining 15% and 28% of derivatives were priced via broker quotations, as of December 31, 2005 and 2004, respectively.
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 support policyholder and corporate obligations, as discussed in the Capital Markets Risk Management section of the MD&A under “Market Risk - Key Market Risk Exposures”.
The following table identifies the invested assets by type held in the general account as of December 31, 2005 and 2004.
Net investment income on equity securities held for trading for 2005 was primarily generated by positive performance of the underlying investment funds supporting the Japanese variable annuity product, partially offset by foreign currency depreciation in comparison to the U.S. dollar. Net investment income on equity securities held for trading for 2004 was primarily generated by
positive performance of the underlying investment funds supporting the Japanese variable annuity product as well as foreign currency appreciation in comparison to the U.S. dollar. The change in net investment income as compared to the prior year is primarily due to the performance of the underlying funds on a higher asset base.
For 2005, the yield on average invested assets was relatively consistent with the prior year. An increase in yield as a result of higher partnership income was offset by a reduction in yield due to lower policy loan income. Based upon forward interest rates as of December 31, 2005, Life expects the average before-tax new investment yield for fixed rate debt securities in 2006 to range from 5.1% to 5.3%, slightly below the current average portfolio yield. However, any slight decline in the average fixed rate debt security yield is expected to be offset by an average higher yield on variable rate securities as well as additional yield generated from diversifying into other asset types. Therefore, excluding partnership income and policy loan income, Life expects the yield on average invested assets for 2006 to be at or slightly higher than the 2005 level. If future interest rates differ from the forward rates as of December 31, 2005, the actual average new investment yields may be significantly different than yields currently expected.
The Japanese fixed annuity contract hedges amount consists of the foreign currency transaction remeasurement associated with the yen denominated fixed annuity contracts offered in Japan and the corresponding off setting cross currency swaps. Although the Japanese fixed annuity contracts are economically hedged, the net realized capital losses result from the accounting treatment, which requires fixed annuity liabilities to be recorded at cost but the associated derivatives to be reported at fair value. The net realized capital losses in 2005 resulted from rising Japanese interest rates, and in the first half of the year, a decrease in U.S. interest rates. (For additional discussion of the Japanese fixed annuity contract hedges see the Capital Markets Risk Management section of the MD&A under “Market Risk - Key Market Risk Exposures” and Note 4 of Notes to Consolidated Financial Statements.) The periodic net coupon settlements on credit derivatives and the Japan fixed annuity cross currency swaps includes the net periodic income/expense or coupon associated with the swap contracts. The net loss for 2005 is associated with the Japan fixed annuity cross currency swaps and results from the interest rate differential between U.S. and Japanese interest rates. The Japanese fixed annuity product was first offered by the Company in the fourth quarter 2004. The adverse change in 2005 in comparison to 2004 primarily resulted from a full year of the Japanese fixed annuity product swap accruals in 2005.
In 2005, gross gains were primarily within fixed maturities and included corporate, foreign government securities and CMBS. Corporate securities were sold primarily to reduce the Company’s exposure to certain lower credit quality issuers. The sale proceeds were primarily reinvested into higher credit quality securities. The gains on sales of corporate securities were primarily the result of credit spread tightening since the date of purchase. Foreign securities were sold primarily to reduce the foreign currency exposure in the portfolio due to the expected near term volatility in foreign exchange rates and to capture gains resulting from credit spread tightening since the date of purchase. The CMBS sales resulted from a decision to divest securities that were backed by a single asset due to the then scheduled expiration of the Terrorism Risk Insurance Act at the end of 2005. Gains on these sales were realized as a result of an improved credit environment and interest rate declines from the date of purchase.
In 2004, gross gains were realized as fixed maturity credit spreads tightened and portions of the investment portfolios were repositioned into higher quality assets where the Company believed greater relative value existed. Credit spreads tightened primarily due to improved credit quality, market liquidity and demand for higher yielding assets, as well as the relatively low interest rate environment. It is expected that the higher quality assets will provide greater liquidity if the credit environment and issuer default rates return to historical norms. In addition, foreign government securities were sold, primarily in the first and fourth quarters of 2004, to reduce the portfolios’ exposure to foreign holdings and realize gains associated with the decline in value of the U.S. dollar against foreign currencies.
Guaranteed separate accounts primarily consist of modified guaranteed individual annuities and modified guaranteed life insurance and generally include market value adjustment features and surrender charges to mitigate the risk of disintermediation. The primary investment objective of these assets is to maximize after-tax returns consistent with acceptable risk parameters, including the management of the interest rate sensitivity of invested assets relative to that of policyholder obligations, as discussed in the Capital Markets Risk Management section of the MD&A under “Market Risk - Life”. Effective January 1, 2004, the guaranteed separate accounts are included with the Company’s general account assets.
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 income. 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 2 of Notes to Consolidated Financial Statements.
During 2005 there were no significant other-than-temporary impairments (e.g. $15 or greater) recorded on any single security or issuer. Other-than-temporary impairments recorded on equity securities primarily related to variable rate perpetual preferred securities issued by one highly-rated financial services company. These securities had sustained a decline in market value for an extended period of time as a result of issuer credit spread widening. Other-than-temporary impairments recorded on corporate securities were primarily the result of the Company’s uncertainty regarding its intent and ability to retain the investment for a period of time sufficient to allow for an anticipated recovery, not to the Company’s expectations regarding the issuers’ payments based upon the contractual terms of the securities. The circumstances giving rise to the decline in value of these corporate securities since the date of purchase and potential impact on other material holdings of these issuers are as follows:
Approximately $25 of impairments on corporate fixed maturities were within the food and beverage sector and related to securities issued by the Italian dairy concern, Parmalat SpA. Parmalat filed for bankruptcy in December 2003 due to liquidity problems when it was discovered that 4 billion euros of liquid investments previously reported on its balance sheet were non-existent.
The Company is not exposed to any credit concentration risk of a single issuer greater than 10% of the Company’s stockholders’ equity other than certain U.S. government and government agencies. For further discussion of concentration of credit risk, see the “Concentration of Credit Risk” section in Note 4 of Notes to Consolidated Financial Statements.
In addition to counterparty credit risk, the Company periodically enters into swap agreements in which the Company assumes credit exposure from or reduces credit exposure to a single entity, referenced index or asset pool. Summaries of these derivatives are as follows:
The Company also uses credit default swaps to reduce its credit exposure by entering into agreements in which the Company pays a derivative counterparty a periodic fee in exchange for compensation from the counterparty should a credit event occur on the part of the referenced security issuer. Alternatively, the derivative counterparty may be required to purchase the referenced security at a predetermined value. The Company enters into these agreements as an efficient means to reduce credit exposure to the specified issuers. As of December 31, 2005 and 2004, the notional value of these credit default swaps totaled $189 and $175, respectively, and the swap fair value totaled $2 and $(1), respectively. As of December 31, 2005, the average S&P rating for these referenced securities issuers is BBB.
The following table identifies fixed maturity securities by type as of December 31, 2005 and 2004.
The Company’s fixed maturity portfolio gross unrealized gains and losses as of December 31, 2005, in comparison to December 31, 2004, were primarily impacted by changes in interest rates as well as credit spread movements, changes in foreign currency exchange rates and security sales. The Company’s fixed maturity gross unrealized gains decreased $1.0 billion and gross unrealized losses increased $324 from December 31, 2004 to December 31, 2005, primarily due to an increase in short-term through intermediate-term interest rates as well as credit spread widening and foreign currency depreciation in comparison to the U.S. dollar for foreign denominated securities, offset in part by a decrease in long-term interest rates and other-than-temporary impairments taken during the year. Gross unrealized gains and losses were reduced by securities sold in a gain or loss position, respectively.
Investment sector allocations as a percentage of total fixed maturities have changed since December 31, 2004, with a shift from certain corporate and short-term securities to ABS and CMBS due to their attractive yields relative to credit quality and MBS due to their relatively low risk profile and attractive spreads. The shift from corporate securities was primarily a result of capturing gains within the technology and communications sector due to credit spreads tightening as well as divesting securities that could be adversely impacted by issuers recapitalizing, pushing the Company’s interest lower in the repayment priority (e.g. leveraged buy-outs) or issuer capital uses that would not benefit the Company’s debt holders position (e.g. share repurchases). Also, HIMCO continues to overweight, in comparison to the Lehman Aggregate Index, ABS supported by diversified pools of consumer loans (e.g. home equity and auto loans and credit card receivables) and CMBS due to the securities’ attractive spread levels and underlying asset diversification and quality. In general, CMBS have lower prepayment risk than MBS due to contractual fees. As of December 31, 2005 and 2004, 26% and 22%, respectively, of the fixed maturities were invested in private placement securities, including 17% and 14%, respectively, in Rule 144A offerings to qualified institutional buyers. Private placement securities are generally less liquid than public securities. Most of the private placement securities are rated by nationally recognized rating agencies.
data has been uneven, the expansion in economic activity appears solid, core inflation has stayed relatively low in recent months and longer-term inflation expectations remain contained. They noted that some further increases may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. The Company believes the Federal Reserve is approaching the end of its rate tightening cycle with an increase or two possible during the first half of 2006. Ultimately, the level of rate increases will be largely dependent on future inflationary data. The risk of inflation could increase for a number of reasons including an increase in energy and commodity prices, an acceleration of wage rates, a slow down of productivity growth, an increase in U.S. budget or trade deficits or the U.S. dollar significantly depreciating in comparison to foreign currencies. Increases in future interest rates may result in lower fixed maturity valuations.
As of December 31, 2005 and 2004, the Company held no issuer of a BIG security with a fair value in excess of 5% of the total fair value for BIG securities. Total BIG securities decreased since December 31, 2004, as a result of a decision to reduce exposure to lower credit quality assets resulting from the securities’ significant credit spread tightening and re-investment in higher quality securities.
The Company held no securities of a single issuer that were at an unrealized loss position in excess of 7% and 8% of the total unrealized loss amount as of December 31, 2005 and 2004, respectively.
The total securities classified as available-for-sale in an unrealized loss position for longer than six months by type as of December 31, 2005 and 2004, are presented in the following table.
The increase in total unrealized loss greater than six months since December 31, 2004, was primarily driven by an increase in short-term through intermediate-term interest rates as well as credit spread widening and foreign currency depreciation in comparison to the
U.S. dollar for foreign denominated securities, offset in part by security sales, a decrease in long-term interest rates and other-than-temporary impairments taken during the year. With the exception of ABS security types, the majority of the securities in an unrealized loss position for six months or more as of December 31, 2005, were depressed primarily due to interest rate changes from the date of purchase. The sectors with the most significant concentration of unrealized losses at December 31, 2005 were ABS supported by aircraft lease receivables, CMBS and corporate fixed maturities primarily within the financial services sector. The Company’s current view of risk factors relative to these fixed maturity types is as follows:
Aircraft lease receivables - The Company’s holdings are ABS secured by leases on aircraft. The decline in the fair values of these securities is primarily attributable to the high risk premium associated with the increase in volatility of airline travel demand in recent years, lack of market liquidity in this sector and long term to maturity of these securities. In recent years, aircraft demand and lease rates have improved as a result of an increase in worldwide travel. However, the continuing difficulties experienced by several major U.S. domestic airlines due to high operating costs, including fuel and certain employee benefits costs, continue to weigh heavily on this sector. Based on the Company’s projections of future cash flows under distressed scenarios, the Company expects to recover the full contractual principal and interest payments of these investments. However, future price recovery will depend on continued improvement in economic fundamentals, political stability, airline operating performance and collateral value.
Financial services - As of December 31, 2005, the Company held approximately 140 different securities in the financial services sector that had been in an unrealized loss position for greater than six months. Substantially all of these securities are investment grade securities priced at or greater than 90% of amortized cost as of December 31, 2005. These positions are a mixture of fixed and variable rate securities with extended maturity dates, which have been adversely impacted by changes in interest rates after the purchase date. Additional changes in fair value of these securities are primarily dependent on future changes in interest rates.
The following table presents the Company’s unrealized loss aging for BIG and equity securities as of December 31, 2005 and 2004.
Available-for-Sale BIG and Equity Securities with Unrealized Loss Greater Than Six Months by Type
The decrease in the available-for-sale BIG and equity securities greater than six months unrealized loss amount since December 31, 2004, was primarily the result of other-than-temporary impairments taken during the year, asset sales and a decrease in long-term interest rates partially offset by the increase in short-term through intermediate-term interest rates as well as credit spread widening and foreign currency depreciation in comparison to the U.S. dollar for foreign denominated securities. For further discussion of risk factors associated with sectors with significant unrealized loss positions, see the sector risk factor commentary under the Total Available-for-Sale Securities with Unrealized Loss Greater than Six Months by Type table in this section of the MD&A.
The Company believes that an increase in interest rates from the current levels is generally a favorable development for the Company. Rate increases are expected to provide additional net investment income, increase sales of fixed rate investment products, reduce the cost of the GMWB hedging program, limit the potential risk of margin erosion due to minimum guaranteed crediting rates in certain products and, if sustained, could reduce the Company’s prospective pension expense. Conversely, a rise in interest rates will reduce the net unrealized gain position of the investment portfolio, increase interest expense on the Company’s variable rate debt obligations and, if long-term interest rates rise dramatically within a six to twelve month time period, certain businesses may be exposed to disintermediation risk. Disintermediation risk refers to the risk that policyholders will surrender their contracts in a rising interest rate environment requiring the Company to liquidate assets in an unrealized loss position. In conjunction with the interest rate risk measurement and management techniques, significant portions of the Company’s fixed income product offerings have market value adjustment provisions at contract surrender.
Interest rate swaps involve the periodic exchange of payments with other parties, at specified intervals, calculated using the agreed upon rates and notional principal amounts. Generally, no cash or principal payments are exchanged at the inception of the contract. Typically, at the time a swap is entered into, the cash flow streams exchanged by the counterparties are equal in value.
Derivative activities are monitored by an internal compliance unit and reviewed frequently by senior management. The notional amounts of derivative contracts represent the basis upon which pay or receive amounts are calculated and are not reflective of credit risk. Notional amounts pertaining to derivative instruments used in the management of market risk at December 31, 2005 and 2004, were $60.9 billion and $52.2 billion, respectively. The increase in the derivative notional amount during 2005 was primarily due to the embedded derivatives associated with the GMWB product feature. For further information, see Note 4 of Notes to Consolidated Financial Statements.
The following discussions focus on the key market risk exposures within the Company’s portfolios.
The Company’s exposure to interest rate risk relates to the market price and/or cash flow variability associated with changes in market interest rates. Changes in interest rates can potentially impact the Company’s profitability. In certain scenarios where interest rates are volatile, the Company could be exposed to disintermediation risk and a reduction in net interest rate spread or profit margins. The investments and liabilities primarily associated with interest rate risk are included in the following discussion. Certain product liabilities, including those containing GMWB or GMDB, expose the Company to interest rate risk but also have significant equity risk. These liabilities are discussed as part of the Equity Risk section below.
The Company also manages the risk of certain insurance liabilities similarly to investment type products due to the relative predictability of the aggregate cash flow payment streams. Products in this category may contain significant actuarial (including mortality and morbidity) pricing and cash flow risks. Product examples include structured settlement contracts, on-benefit annuities (i.e. the annuitant is currently receiving benefits thereon) and short-term and long-term disability contracts. The cash out flows associated with these policy liabilities are not interest rate sensitive but do vary based on the timing and amount of benefit payments. The primary risks associated with these products are that the benefits will exceed expected actuarial pricing and/or that the actual timing of the cash flows will differ from those anticipated, resulting in an investment return lower than that assumed in pricing. Average contract duration can range from less than one year to typically up to fifteen years.
The after-tax change in the net economic value of investment contracts (e.g. guaranteed investment contracts) and certain other insurance product liabilities (e.g. short-term and long-term disability contracts), for which the payment rates are fixed at contract issuance and the investment experience is substantially absorbed by the Company, are included in the following table along with the corresponding invested assets. Also included in this analysis are the interest rate sensitive derivatives used by the Company to hedge its exposure to interest rate risk. Certain financial instruments, such as limited partnerships, have been omitted from the analysis due to the fact that the investments are accounted for under the equity method and generally lack sensitivity to interest rate changes. Non-guaranteed separate account assets and liabilities and equity securities held for trading and the corresponding liabilities associated with the variable annuity products sold in Japan are excluded from the analysis because gains and losses in separate accounts accrue to policyholders. The hypothetical calculation of the estimated change in net economic value below assumes a 100 basis point upward and downward parallel shift in the yield curve.
The fixed liabilities included above represented approximately 45% and 50% of the Company’s general account liabilities as of December 31, 2005 and 2004, 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 hypothetical calculation of the estimated change in fair value below assumes a 100 basis point upward and downward parallel shift in the yield curve.
The accounting for various benefit guarantees offered with variable annuity contracts can be significantly different. Those accounted for under SFAS No. 133 (such as GMWBs) are subject to significant fluctuation in value, which is reflected in net income, due to changes in interest rates, equity markets and equity market volatility as use of those capital market rates are required in determining the liability’s fair value at each reporting date. Benefit guarantee liabilities accounted for under SOP 03-1 (such as GMIBs and GMDBs) may also change in value; however, the change in value is not immediately reflected in net income. Under SOP 03-1, the income statement reflects the current period increase in the liability due to the deferral of a percentage of current period revenues. The percentage is determined by dividing the present value of claims by the present value of revenues using best estimate assumptions over a range of market scenarios. Current period revenues are impacted by actual increases or decreases in account value. Claims recorded against the liability have no immediate impact on the income statement unless those claims exceed the liability. As a result of these significant accounting differences the liability for guarantees recorded under SOP 03-1 may be significantly different if it was recorded under SFAS No. 133 and vice versa. In addition, the conditions in the capital markets in Japan vs. those in the U.S. are sufficiently different that if the Company’s GMWB product currently offered in the U.S. were offered in Japan, the capital market conditions in Japan would have a significant impact on the valuation of the GMWB, irrespective of the accounting model. The same would hold true if the Company’s GMIB product currently offered in Japan were to be offered in the U.S. Capital market conditions in the U.S. would have a significant impact on the valuation of the GMIB. Many benefit guarantees meet the definition of an embedded derivative, under SFAS No. 133 (GMWB), and as such are recorded at fair value with changes in fair value recorded in net income. However, certain contract features that define how the contract holder can access the value of the guaranteed benefit change the accounting from SFAS No. 133 to SOP 03-1. For contracts where the contract holder can only obtain the value of the guaranteed benefit upon the occurrence of an insurable event such as death (GMDB) or by making a significant initial net investment (GMIB), such as when one invests in an annuity, the accounting for the benefit is prescribed by SOP 03-1.
In Japan, the Company offers certain variable annuity products with both a guaranteed death benefit and a guaranteed income benefit. The Company maintains a liability for these death and income benefits, under SOP 03-1, of $50 as of December 31, 2005. Declines in equity markets as well as a strengthening of the Japanese Yen in comparison to the U.S. dollar may increase the Company’s exposure to these guaranteed benefits. This increased exposure may be significant in extreme market scenarios. For the guaranteed death benefits, the Company pays the greater of (1) account value at death; (2) a guaranteed death benefit which, depending on the contract, may be based upon the premium paid and/or the maximum anniversary value established no later than age 80, as adjusted for withdrawals under the terms of the contract.. The guaranteed income benefit guarantees to return the contract holder’s initial investment, adjusted for any earnings withdrawals, through periodic payments that commence at the end of a minimum deferral period of 10, 15 or 20 years as elected by the contract holder.
In addition, the Company offers certain variable annuity products with a GMWB rider. GMWB is accounted for under SFAS No. 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. As of July 6, 2003, the Company exhausted all but a small portion of the reinsurance capacity for new business under the current arrangement and will be ceding only a very small number of new contracts subsequent to July 6, 2003. Substantially all new contracts with the GMWB are not covered by reinsurance. These unreinsured contracts are expected to generate volatility in net income as the underlying embedded derivative liabilities are recorded at fair value each reporting period, resulting in the recognition of net realized capital gains or losses in response to changes in certain critical factors including capital market conditions and policyholder behavior. In order to minimize the volatility associated with the unreinsured GMWB liabilities, the Company established an alternative risk management strategy. During the third quarter of 2003, the Company began hedging it’s unreinsured GMWB exposure using interest rate futures, S&P 500 Index and the National Association of Securities Dealers Automated Quotations (“NASDAQ”) Index put options and futures contracts. During the first quarter of 2004, the Company entered into Europe, Australasia and Far East (“EAFE”) Index swaps to hedge GMWB exposure to international equity markets. The hedging program involves a detailed monitoring of policyholder behavior and capital markets conditions on a daily basis and rebalancing of the hedge position as needed. While the Company actively manages this hedge position, hedge ineffectiveness may result due to factors including, but not limited to, policyholder behavior, capital markets dislocation or discontinuity and divergence between the performance of the underlying funds and the hedging indices.
In December 2004 and August 2005, the Company purchased one and two year S&P 500 Index put option contracts to economically hedge certain liabilities that could increase if the equity markets decline. As of December 31, 2005 and 2004, the notional value related to this strategy was $1.1 billion and $1.9 billion, respectively, while the fair value related to this strategy was $14 and $32, respectively. Because this strategy is intended to partially hedge certain equity-market sensitive liabilities calculated under statutory accounting (see Capital Resources and Liquidity), changes in the value of the put options may not be closely aligned to changes in liabilities determined in accordance with Generally Accepted Accounting Principles in the United States of America (“GAAP”), causing volatility in GAAP net income. The Company anticipates employing similar strategies in the future, which could further increase volatility in GAAP net income.
The functional currency of the Japanese operation is the Japanese yen. Accordingly, the premiums, claims, commissions and investment income are paid or received in yen. In addition, most of the Japanese operation’s investments are yen denominated. In 2003, the Company had entered into yen denominated forwards to hedge a substantial portion of the yen to U.S. dollar exchange rate
The liquidity requirements of Hartford Life have been and will continue to be met by funds from operations as well as the issuance of commercial paper, debt securities and borrowings from its credit facilities. The principal sources of operating funds for its insurance entities are fees, premiums and investment income as well as maturities and sales of invested assets. Hartford Life is a holding company which relies upon operating cash flow in the form of dividends from its subsidiaries, which enables it to service its debt, pay dividends to its parent, and pay certain business expenses. As a holding company, Hartford Life, Inc. has no significant business operations of its own and, therefore, relies mainly on the dividends from its insurance company subsidiaries, which are primarily domiciled in Connecticut, as the principal source of cash to meet its obligations (predominantly debt obligations) and pay stockholder dividends.
During the second quarter of 2005, the Company sought and secured approval of a proposed plan to change the ownership structure of HLIKK. The proposed plan provided for a change in the ownership of HLIKK whereby the stock of HLIKK, an insurance operating company, would be transferred to Hartford Life, Inc., HLA’s parent company. The proposed plan was approved by both the State of Connecticut Insurance Department, HLA’s primary regulator, as well as the FSA, HLIKK’s primary regulator. On September 1, 2005 this plan was executed and the stock of HLIKK was transferred from HLA to Hartford Life, Inc. The transfer of the stock has been treated as a return of capital for GAAP and statutory accounting purposes for the respective entities. This transaction had no effect on the Company’s consolidated financial statements. The primary financial effect of the transaction was to reduce the statutory capital of HLA by the amount of the carrying value of HLIKK, which was $963 as of September 1, 2005. In addition, for certain capital adequacy ratios, a corresponding reduction in required capital will occur, which will result in an improved capital adequacy ratio. However, as previously disclosed, this action could potentially reduce certain other capital adequacy ratios employed by the regulators and rating agencies to assess the capital growth of The Hartford’s life insurance operations. At the current time, taking into consideration the effects of the transaction, the Company believes it has sufficient capital resources to maintain capital solvency ratios consistent with all of its objectives.
Dividends to Hartford Life, Inc. from its direct subsidiary, Hartford Life and Accident Insurance Company (“HLA”), are restricted. The payment of dividends by Connecticut-domiciled insurers is limited under the insurance holding company laws of Connecticut. Under these laws, the insurance subsidiaries may only make their dividend payments out of unassigned surplus. These laws require notice to and approval by the state insurance commissioner for the declaration or payment of any dividend, which, together with other dividends or distributions made within the preceding twelve months, exceeds the greater of (i) 10% of the insurer’s policyholder surplus as of December 31 of the preceding year or (ii) net income (or net gain from operations, if such company is a life insurance
The primary uses of funds are to pay claims, policy benefits, operating expenses and commissions, and to purchase new investments. In addition, Hartford Life has a policy of carrying a significant short-term investment positions and accordingly does not anticipate selling intermediate 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 and Capital Markets Risk Management sections.)
Long-term debt obligations also includes principal and interest payments of $200 and $676, respectively, related to junior subordinated debentures which are callable beginning in 2006.
Estimated life, annuity and disability obligations include death and disability claims, policy surrenders, policyholder dividends , and trail commissions offset by expected future deposits and premiums on in-force contracts. Estimated contractual policyholder obligations are based on mortality, morbidity and lapse assumptions comparable with Life’s historical experience, modified for recent observed trends. Life has also assumed market growth and interest crediting consistent with assumptions used in amortizing deferred acquisition costs. In contrast to this table, the majority of Life’s obligations are recorded on the balance sheet at the current account value, as described in Critical Accounting Estimates, and do not incorporate an expectation of future market growth, interest crediting, or future deposits . Therefore, the estimated contractual policyholder obligations presented in this table significantly exceed the liabilities recorded in reserve 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 materially differ from actual results. As separate account obligations are legally insulated from general account obligations, the separate account obligations will be fully funded by cash flows from separate account assets. Life expects to fully fund the general account obligations from cash flows from general account investments and future deposits and premiums.
At December 31, 2005, the Company has outstanding commitments totaling $562, of which $265 is committed to fund limited partnership investments. These capital commitments can be called by the partnership during the commitment period (on average 2 to 5 years) to fund working capital needs or purchase new investments. Once the commitment period expires, the Company is under no obligation to fund the remaining unfunded commitment but may elect to do so. The remaining $297 of outstanding commitments are primarily related to various funding obligations associated with investments in mortgage and construction loans. These have a commitment period of one month to 3 years.
For a discussion of Debt, see Note 14 of Notes to Consolidated Financial Statements.
The Company declared $300 in dividends to Hartford Holdings, Inc. for 2005. Future dividend decisions will be based on, and affected by, a number of factors, including the operating results and financial requirements of the Company on a stand-alone basis and the impact of regulatory restrictions discussed in Liquidity Requirements below.
2004 Compared to 2003- The increase in cash provided by operating activities was primarily the result of the timing of funds received for policyholder accounts, net of the activity in the equity securities, held for trading purposes, and timing of the settlement of receivables and payables. The cash used for investing activities as compared to the prior year period was lower primarily due to higher sales of investments, partially offset by slightly higher purchases of investments. The decrease in net cash provided by financing activities was primarily due to a decrease in net receipts from policyholders accounts related to investment and universal life contracts,
The following table summarizes Hartford Life’s significant member companies’ financial ratings from the major independent rating organizations as of February 22, 2006.
employed such as hedging and reinsurance. The company expects the capital requirements to fluctuate primarily with changes in market levels and returns.
As at December 31, 2005 the implementation of C-3 Phase II Capital requirements had a positive impact on the Hartford’s life insurance companies’ NAIC RBC ratio.
For a discussion regarding contingencies related to the manner in which the Company compensates brokers and other producers, please see “Overview-Broker Compensation” above.
For further information on other contingencies, see Note 12 of Notes to Consolidated Financial Statements.
Legislation introduced in Congress would provide for new retirement and savings vehicles designed to simplify retirement plan administration and expand individual participation in retirement savings plans. If enacted, these proposals could have a material effect on sales of the Company’s life insurance and investment products. Prospects for enactment of this legislation in 2006 are uncertain.