MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (DOLLAR AMOUNTS IN MILLIONS, EXCEPT PER SHARE DATA, UNLESS OTHERWISE STATED)
Certain of the statements contained herein or in Part I of the Company's Form 10-K (other than statements of historical fact) are forward-looking statements. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include estimates and assumptions related to economic, competitive and legislative developments. These forward-looking statements are subject to change and uncertainty which are, in many instances, beyond the Company's control and have been made based upon management's expectations and beliefs concerning future developments and their potential effect upon the Company. There can be no assurance that future developments will be in accordance with management's expectations or that the effect of future developments on The Hartford will be those anticipated by management. Actual results could differ materially from those expected by the Company, depending on the outcome of various factors. These factors include: the uncertain nature of damage theories and loss amounts and the development of additional facts related to the September 11 terrorist attack ("September 11"); the response of reinsurance companies under reinsurance contracts, the impact of increasing reinsurance rates, and the adequacy of reinsurance to protect the Company against losses; the possibility of more unfavorable loss experience than anticipated; the possibility of general economic and business conditions that are less favorable than anticipated; the incidence and severity of catastrophes, both natural and man-made; the effect of changes in interest rates, the stock markets or other financial markets; stronger than anticipated competitive activity; unfavorable legislative, regulatory or judicial developments; the difficulty in predicting the Company's potential exposure for environmental and asbestos claims and related litigation; the Company's ability to distribute its products through distribution channels, both current and future; the uncertain effects of emerging claim and coverage issues; the effect of assessments and other surcharges for guaranty funds and second-injury funds and other mandatory pooling arrangements; a downgrade in the Company's claims-paying, financial strength or credit ratings; the ability of the Company's subsidiaries to pay dividends to the Company; and other factors described in such forward-looking statements.
2001 COMPARED TO 2000 -- Revenues increased $444, or 3%. Included in revenues in 2001 was a $91 reduction in North American Property & Casualty premiums, resulting from additional reinsurance cessions related to September 11. Also included in revenues were net realized capital losses of $236 in 2001 and net realized capital gains of $145 in 2000. These capital gains and losses related primarily to the sales of international subsidiaries and other than temporary impairments on securities. Excluding the effects of both September 11 and the net realized capital gains and losses, revenues increased $916, or 6%. The increase was related to continued new business growth in Group Benefits, increased fee income in Individual Life, primarily as a result of the April 2001 acquisition of the United States individual life insurance, annuity and mutual fund businesses of Fortis, Inc. (operating as "Fortis" or "Fortis Financial Group") and earned premium growth in most of the Property & Casualty underwriting segments. (For further discussion of the Fortis acquisition, see Note 18 (a) of Notes to Consolidated Financial Statements). Also contributing to the increase was higher net investment income, primarily due to income earned on fixed maturities. These increases were partially offset by a decrease in revenues in the Other Operations segment, reflecting the sales of Property & Casualty's international subsidiaries.
Tax-exempt interest earned on invested assets was the principal cause of effective rates lower than the 35% United States statutory rate in all years. Income taxes paid (received) in 2001, 2000 and 1999 were $(52), $95 and $41, respectively. (See Note 14 of Notes to Consolidated Financial Statements for further information.)
2001 2000 1999 - ------------------------------------------------------------------- Basic earnings per share $2.13 $4.42 $3.83 Diluted earnings per share $2.10 $4.34 $3.79 Weighted average common shares outstanding 237.7 220.6 224.9 Weighted average common shares outstanding and dilutive potential common shares 241.4 224.4 227.5 Return on equity excluding September 11 and Life tax benefit [1] 10.5% 15.4% 15.3% Return on equity [1] 6.6% 15.4% 15.3% - ------------------------------------------------------------------- [1] Calculated by dividing net income by average equity excluding unrealized gain (loss), after-tax.
The Hartford is organized into two major operations: Life and Property & Casualty. Within these operations, The Hartford conducts business principally in ten operating segments. Additionally, all activities related to The HLI Repurchase and the minority interest in HLI for pre-acquisition periods are included in Corporate.
Property & Casualty was reorganized into six reportable operating segments and, effective January 1, 2001, is reported as the North American underwriting segments of Business Insurance, Affinity Personal Lines, Personal Insurance, Specialty Commercial and Reinsurance; and the Other Operations segment, formerly "International and Other Operations".
The measure of profit or loss used by The Hartford's management in evaluating performance is operating income, except for its North American underwriting segments, which are evaluated by The Hartford's management primarily based upon underwriting results. While not considered segments, the Company also reports and evaluates operating income results for Life, Property & Casualty, and North American, which includes the combined underwriting results of the North American underwriting segments along with income and expense items not directly allocable to these segments, such as
Certain transactions between segments occur during the year that primarily relate to tax settlements, insurance coverage, expense reimbursements, services provided and capital contributions. Certain reinsurance stop loss agreements exist between the segments which specify that one segment will reimburse another for losses incurred in excess of a predetermined limit. Also, one segment may purchase group annuity contracts from another to fund pension costs and claim annuities to settle casualty claims. In addition, certain intersegment transactions occur in Life. These transactions include interest income on allocated surplus and the allocation of net realized capital gains and losses through net invested income utilizing the duration of the segment's investment portfolios.
Life provides investment and retirement products such as variable and fixed annuities; mutual funds, and retirement plan services; individual and corporate owned life insurance; and group benefit products, such as group life and group disability insurance.
Life derives its revenues principally from: (a) fee income, including asset management fees on separate account and mutual fund assets and mortality and expense fees, as well as cost of insurance charges; (b) fully insured premiums; (c) certain other fees; and (d) net investment income on general account assets. Asset management fees and mortality and expense fees are primarily generated from separate account assets, which are deposited with the Company through the sale of variable annuity and variable life products, and mutual funds. Cost of insurance charges are assessed on the net amount at risk for investment-oriented life insurance products. Premium revenues are derived primarily from the sale of group life and group disability insurance products.
Life's profitability depends largely on the amount of assets under management, the level of fully insured premiums, the adequacy of product pricing and underwriting discipline, claims management and operating efficiencies, and its ability to earn target spreads between earned investment rates on general account assets and credited rates to customers. The level of assets under management is generally impacted by equity market performance, persistency of the in-force block of business, sales and other deposits, as well as any acquired blocks of business.
On June 27, 2000, The Hartford acquired all of the outstanding shares of HLI that it did not already own. (For additional information, see the Capital Resources and Liquidity section
Benefits claims and expenses increased $582, or 11%, primarily associated with the growth in Life revenues discussed above.
Benefits, claims and expenses increased $352, or 7%, primarily related to the growth in Life's principal operating segments described above.
Operating income increased $165, or 35%, led by the Investment Products segment, where operating income increased $94, or 28%. Additionally, operating income related to each of the remaining three operating segments increased 10% or more. As discussed above, Life also recorded benefits of $32 in 2000 related to favorable tax items. Excluding these tax items, operating income increased $133, or 28%.
2001 COMPARED TO 2000 -- Revenues in the Investment Products segment increased $126, or 5%, driven primarily by other investment products. Fee income from other investment products increased $59, or 21%, principally due to growth in Life's mutual fund assets under management. Mutual fund assets increased $5.4 billion, or 47%, to $16.8 billion as of
Benefits, claims and expenses increased $121, or 7%, driven by higher interest credited and insurance operating expenses related to other investment products consistent with the revenue growth described above. Interest credited related to other investment products increased $83, or 18%, while insurance operating expenses increased $44, or 17%. Also, individual annuity benefits and claims expenses increased $35, or 14%, principally due to the business acquired from Fortis and higher death benefits resulting from the lower equity markets in 2001. Individual annuity's insurance operating costs increased $13, or 4%, due to the business acquired from Fortis. Excluding Fortis, individual annuity's operating expenses decreased $39, or 4%, from prior year, driven by management's continued focus on maintaining operating expense levels. Partially offsetting the increase in benefits, claims, and insurance operating costs was a decrease in amortization of deferred policy acquisition costs resulting from the lower gross profits associated with the individual annuity business. In addition, income tax expense for the twelve months ended December 31, 2001 was $118, a $45, or 28%, decrease due to lower pretax operating income and the ongoing tax impact related to separate account investment activity.
Operating income increased $94, or 28%, primarily due to the growth in revenues discussed above. Additionally, the Investment Products segment continued to maintain its profit margins related to its primary businesses, thus contributing to the segment's earnings growth. In particular, its individual annuity operation's operating expenses as a percentage of average individual annuity account values remained consistent with the prior year at 21 basis points.
The market for retirement products continues to expand as individuals increasingly save and plan for retirement. Demographic trends suggest that as the "baby boom" generation matures, a significant portion of the United States population will allocate a greater percentage of their disposable incomes to saving for their retirement years due to uncertainty surrounding the Social Security system and increases in average life expectancy. As this market grows, particularly for variable annuities and mutual funds, new companies are continually entering the market, aggressively seeking distribution channels and pursuing market share. This trend is not expected to subside, particularly in light of the Gramm-Leach-Bliley Act of 1999 ("the Financial Services Modernization Act"), which permits affiliations among banks, insurance companies and securities firms.
Management believes that it has developed and implemented strategies to maintain and enhance its position as a market leader in the financial services industry. For example, The Hartford is introducing a tax advantaged college savings product (529 plan) in early 2002 called SMART 529. SMART 529 is a state-sponsored education savings program established by the State of West Virginia which offers an easy way for both the residents of West Virginia and out-of-state participants to invest for a college education. SMART 529 will allow investors to choose from a wide variety of investment portfolios to match their risk preference to help accumulate savings for college. The SMART 529 product complements Hartford Life's existing offering of investment products (mutual funds, variable annuities, 401 (k), 457 and 403 (b) plans). It also leverages The Company's capabilities in distribution, service and fund performance. The Hartford believes this is a significant market opportunity and the benefits of investing in 529 plans will be well received by many Americans saving for college.
Benefits, claims and expenses increased $190, or 36%, due principally to the growth in revenues described above. Although death benefits were higher in 2001 than the prior year as a result of the increase in life insurance in force, year-to-date mortality experience (expressed as death claims as a percentage of net amount at risk) for 2001 was within pricing assumptions.
Operating income increased $42, or 53%, primarily due to the revenue growth described above. Individual Life incurred an after-tax loss of $3 related to September 11. Excluding this loss, operating income increased $45, or 57%, primarily due to the growth factors described above.
Benefits, claims and expenses increased $47, or 10%, primarily due to a $16, or 6%, increase in benefits, claims and claim adjustment expenses and a $16, or 12%, increase in amortization of deferred policy acquisition costs mostly associated with the growth in this segment's variable business. Additionally, insurance operating costs and other expenses increased $15, or 17%, directly associated with the growth in this segment as previously described.
Operating income increased $16, or 18%, driven by overall revenue growth and consistent loss and expense ratios as compared to the prior year. Group Benefits incurred an after-tax loss of $2 related to September 11; excluding this loss, operating income increased $18, or 20%. 2000 COMPARED TO 1999 -- Revenues increased $183, or 9%, driven primarily by growth in fully insured premiums, excluding buyouts, which increased $182, or 10%, principally due to favorable persistency of the in force block of business, as well as new sales. Also contributing to the revenue growth was an increase in net investment income of $31, or 16%.
Total benefits, claims and expenses increased $171, or 9%, primarily due to higher benefits, claims and claim adjustment expenses which, excluding buyouts, increased $168, or 12%, directly related to revenue growth in this segment. The segment's combined ratio (ratio of total benefits, claims and expenses as a percentage of earned premiums and other) was consistent with the prior year.
Operating income increased $11, or 14%, primarily driven by the increased revenues described above.
Operating income increased $3, or 9%, primarily due to the overall growth in variable COLI business and earnings associated with the leveraged COLI business recaptured in 1998. COLI incurred an after-tax charge of $2 related to September 11; excluding this charge, operating income increased $5, or 15%.
Total benefits, claims and expenses decreased $70, or 9%, primarily due to the factor described above.
Operating income increased $4, or 13%, principally due to the variable COLI business where related account values increased $3.6 billion, or 29%, as well as earnings associated with a block of leveraged COLI business recaptured in 1998.
As discussed above, Property & Casualty was reorganized into six reportable operating segments and, effective January 1, 2001, is reported as the North American underwriting segments of Business Insurance, Affinity Personal Lines, Personal Insurance, Specialty Commercial and Reinsurance; and the Other Operations segment. Also reported within Property & Casualty is North American, which includes the combined underwriting results of the North American underwriting segments along with income and expense items not directly allocable to these segments, such as net investment income, net realized capital gains and losses, other expenses including interest and income taxes.
The following is a summary of Property & Casualty operating income, after-tax. Operating income excludes net realized capital gains and losses, restructuring charges, extraordinary items and the cumulative effect of accounting changes.
Underwriting results are discussed in each of the Business Insurance, Affinity Personal Lines, Personal Insurance, Specialty Commercial and Reinsurance segment sections. Net investment income and net realized capital gains and losses are
discussed in the Investments section. (For a further discussion of September 11, see Capital Resources and Liquidity section and Note 2 of Notes to Consolidated Financial Statements.)
2001 COMPARED TO 2000 -- Operating income decreased $443 as compared with 2000. Excluding the $420 impact of September 11, operating income decreased $23, or 5%. Earned premium growth in Business Insurance due to price increases, strong new business growth and improved premium renewal retention, as well as an increase in North American investment income, was offset by increased losses in the personal automobile lines of business and in Reinsurance. A decrease in underwriting results of $16, after-tax, related to Enron Corporation and lower income resulting from the sales of international subsidiaries also contributed to the decrease.
Business Insurance provides workers' compensation, property, automobile and liability coverages to small ("Select Customer") and mid-sized ("Key Accounts") commercial businesses primarily throughout the United States. This segment also provides commercial risk management products and services to small and mid-sized members of affinity groups in addition to marine coverage.
2001 COMPARED TO 2000 -- Written premiums increased $481, or 20%, driven by strong growth in Select Customer and Key Accounts. Select Customer increased $209, or 19%, as a result of pricing increases, strong premium renewal retention and the success of product, marketing, technology and service growth initiatives. The increase in Key Accounts of $195, or 19%, was attributable primarily to significant pricing increases and improved premium renewal retention as well as strong new business growth.
2000 COMPARED TO 1999 -- Written premiums increased $178, or 8%, primarily as a result of strong growth in Select Customer, up $171, or 19%. Enhanced product offerings, targeted geographic strategies and new business growth coupled with mid-single digit price increases were the primary drivers of the Select Customer growth. This increase was slightly offset by a 2% decrease in Key Accounts. The decline in mid-market premiums reflected the effective execution of the Company's underwriting initiatives, although significant price increases partially mitigated this decrease.
Underwriting results improved $73, or 5.0 combined ratio points, primarily the result of reduced loss ratios due to the effective execution of pricing actions and lower catastrophe losses. A decrease in the expense ratio, despite field and claim reorganization costs, also contributed to the lower combined ratio.
Excluding the impact of September 11, underwriting results decreased $53, with a corresponding 2.8 point increase in the combined ratio. Higher automobile losses continue to adversely impact underwriting results and the combined ratio. In addition, the loss adjustment expense ratio increased, primarily as a result of higher losses and increased litigation costs. Although underwriting expenses increased, primarily due to increased written premiums, the expense ratio improved slightly as compared to the prior year, primarily as a result of prudent expense management.
Personal Insurance provides automobile, homeowners and home-based business coverages to individuals across the United States. Personal Insurance is organized to provide products and services to individuals who prefer local agent involvement through a network of independent agents in the standard personal lines market and through Omni Insurance Group ("Omni"), in the non-standard automobile market.
2001 COMPARED TO 2000 -- Written premiums increased $33, or 3%, primarily due to premium growth in the standard automobile and homeowners lines as a result of pricing increases and strong premium renewal retention. Premium declines in non-standard auto reflect decreased policy counts, the result of significant price increases to address loss cost issues.
Excluding the impact of September 11, underwriting results decreased $27, with a corresponding 2.6 point increase in the combined ratio. Increased automobile losses in both standard and non-standard adversely impacted the underwriting results and combined ratios. In addition, higher losses and increased litigation costs resulted in an increase in the loss adjustment expense ratio. Partially offsetting the combined ratio increase was improvement in the expense ratio, primarily due to lower commissions and prudent expense management.
2000 COMPARED TO 1999 -- Written premiums increased $45, or 5%, due primarily to policy count growth and improved renewal retention in the standard automobile and homeowners' lines. Non-standard automobile written premiums through Omni decreased for the year as a result of an expected consumer reaction to rate increases in certain states.
Underwriting results decreased $30, with a corresponding 1.9 point increase in the combined ratio. The decrease in underwriting results and related increase in the combined ratio were primarily due to increased standard and non-standard automobile losses. Partially offsetting this decrease was an improvement in the homeowners line of business. A 1.4 point decrease in the expense ratio for the year reflected the continued trend of productivity gains from prior initiatives.
The personal lines industry is struggling to regain its momentum towards profitability as rising loss costs resulting from inflation in both medical and automobile repair costs have adversely impacted results. In addition, September 11 will likely have negative short-term implications to the industry in the form of lower investment yields and higher reinsurance rates. More severe catastrophes could also impact future results. Management does believe, however, that with increased rate activity, the personal lines industry will be positioned for recovery.
Underwriting results decreased $55, impacting the combined ratio by 2.0 points, primarily the result of increased losses and loss adjustment expenses in the property and bond lines of business as well as in PENCO and Canada. The combined ratio was adversely impacted by the higher loss ratios. The increase in the combined ratio was partially offset by a decrease in the expense ratio.
Underwriting results decreased $25, with a corresponding 1.7 point increase in the combined ratio. This decrease was primarily due to adverse prior underwriting years loss development, partially offset by lower property catastrophe losses.
The Other Operations segment results include activity for the Company's international property and casualty businesses up until their dates of sale as discussed below. Products offered by these companies included property and casualty products in both personal and commercial lines as well as life insurance products and services designed to meet the needs of local customers. The sale of all of The Hartford's property and casualty international businesses continued the Company's strategic shift in its international operations to emphasize growth opportunities in asset accumulation business.
On February 8, 2001, The Hartford completed the sale of its Spain-based subsidiary, Hartford Seguros. The Hartford received $29, before costs of sale and recorded a $16 after-tax net realized capital loss which was reported in the 2001 investment results of North American.
On December 22, 2000, The Hartford completed the sale of Zwolsche located in the Netherlands, Belgium and Luxembourg. The Hartford received $547, before costs of sale and recorded a $69 after-tax net realized capital gain which was reported in the 2000 investment results of North American.
2000 COMPARED TO 1999 -- Revenues were down $59, or 9%, primarily due to lower earned premiums at Zwolsche. Operating income was down $5, or 23%, primarily due to a higher calendar year loss ratio in automobile business in Hartford Seguros and unfavorable foreign exchange impacts.
In accordance with applicable insurance regulations under which Life operates, life insurance subsidiaries of The Hartford establish and carry as liabilities actuarially determined reserves which are calculated to meet The Hartford's future obligations. Reserves for life insurance and disability contracts are based on actuarially recognized methods using prescribed morbidity and mortality tables in general use in the United States, which are modified to reflect The Hartford's actual experience when appropriate. These reserves are computed at amounts that, with additions from estimated premiums to be received and with interest on such reserves compounded annually at certain assumed rates, are expected to be sufficient to meet The Hartford's policy obligations at their maturities or in the event of an insured's death. Reserves also include unearned premiums, premium deposits, claims incurred but not reported ("IBNR") and claims reported but not yet paid. Reserves for assumed reinsurance are computed in a manner that is comparable to direct insurance reserves.
by product, and generally decreases gradually during the penalty period. Surrender charges are set at levels to protect The Hartford from loss on early terminations and to reduce the likelihood of policyholders terminating their policies during periods of increasing interest rates, thereby lengthening the effective duration of policy liabilities and improving the Company's ability to maintain profitability on such policies.
The Hartford continually reviews the adequacy of its estimated claims and claim adjustment expense reserves on an overall basis. As additional experience and other relevant data become available, reserve levels are adjusted accordingly. Adjustments to previously established reserves, if any, will be reflected in the operating results of the period in which the adjustment is made. For the year ended December 31, 2001, there were no changes to these reserving assumptions that had a significant impact on the reserves or results of operations. In the judgment of management, all information currently available has been properly considered in the reserves established for claims and claim adjustment expenses. For a discussion of environmental and asbestos claims and the uncertainties related to these reserves, refer to the next section.
The study included a review of identified environmental and asbestos exposures of North American Property & Casualty, along with the United States exposures of The Hartford's Other Operations segment. The methodology utilized a ground-up analysis of policy, site and exposure level data for a representative sample of The Hartford's claims. The results of the evaluation were extrapolated against the balance of the claim population to estimate the Company's overall exposure for reported claims.
In addition to estimating liabilities on reported environmental and asbestos claims, The Hartford estimated reserves for claims incurred but not reported. The IBNR reserve was estimated using information on reporting patterns of known insureds, characteristics of insureds such as limits exposed, attachment points and number of coverage years involved, third party costs and closed claims.
coverage. Reinsurance coverage applicable to the sample was used to estimate the reinsurance coverage that applied to the balance of the reported environmental and asbestos claims and to the IBNR estimates.
An international actuarial firm reviewed The Hartford's approach and concluded that the way the Company studied its exposures, the thoroughness of its analysis and the way The Hartford came to its estimates were reasonable and comprehensive. The Company believes that its methodology continues to be reasonable and comprehensive.
Reserve activity for both reported and unreported environmental and asbestos claims, including reserves for legal defense costs, for the years ended December 31, 2001, 2000 and 1999, was as follows (net of reinsurance):
Actual claim settlements since 1996 have indicated that a smaller proportion of the total environmental and asbestos reserves should have originally been allocated to environmental, with a greater portion allocated to asbestos. As a result, during the fourth quarter of 2001, the Company reclassified $100 of environmental reserves to asbestos.
With the consolidation of The Hartford's environmental and asbestos liabilities into the Other Operations segment, as previously discussed in the Other Operations section, essentially all of the Company's environmental and asbestos reserves are held within Other Operations. The Hartford believes that the environmental and asbestos reserves, reported at December 31, 2001, are a reasonable estimate of the ultimate remaining liability for these claims based upon known facts, current assumptions and The Hartford's methodologies. Future social, economic, legal or legislative developments may alter the original intent of policies and the scope of coverage. The Hartford will continue to evaluate new methodologies and developments, such as the increasing level of asbestos claims being tendered under the comprehensive general liability operations (non-product) section of policies, as they arise in order to supplement the Company's ongoing analysis and review of its environmental and asbestos exposures. These future reviews may result in a change in reserves, impacting The Hartford's results of operations in the period in which the reserve estimates are changed. While the impact of these changes could have a material effect on future results of operations, The Hartford does not expect such changes would have a material effect on its liquidity or financial condition.
Return on invested assets is an important element of The Hartford's financial results. Significant fluctuations in the fixed income or equity markets could weaken the Company's financial condition or its results of operations. Net investment income and net realized capital gains and losses accounted for approximately 17% and 19% of the Company's consolidated revenues for the years ended December 31, 2001 and 2000, respectively.
The following table identifies the invested assets by type held in the general account as of December 31, 2001 and 2000.
During 2001, fixed maturity investments increased $5.1 billion as a result of the Fortis acquisition, increased operating cash flow and an increase in fair value due to a lower interest rate environment. The decrease in policy loans was primarily due to the decrease in leveraged COLI business, partially offset by policy loans acquired as a result of the Fortis acquisition. Policy loans are secured by the cash value of the associated life policy and do not mature in a conventional sense, but expire in conjunction with the related policy liabilities.
During 2001, corporate and ABS fixed maturity investments increased due to the Fortis acquisition.
As of December 31, 2001 and 2000, approximately 21% and 22%, respectively, of Life's fixed maturities were invested in private placement securities (including 12% and 13% of Rule 144A offerings as of December 31, 2001 and December 31, 2000, respectively). Private placement securities are generally less liquid than public securities. However, private placements generally have covenants designed to compensate for liquidity risk. Most of the private placement securities in the operation's portfolio are rated by nationally recognized rating agencies. (For further discussion of the Company's investment credit policies, see the Capital Markets Risk Management section under "Credit Risk".)
During 2001, corporate fixed maturities increased primarily due to a reallocation from municipal tax-exempts, resulting from a strategy to invest in this sector during a period of wide credit spreads.
Net realized capital gains increased by $195 for 2000 primarily as a result of the $242 before-tax gain recognized on the sale of Zwolsche, partially offset by net realized capital losses in the investment portfolio.
Separate account products are those for which a separate investment and liability account is maintained on behalf of the policyholder. The Company's separate accounts reflect two categories of risk assumption: non-guaranteed separate accounts totaling $104.6 billion and $104.3 billion as of December 31, 2001 and 2000, respectively, wherein the policyholder assumes substantially all the risk and reward; and guaranteed separate accounts totaling $10.1 billion and $9.8 billion as of December 31, 2001 and 2000, respectively, wherein The Hartford contractually guarantees either a minimum return or the account value to the policyholder. Guaranteed separate account products 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 guaranteed separate accounts 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 under "Market Risk - Life - Interest Rate Risk."
The Hartford has a disciplined approach to managing risks associated with its capital markets and asset/liability management activities. Investment portfolio management is organized to focus investment management expertise on specific classes of investments, while asset/liability management is the responsibility of separate and distinct risk management units supporting Life and Property & Casualty operations. Derivative instruments are utilized in compliance with established Company policy and regulatory requirements and are monitored internally and reviewed by senior management.
counterparty to make timely payments of principal and/or interest, and market risk, relating to the market price and/or cash flow variability associated with changes in interest rates, securities prices, market indices, yield curves or currency exchange rates. The Company does not hold any financial instruments purchased for trading purposes.
The following tables identify fixed maturity securities for Life, including guaranteed separate accounts, and Property & Casualty by credit quality. The ratings referenced in the tables are based on the ratings of a nationally recognized rating organization or, if not rated, assigned based on the Company's internal analysis of such securities.
As of December 31, 2001 and 2000, over 94% and 95%, respectively, of the fixed maturity portfolio was invested in securities rated investment grade. During 2001, the percentage of BBB rated fixed maturity investments increased primarily due to the continued active management of the general account portfolios.
The Hartford has several objectives in managing market risk associated with Life and Property & Casualty. Life is responsible for maximizing after-tax returns within acceptable risk parameters, including the management of the interest rate sensitivity of invested assets and the generation of sufficient liquidity to that of corporate and policyholder obligations.
Life's fixed maturity portfolios have material market exposure to interest rate risk. Property & Casualty attempts to maximize economic value while generating appropriate after-tax income and sufficient liquidity to meet corporate and policyholder obligations. Property & Casualty has material exposure to interest rate and equity market risk. The Company continually monitors these exposures and makes portfolio adjustments to manage these risks within established limits.
The Company uses derivative instruments in its management of market risk consistent with four risk management strategies: hedging anticipated transactions, hedging liability instruments, hedging invested assets and hedging portfolios of assets and/or liabilities. (For additional information on these strategies along with tables reflecting outstanding derivative instruments, see the Life and Property & Casualty discussions below.)
Derivative activities are monitored by an internal compliance unit, reviewed frequently by senior management and reported to the Finance Committee of the Board of Directors. 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 for both general and guaranteed separate accounts at December 31, 2001 and 2000 totaled $11.2 billion and $8.8 billion, respectively.
Expected maturities differ from contractual maturities due to call or prepayment provisions. The weighted average coupon ("WAC") on variable rate securities is based on spot rates as of December 31, 2001 and 2000, and is primarily based on London Interbank Offered Rate ("LIBOR"). Callable bonds and notes are distributed to either call dates or maturity, depending on which date produces the most conservative yield. Asset-backed securities, collateralized mortgage obligations and mortgage-backed securities are distributed based on estimates of the rate of future prepayments of principal over the remaining life of the securities. These estimates are developed using prepayment speeds provided in broker consensus data. Such estimates are derived from prepayment speeds previously experienced at the interest rate levels projected for the underlying collateral. Actual prepayment experience may vary from these estimates. Financial instruments with certain leverage features have been included in each of the fixed maturity categories. These instruments have not been separately displayed because they were immaterial to the Life investment portfolio.
Asset and Liability Management Strategies Used to Manage Market Risk - --------------------------------------------------------------------
matched against variable rate assets. Finally, interest rate caps and option contracts are used to hedge against the risk of contract holder disintermediation in a rising interest rate environment. The notional amounts of derivatives used for liability hedging as of December 31, 2001 and 2000 were $1.7 billion and $2.0 billion, respectively.
Portfolio Hedging -- The Company periodically compares the duration and convexity of its portfolios of assets to its corresponding liabilities and enters into portfolio hedges to reduce any difference to desired levels. Portfolio hedges reduce the duration and convexity mismatch between assets and liabilities and offset the potential impact to cash flows caused by changes in interest rates. The notional amounts of portfolio hedges as of December 31, 2001 and 2000 were $1.1 and $1.0 billion, respectively.
Life's product liabilities, other than non-guaranteed separate accounts, include accumulation vehicles such as fixed and variable annuities, other investment and universal life-type contracts, and other insurance products such as long-term disability and term life insurance.
Interest Credited -- Products in this category credit interest to policyholders, subject to market conditions and minimum guarantees. Policyholders may surrender at book value but are subject to surrender charges for an initial period. Product examples include universal life contracts and the general account portion of Life's variable annuity products. Liability duration is short- to intermediate-term.
Management of the duration of investments with respective policyholder obligations is an explicit objective of Life's management strategy. The estimated cash flows of insurance policy liabilities based upon internal actuarial assumptions as of December 31, 2001 are reflected in the table below by expected maturity year. Comparative totals are included for December 31, 2000.
For liabilities whose cash flows are not substantially affected by changes in interest rates ("fixed liabilities") and where investment experience is substantially absorbed by Life, the sensitivity of the net economic value (discounted present value of asset cash flows less the discounted present value of liability cash flows) of those portfolios to 100 basis point shifts in interest rates are shown in the following table.
These fixed liabilities represented about 61% and 60% of Life's general and guaranteed separate account liabilities at December 31, 2001 and 2000, respectively. The remaining liabilities generally allow Life significant flexibility to adjust credited rates to reflect actual investment experience and thereby pass through a substantial portion of actual investment experience to the policyholder. The fixed liability portfolios are managed and monitored relative to defined objectives and are analyzed regularly by management for internal risk management purposes using scenario simulation techniques, and are evaluated on an annual basis, in compliance with regulatory requirements.
The principal amounts of the fixed and variable rate fixed maturity portfolios, along with the respective weighted average coupons by estimated maturity year at December 31, 2001, are reflected in the following table. Comparative totals are included as of December 31, 2000. Expected maturities differ from contractual maturities due to call or prepayment provisions. The WAC on variable rate securities is based on spot rates as of December 31, 2001 and 2000, and is based primarily on LIBOR. Callable bonds and notes are primarily municipal bonds, and are distributed to either call dates or maturity depending on which date produces the most conservative yield. Asset-backed securities, collateralized mortgage obligations and mortgage-backed securities are distributed based on estimates of the rate of future prepayments of principal over the remaining life of the
Property & Casualty uses option contracts to hedge fixed maturity investments that totaled $252 in notional value and $1 in carrying value as of December 31, 2001. There were no option contracts in use as of December 31, 2000.
2001 2000 ------------------------------------------- FAIR VALUE PERCENT FAIR VALUE PERCENT - -------------------------------------------------------------------- EQUITY SECURITIES Domestic Large cap $ 393 42.7% $ 521 58.9% Midcap/small cap 342 37.1% 179 20.2% Foreign EAFE [1]/ Canadian 184 20.0% 185 20.9% Emerging 2 0.2% -- -- - -------------------------------------------------------------------- TOTAL $ 921 100.0% $ 885 100.0% ==================================================================== [1] Europe, Australia, Far East countries index.
Currency exchange risk also exists with respect to investments in foreign equity securities. Forward foreign contracts with a notional amount of $7 and $8 were used to manage this risk at December 31, 2001 and 2000, respectively.
The primary exposure to interest rate risk in Corporate relates to the debt issued in connection with The HLI Repurchase. Corporate also has $3 in fixed maturity security investments that represent an immaterial interest rate exposure.
The table below provides information as of December 31, 2001 on Corporate's debt obligations and reflects principal cash flows and related weighted average interest rates by maturity year.
Capital resources and liquidity represent the overall financial strength of The Hartford and its ability to generate strong cash flows from each of the business segments and borrow funds at competitive rates to meet operating and growth needs. The capital structure of The Hartford as of December 31, 2001 and 2000 consisted of debt and equity, and as of December 31, 1999 also consisted of minority interest, summarized as follows:
Issuance of: - ------------ Common stock issuance (10 million shares @ $64.00 per share), net of transaction costs $ 615 Long-term notes: $400 7.375% notes due March 1, 2031 400 Trust preferred securities: $200 7.625% Trust Preferred Securities (Series B) due February 15, 2050 200 - ----------------------------------------------------------------------- Consideration raised $ 1,215 =======================================================================
For a further discussion of the Fortis Acquisition, see Note 18(a) of Notes to Consolidated Financial Statements.
For a further discussion of the shelf registration statements, see Note 6 of Notes to Consolidated Financial Statements.
As of December 31, 2001, HLI maintained a $250 five-year revolving credit facility comprised of four participatory banks. As of December 31, 2001, there were no outstanding borrowings under the facility.
On March 1, 2001, HLI issued and sold $400 of senior debt securities to partially finance the Fortis acquisition.
On June 16, 2000, The Hartford issued and sold $525 of unsecured redeemable long-term debt. On June 23, 2000, The Hartford issued $400 of commercial paper. Proceeds from the debt issuances were used to partially fund The HLI Repurchase. The Company used proceeds from the sale of Zwolsche to pay off the $400 of commercial paper on December 29, 2000.
For additional information regarding debt, see Note 6 of Notes to Consolidated Financial Statements.
On December 31, 2001, The Hartford redeemed its 20,000,000 Series B, 8.35% Cumulative Quarterly Income Preferred Securities due October 30, 2026 for $500. The Company used proceeds from its October 26, 2001 issuance of 7.45% Trust Originated Preferred Securities, Series C to redeem the securities.
On March 6, 2001, HLI issued and sold $200 of trust preferred securities to partially finance the Fortis acquisition.
For a further discussion of Company Obligated Mandatorily Redeemable Preferred Securities of Subsidiary Trusts Holding Solely Junior Subordinated Debentures, see Note 7 of Notes to Consolidated Financial Statements.
Dividends - The Hartford declared $242 and paid $235 in dividends to shareholders in 2001, declared $214 and paid $210 in 2000 and declared $209 and paid $207 in 1999.
For additional information on stockholders' equity, see Note 8 of Notes to Consolidated Financial Statements.
The following table summarizes The Hartford's significant United States member companies' financial ratings from the major independent rating organizations as of February 28, 2002.
- -------------------------------------------------------------------- A.M. STANDARD BEST FITCH & POOR'S MOODY'S - -------------------------------------------------------------------- Insurance Ratings: Hartford Fire A+ AA AA Aa3 Hartford Life Insurance Company A+ AA+ AA Aa3 Hartford Life & Accident A+ AA+ AA Aa3 Hartford Life & Annuity A+ AA+ AA Aa3 - -------------------------------------------------------------------- OTHER RATINGS: The Hartford Financial Services Group, Inc.: Senior debt a+ A+ A A2 Commercial paper AMB-1 A-1 P-1 Hartford Capital I quarterly income preferred securities [1] a- A BBB+ A3 Hartford Capital III trust originated preferred securities [1] a- A BBB+ A3 Hartford Life, Inc.: Senior debt a+ A+ A A2 Commercial paper -- A-1 P-1 Hartford Life, Inc.: Capital I and II trust preferred securities [1] a- A BBB+ A3 - -------------------------------------------------------------------- [1] In 2001, Moody's Investor Service recalibrated its rating scale for preferred stock and subordinated bonds to increase comparability of credit risk assessments across sectors of fixed income markets globally. The recalibration represents a change in Moody's overall rating system for preferred stocks and subordinated bonds but not a change in its risk assessment of an issuer's fundamental credit quality. The Company's preferred securities ratings were changed from A2 to A3 as a result of the recalibration.
As a result of September 11 and subsequent reviews by major independent rating agencies, all insurance financial strength and debt ratings of The Hartford were reaffirmed. However, negative outlooks were placed upon the debt ratings of the Company by Moody's and the property and casualty financial strength rating by Standard & Poor's. All other ratings were reaffirmed with stable outlooks.
2000 COMPARED TO 1999 -- The increase in operating cash flow was primarily the result of growth in Life business, along with favorable underwriting cash flows in Property & Casualty. The decrease in cash used for financing activities was attributable to net financing for The HLI Repurchase as well as a lower level of disbursements for investment type contracts related to the leveraged block of COLI business. The financing activities, along with the increase in cash provided by operating activities, accounted for the change in cash from investing activities.
Enactment of the Financial Services Modernization Act at the federal level has also focused renewed attention on state regulation of insurance. Elements of the insurance industry are involved in a countrywide initiative to streamline regulatory procedures, either through the modification of rate and form filing requirements or Congressional adoption of optional federal charter legislation.
Congress is expected to continue considering terrorism insurance backstop legislation and proposals to moderate the business community's asbestos exposure. Both have the potential to reduce claim exposures; however, enactment of such legislation may not occur in the current Congress. Proposed legislation to reduce abusive class-action lawsuits would also have a beneficial impact, but prospects for near-term enactment are likewise uncertain. So-called "patient protection" legislation introduced in Congress and passed in many states includes provisions permitting lawsuits against health maintenance organizations ("HMOs") for denial of coverage. Although the Company is not a health insurer or health care provider, passage of such legislation could affect medical claim costs to the extent that HMOs were constrained from actively managing care.
In all states, insurers licensed to transact certain classes of insurance are required to become members of an insolvency fund. In most states, in the event of the insolvency of an insurer writing any such class of insurance in the state, members of the fund are assessed to pay certain claims of the insolvent insurer. A particular state's fund assesses its members based on their respective written premiums in the state for the classes of insurance in which the insolvent insurer is engaged. Assessments are generally limited for any year to one or two percent of premiums written per year depending on the state. Such assessments paid by The Hartford approximated $6 in 2001, $2 in 2000 and $4 in 1999.