Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) addresses the financial condition of Hartford Life Insurance Company and its subsidiaries (“Hartford Life Insurance Company” or the “Company”) as of and for the year ended December 31, 2016 compared with the comparable 2015 periods. Management’s narrative analysis of the results of operations is presented pursuant to General Instruction I (2) (a) of Form 10-K. This discussion should be read in conjunction with the Consolidated Financial Statements and related Notes beginning on page. Certain reclassifications have been made to prior year financial information to conform to the current year presentation.
The decrease in net income from 2015 to 2016 was primarily due to higher net realized capital losses, lower fee income, lower net investment income and higher benefits, losses and loss adjustment expenses and DAC amortization, partially offset by higher earned premiums and lower insurance operating costs and other expenses.
Fee income and other for the year ended December 31, 2016, decreased as compared to the prior year primarily due to the continued run-off of the variable annuity block of business. Earned premiums and benefits, losses and loss adjustment expenses increased for the year ended December 31, 2016, as compared to the prior year period, primarily due to the impact of the recapture of a reinsurance agreement with Hartford Life and Accident Insurance Company ("HLA"). Effective August 1, 2016, the Company recaptured a reinsurance agreement with HLA, a wholly owned subsidiary of Hartford Life, Inc. whereby the Company had ceded a single group annuity contract to HLA under a 100% quota share agreement. As a result of this recapture, the Company received a return of premium of $90 and increased reserves by $63 resulting in a recognized pre-tax gain of approximately $27.
The increase in DAC amortization for the year ended December 31, 2016 was primarily driven by a higher unfavorable unlock due to the reduction of the fixed annuity DAC balance to zero. For further discussion of the unlock, see MD&A - Estimated Gross Profits Used in the Valuation and Amortization of Assets and Liabilities Associated with Variable Annuity and Other Universal Life-Type Contracts.
Insurance operating costs and expenses decreased from 2015 to 2016 largely due to the runoff of the business requiring less staff and other operating expenses.
The effective tax rate differs from the U.S. Federal statutory rate of 35% in 2016 and 2015, primarily due to the separate account dividends received deduction. Income tax expense for the year ended December 31, 2015, included an income tax benefit of $36 related to intercompany tax settlements. For a reconciliation of the income tax provision at the U.S. Federal statutory rate to the provision for income taxes, see Note 9 - Income Taxes of Notes to Consolidated Financial Statements.
Includes equity securities at fair value using the FVO of $281 as of December 31, 2015. The Company did not hold any equity securities, FVO as of December 31, 2016.
Total investments decreased since December 31, 2015, primarily as a result of a decline in fixed maturities, AFS, equity, AFS and limited partnerships and other alternative investments, partially offset by an increase in short-term investments. The decrease in fixed maturities, AFS was primarily the result of the continued runoff of the Company's business. The decline in equity, AFS was primarily the result of sales which were reinvested into other assets classes. The decrease in limited partnerships and other alternative investments was primarily driven by redemptions in hedge funds which were reinvested into other asset classes. The increase in short-term investments was primarily due to holding more short-term investments until those assets are reinvested into longer duration asset classes.
Year ended December 31, 2016, compared to the year ended December 31, 2015
Total net investment income decreased primarily due to lower make-whole payments on fixed maturities and prepayment penalties on mortgage loans, as well as lower asset levels and reinvesting at lower interest rates.
The annualized net investment income yield, excluding limited partnerships and other alternative investments, decreased slightly, to 4.5% in 2016, versus 4.6% in 2015. The decrease was primarily attributable to higher income received in 2015 from previously impaired securities, make-whole payments on fixed maturities and prepayment penalties on mortgage loans. Excluding make-whole payments on fixed maturities, income received from previously impaired securities, and prepayment penalties on mortgage loans, the annualized investment income yield, excluding limited partnerships and other alternative investments, was 4.4% in 2016 and 4.3% in 2015.
The new money yield, excluding certain U.S. Treasury securities and cash equivalent securities, for the year ended December 31, 2016 was approximately 3.5%, which was below the average yield of sales and maturities of 4.0% for the same period. For the year ended December 31, 2016, the new money yield of 3.5% increased slightly from 3.4% in 2015 largely due to an increase in interest rates.
Gross gains and losses on sales for the year ended December 31, 2016, were primarily due to sales of corporate securities and U.S. Treasuries as a result of duration, liquidity and credit management.
Gross gains and losses on sales for the year ended December 31, 2015, were primarily due to sales of corporate, U.S. treasury, and equity securities. The sales were primarily a result of duration, liquidity and credit management, as well as tactical changes to the portfolio as a result of changing market conditions, including sales to reduce exposure to energy, emerging markets and other below investment grade corporate securities.
For the year ended December 31, 2016, the loss related to the combined GMWB derivatives, net, which include the GMWB product, reinsurance, and hedging derivatives, was primarily driven by losses of $53 due to liability/model assumption updates, $22 due to the effect of increases in equity markets and losses of $12 resulting from regression updates and other changes, partially offset by gains of $40 resulting from policyholder behavior and $29 related to an outperformance of the underlying actively managed funds compared to their respective indices. The macro hedge program loss was primarily due to a loss of $96 due to an increase in equity markets and a loss of $58 driven by time decay on options.
For the year ended December 31, 2015, the loss related to the combined GMWB derivatives, net, which include the GMWB product, reinsurance, and hedging derivatives, was primarily driven by losses of $42 due to liability/model assumption updates, and losses of $18 resulting from an underperformance of the underlying actively managed funds compared to their respective indices. The loss on the macro hedge program for the year ended December 31, 2015 was primarily due to a loss of $44 driven by time decay on options.
The net loss for the year ended December 31, 2016, was primarily driven by tightening of credit spreads, partially offset by higher interest rates. Modified coinsurance reinsurance contracts are accounted for as embedded derivatives and transfer to the reinsurer the investment experience related to the assets supporting the reinsured policies.
The net gain for the year ended December 31, 2015, was primarily driven by widening credit spreads and an increase in interest rates.
Estimated gross profits (“EGPs”) are used in the valuation and amortization of assets, including deferred policy acquisition cost ("DAC"). Portions of EGPs are also used in the valuation of reserves for death and other insurance benefit features on variable annuity and other universal life type contracts.
In the fourth quarter of 2016, the Company completed a comprehensive policyholder behavior assumption study which resulted in a non-market related after-tax charge of $17 and incorporated the results of that study into its projection of future gross profits. Additionally, throughout the year, the Company evaluates various aspects of policyholder behavior and will revise its policyholder assumptions if credible emerging data indicates that changes are warranted. The Company will continue to evaluate its assumptions related to policyholder behavior as initiatives to reduce the size of the annuity business are implemented by management. Upon completion of an annual assumption study or evaluation of credible new information, the Company will revise its assumptions to reflect its current best estimate. These assumption revisions will change the projected account values and the related EGPs in the DAC amortization models, as well as the death and other insurance benefit reserving model.
After each quarterly Unlock, the Company also tests the aggregate recoverability of DAC by comparing the DAC balance to the present value of future EGPs. The margin between the DAC balance and the present value of future EGPs for variable annuities was 34% as of December 31, 2016. If the margin between the DAC asset and the present value of future EGPs is exhausted, then further reductions in EGPs would cause portions of DAC to be unrecoverable and the DAC asset would be written down to equal future EGPs.
For further discussion on the impact of fair value changes from living benefits see Note 2 - Fair Value Measurements of Notes to the Consolidated Financial Statements, and for a discussion on the sensitivities of certain living benefits due to capital market factors see Part II, Item 7, MD&A - Variable Product Guarantee Risks and Risk Management.
Deferred tax assets represent the tax benefit of future deductible temporary differences and tax credit carryforwards. Deferred tax assets are measured using the enacted tax rates expected to be in effect when such benefits are realized if there is no change in tax law. Under U.S. GAAP, we test the value of deferred tax assets for impairment on a quarterly basis at the entity level within each tax jurisdiction, consistent with our filed tax returns. Deferred tax assets are reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion, or all, of the deferred tax assets will not be realized. The determination of the valuation allowance for our deferred tax assets requires management to make certain judgments and assumptions. In evaluating the ability to recover deferred tax assets, we have considered all available evidence as of December 31, 2016 including past operating results, forecasted earnings, future taxable income, and prudent and feasible tax planning strategies. In the event we determine it is more likely than not that we will not be able to realize all or part of our deferred tax assets in the future, an increase to the valuation allowance would be charged to earnings in the period such determination is made. Likewise, if it is later determined that it is more likely than not that those deferred tax assets would be realized, the previously provided valuation allowance would be reversed. Our judgments and assumptions are subject to change given the inherent uncertainty in predicting future performance and specific industry and investment market conditions.
As of December 31, 2016 and 2015, the Company had no valuation allowance. In assessing the need for a valuation allowance, management considered future taxable temporary difference reversals, future taxable income exclusive of reversing temporary differences and carryovers, taxable income in open carry back years and other tax planning strategies. From time to time, tax planning strategies could include holding a portion of debt securities with market value losses until recovery, altering the level of tax exempt securities held, making investments which have specific tax characteristics, and business considerations such as asset-liability matching. Management views such tax planning strategies as prudent and feasible and would implement them, if necessary, to realize the deferred tax assets.
An increase in interest rates from current levels is generally a favorable development for the Company. Interest rate increases are expected to provide additional net investment income, reduce the cost of the variable annuity hedging program, and limit the potential risk of margin erosion due to minimum guaranteed crediting rates in certain products. However, 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. An increase in interest rates may also impact the Company’s tax planning strategies and in particular its ability to utilize tax benefits of previously recognized realized capital losses.
A decline in interest rates results in certain mortgage-backed and municipal securities being more susceptible to paydowns and prepayments or calls. During such periods, the Company generally will not be able to reinvest the proceeds at comparable yields. Lower interest rates will also likely result in lower net investment income, increased hedging costs associated with variable annuities and, if declines are sustained for a long period of time, it may subject the Company to reinvestment risk and possibly reduced profit margins associated with guaranteed crediting rates on certain products. Conversely, the fair value of the investment portfolio will increase when interest rates decline.
Asset accumulation vehicles primarily require a fixed rate payment, often for a specified period of time, and fixed rate annuities contain surrender values that are based upon a market value adjusted formula if held for shorter periods. In addition, certain products such as corporate owned life insurance contracts and the general account portion of variable annuity products credit interest to policyholders subject to market conditions and minimum interest rate guarantees. As of December 31, 2016 and 2015, the Company had $5,187 and $5,613, respectively, of liabilities for fixed annuities and $194 and $192, respectively, of liabilities for guaranteed investment products.
As of December 31, 2016, the Company has reinsurance recoverables from MassMutual and Prudential of $8.6 billion and $10.8 billion, respectively. As of December 31, 2015, the Company has reinsurance recoverables from MassMutual and Prudential of $8.6 billion and $10.4 billion, respectively. The Company's obligations to its direct policyholders that have been reinsured to MassMutual and Prudential are secured by invested assets held in trust. Net of invested assets held in trust, as of December 31, 2016, the Company has $1.2 billion of reinsurance recoverables from Prudential representing approximately 15% of the Company's consolidated stockholder's equity. As of December 31, 2016, the Company has no other reinsurance-related concentrations of credit risk greater than 10% of the Company’s Consolidated Stockholder's Equity.
The NAR is generally defined as the guaranteed minimum benefit amount in excess of the contractholder’s current account value. Variable annuity account values with guarantee features were $40.7 billion and $44.2 billion as of December 31, 2016 and December 31, 2015, respectively.
While the Company actively manages this dynamic hedging program, increased U.S. GAAP earnings volatility may result from factors including, but not limited to: policyholder behavior, capital markets, divergence between the performance of the underlying funds and the hedging indices, changes in hedging positions and the relative emphasis placed on various risk management objectives.
The underlying guaranteed withdrawal benefit liabilities (excluding the life contingent GMWB contracts) and hedge assets within the GMWB hedge and Macro hedge programs are carried at fair value.
Changes in relative values between currencies can create variability in cash flows and realized or unrealized gains and losses on changes in the fair value of assets and liabilities. Based on the fair values of the Company’s non-U.S. dollar denominated securities and derivative instruments as of December 31, 2016 and 2015, management estimates that a hypothetical 10% unfavorable change in exchange rates would decrease the fair values by an immaterial amount.
The Company has entered into pay U.S. dollar, receive yen swap contracts to hedge the currency exposure between the U.S. dollar denominated assets and the yen denominated fixed liability reinsurance payments.
Rising equity markets will generally result in an increase in statutory surplus and RBC ratios. However, as a result of a number of factors and market conditions, including the level of hedging costs and other risk transfer activities, reserve requirements for death and living benefit guarantees and RBC requirements could increase with rising equity markets, resulting in lower RBC ratios. The Company has reinsured approximately 39% of its risk associated with GMWB and 79% of its risk associated with the aggregate GMDB exposure. These reinsurance agreements reduce the Company’s exposure to changes in the statutory reserves and the related capital and RBC ratios associated with changes in the capital markets.
The Company also enters into credit default swaps that assume credit risk as part of replication transactions. Replication transactions are used as an economical means to synthetically replicate the characteristics and performance of assets that are permissible investments under the Company’s investment policies. These swaps reference investment grade single corporate issuers and baskets, which include customized diversified portfolios of corporate issuers, which are established within sector concentration limits and may be divided into tranches which possess different credit ratings. As of December 31, 2016 and 2015, the notional amount related to credit derivatives that assume credit risk was $458 and $1.4 billion, respectively, while the fair value was $4 and $(10), respectively. These amounts do not include positions that are in offsetting relationships.
The decline in the fair value of AFS securities as compared to December 31, 2015 was due to the continued run-off of the Company's business. The Company also reduced its allocation to financial services and U.S. Treasuries and purchased RMBS.
The Company also has exposure to CRE CDOs with an amortized cost and fair value of $13 and $30, respectively, as of December 31, 2016, and $85 and $119, respectively, as of December 31, 2015. These securities are comprised of pools of commercial mortgage loans or equity positions of other CMBS securitizations.
For the year ended December 31, 2016, there was no change in valuation allowances on mortgage loans.
For the year ended December 31, 2015, the change in valuation allowances on mortgage loan additions of $4 was largely driven by individual property performance.
Total gross unrealized losses were $206 as of December 31, 2016, and have decreased $136, or 40%, from December 31, 2015, due to tighter credit spreads, partially offset by a rise in interest rates. As of December 31, 2016, $202 of the gross unrealized losses were associated with securities depressed less than 20% of cost or amortized cost. The remaining $4 of gross unrealized losses were associated with securities depressed greater than 20%. The securities depressed more than 20% are primarily securities with exposure to commercial real estate and corporate securities in the energy sector that decreased in value primarily due to wider credit spreads since the securities were purchased.
As part of the Company’s ongoing security monitoring process, the Company has reviewed its AFS securities in an unrealized loss position and concluded that these securities are temporarily depressed and are expected to recover in value as the securities approach maturity or as market spreads tighten. For these securities in an unrealized loss position where a credit impairment has not been recorded, the Company’s best estimate of expected future cash flows are sufficient to recover the amortized cost basis of the security. Furthermore, the Company neither has an intention to sell nor does it expect to be required to sell these securities. For further information regarding the Company’s impairment analysis, see Other-Than-Temporary Impairments in the Investment Portfolio Risks and Risk Management section of this MD&A.
The following table presents the Company’s unrealized loss aging for AFS securities continuously depressed over 20% by length of time (also included in the table above).
For the year ended December 31, 2016, impairments recognized in earnings were comprised of credit impairments of $22, securities that the Company intends to sell ("intent-to-sell impairments") of $4 and impairments on equity securities of $2.
For the year ended December 31, 2015, impairments recognized in earnings were comprised of intent-to-sell impairments of $24 and credit impairments of $23, both of which were primarily concentrated in corporate securities. Also, impairments recognized in earnings included impairments on equity securities of $14 that were in an unrealized loss position and the Company no longer believed the securities would recover in the foreseeable future.
The Hartford has an intercompany liquidity agreement that allows for short-term advances of funds among The Hartford Financial Services Group, Inc. (“HFSG Holding Company”) and certain affiliates of up to $2.0 billion for liquidity and other general corporate purposes. The Connecticut Insurance Department ("CTDOI") granted approval for certain affiliated insurance companies that are parties to the agreement to treat receivables from a parent, including the HFSG Holding Company, as admitted assets for statutory accounting purposes. As of December 31, 2016, there were no amounts outstanding from the HFSG Holding Company.
The Company is a member of the Federal Home Loan Bank of Boston (“FHLBB”). Membership allows the Company access to collateralized advances, which may be used to support various spread-based business and enhance liquidity management. FHLBB membership requires the company to own member stock and advances require the purchase of activity stock. The amount of advances that can be taken are dependent on the asset types pledged to secure the advances. The Connecticut Department of Insurance (“CTDOI”) will permit the Company to pledge up to $1.1 billion in qualifying assets to secure FHLBB advances for 2017. The pledge limit is recalculated annually based on statutory admitted assets and capital and surplus. The Company would need to seek the prior approval of the CTDOI in order to exceed these limits. As of December 31, 2016, HLIC had no advances outstanding under the FHLBB facility.
Relates to annuities that are recorded in the general account under U.S. GAAP as the contractholders are subject to the Company's credit risk, although these annuities are held in a statutory separate account. In the statutory separate account, the Company is required to maintain invested assets with a fair value greater than or equal to the MVA surrender value of the Fixed MVA contract. In the event assets decline in value at a greater rate than the MVA surrender value of the Fixed MVA contract, the Company is required to contribute additional capital to the statutory separate account. The Company will fund these required contributions with operating cash flows or short-term investments. In the event that operating cash flows or short-term investments are not sufficient to fund required contributions, the Company may have to sell other invested assets at a loss, potentially resulting in a decrease in statutory surplus. As the fair value of invested assets in the statutory separate account are at least equal to the MVA surrender value of the Fixed MVA contract, surrender of Fixed MVA annuities will have an insignificant impact on the liquidity requirements of the Company.
The following table summarizes the Company’s contractual obligations as of December 31, 2016:
Included in purchase obligations is $30 relating to contractual commitments to purchase various goods and services such as maintenance and information technology in the normal course of business. Purchase obligations exclude contracts that are cancelable without penalty, or contracts that do not specify minimum levels of goods or services to be purchased.
Net cash provided by operating activities increased in 2016 as compared to 2015 primarily due to the receipt of income tax refunds and decreases in claims paid and operating expenses paid in 2016.
Net cash provided by investing activities in 2016 primarily relates to net proceeds from available-for-sale securities of approximately $1.5 billion, partially offset by net payments for short-term investments of $769. Net cash provided by investing activities in 2015 primarily relates to net proceeds from short-term investments of approximately $1.6 billion.
Net cash used for financing activities in 2016 relates to net payments for deposits, transfers and withdrawals for investment and universal life-type contracts of approximately $0.9 billion and the return of capital to the parent of approximately $0.8 billion. Net cash used for financing activities in 2015 relates to the return of capital to the parent of approximately $1.0 billion and net payments for deposits, transfers and withdrawals for investment and universal life-type contracts of approximately $1.3 billion.
The following table summarizes Hartford Life Insurance Company’s significant member companies’ financial ratings from the major independent rating organizations as of February 22, 2017:
The assumptions used in the determination of benefit reserves are prescribed under U.S. STAT, while the assumptions used under U.S. GAAP are generally the Company’s best estimates. The methodologies for determining life insurance reserve amounts are also different. For example, reserving for living benefit reserves under U.S. STAT is generally addressed by the Commissioners’ Annuity Reserving Valuation Methodology and the related Actuarial Guidelines, while under U.S. GAAP, those same living benefits are either embedded derivatives recorded at fair value or are recorded as additional minimum guarantee benefit reserves. The sensitivity of these life insurance reserves to changes in equity markets, as applicable, will be different between U.S. GAAP and U.S. STAT.