2004 includes a $216 tax benefit related to agreement with the IRS on the resolution of matters pertaining to tax years prior to 2004. 2003 includes an after-tax charge of $1.7 billion related to the Company’s 2003 asbestos reserve addition, $40 of after-tax expense related to the settlement of a certain litigation dispute, $30 of tax benefit in Life primarily related to the favorable treatment of certain tax items arising during the 1996-2002 tax years, and $27 of after-tax severance charges in Property & Casualty.
2004 includes a $23 after-tax charge related to the cumulative effect of accounting change for the Company’s adoption of the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts”.
As a result of the net loss for the year ended December 31, 2003, FASB Statement of Financial Accounting Standards No. 128, “Earnings per Share” requires the Company to use basic weighted average common shares outstanding in the calculation of the year ended December 31, 2003 diluted earnings (loss) per share, since the inclusion of options of 1.8 would have been antidilutive to the earnings per share calculation. In the absence of the net loss, weighted average common shares outstanding and dilutive potential common shares would have totaled 274.2.
Mutual funds are owned by the shareholders of those funds and not by the Company. As a result, they are not reflected in total assets in the Company’s balance sheet.
Certain of the statements contained herein are forward-looking statements. These forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and include estimates and assumptions related to economic, competitive and legislative developments. These forward-looking statements are subject to change and uncertainty which are, in many instances, beyond the Company’s control and have been made based upon management’s expectations and beliefs concerning future developments and their potential effect upon the Company. There can be no assurance that future developments will be in accordance with management’s expectations or that the effect of future developments on The 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, including, but not limited to, those set forth in Part I, Item 1A, Risk Factors. These factors include: the difficulty in predicting the Company’s potential exposure for asbestos and environmental claims; the possible occurrence of terrorist attacks; the response of reinsurance companies under reinsurance contracts and the availability, pricing and adequacy of reinsurance to protect the Company against losses; changes in financial and capital markets, including changes in interest rates, credit spreads, equity prices and foreign exchange rates; the inability to effectively mitigate the impact of equity market volatility on the Company’s financial position and results of operations arising from obligations under annuity product guarantees; the possibility of unfavorable loss development; the incidence and severity of catastrophes, both natural and man-made; stronger than anticipated competitive activity; unfavorable judicial or legislative developments; the potential effect of domestic and foreign regulatory developments, including those which could increase the Company’s business costs and required capital levels; the possibility of general economic and business conditions that are less favorable than anticipated; the Company’s ability to distribute its products through distribution channels, both current and future; the uncertain effects of emerging claim and coverage issues; a downgrade in the Company’s financial strength or credit ratings; the ability of the Company’s subsidiaries to pay dividends to the Company; the Company’s ability to adequately price its property and casualty policies; the ability to recover the Company’s systems and information in the event of a disaster or other unanticipated event; potential for difficulties arising from outsourcing relationships; potential changes in Federal or State tax laws, including changes impacting the availability of the separate account dividend received deduction; losses due to defaults by others; the Company’s ability to protect its intellectual property and defend against claims of infringement; and other factors described in such forward-looking statements.
The Hartford is a diversified insurance and financial services company with operations dating back to 1810. The Company is headquartered in Connecticut and is organized into two major operations: Life and Property & Casualty, each containing reporting segments. Within the Life and Property & Casualty operations, The Hartford conducts business principally in eleven reporting segments. Corporate primarily includes the Company’s debt financing and related interest expense, as well as other capital raising activities and purchase accounting adjustments.
Many of the principal factors that drive the profitability of The Hartford’s Life and Property & Casualty operations are separate and distinct. Management considers this diversification to be a strength of The Hartford that distinguishes the Company from many of its peers. To present its operations in a more meaningful and organized way, management has included separate overviews within the Life and Property & Casualty sections of the MD&A. For further overview of Life’s profitability and analysis, see page 54. For further overview of Property & Casualty’s profitability and analysis, see page 76.
The Company has identified the following estimates as critical in that they involve a higher degree of judgment and are subject to a significant degree of variability: property and casualty reserves, net of reinsurance; life estimated gross profits used in the valuation and amortization of assets and liabilities associated with variable annuity and other universal life-type contracts; living benefits required to be fair valued; valuation of investments and derivative instruments; evaluation of other-than-temporary impairments on available-for-sale securities; pension and other postretirement benefit obligations; and contingencies relating to corporate litigation and regulatory matters. In developing these estimates management makes subjective and complex judgments that are inherently uncertain and subject to material change as facts and circumstances develop. Although variability is inherent in these estimates, management believes the amounts provided are appropriate based upon the facts available upon compilation of the financial statements.
The Hartford establishes property and casualty reserves to provide for the estimated costs of paying claims under insurance policies written by the Company. These reserves include estimates for both claims that have been reported and those that have not yet been reported, and include estimates of all expenses associated with processing and settling these claims. Estimating the ultimate cost of future losses and loss adjustment expenses is an uncertain and complex process. This estimation process is based largely on the assumption that past developments are an appropriate predictor of future events and involves a variety of actuarial techniques that analyze experience, trends and other relevant factors. Reserve estimates can change over time because of unexpected changes in the external environment. Potential external factors include (1) changes in the inflation rate for goods and services related to covered damages such as medical care, hospital care, auto parts, wages and home repair, (2) changes in the general economic environment that could cause unanticipated changes in the claim frequency per unit insured, (3) changes in the litigation environment as evidenced by changes in claimant attorney representation in the claims negotiation and settlement process, (4) changes in the judicial environment regarding the interpretation of policy provisions relating to the determination of coverage and/or the amount of damages awarded for certain types of damages, (5) changes in the social environment regarding the general attitude of juries in the determination of liability and damages, (6) changes in the legislative environment regarding the definition of damages and (7) new types of injuries caused by new types of injurious exposure: past examples include breast implants, lead paint and construction defects. Reserve estimates can also change over time because of changes in internal company operations. Potential internal factors include (1) periodic changes in claims handling procedures, (2) growth in new lines of business where exposure and loss development patterns are not well established or (3) changes in the quality of risk selection in the underwriting process. In the case of assumed reinsurance, all of the above risks apply. In addition, changes in ceding company case reserving and reporting patterns can create additional factors that need to be considered in estimating the reserves. Due to the inherent complexity of the assumptions used, final claim settlements may vary significantly from the present estimates, particularly when those settlements may not occur until well into the future.
Reinsurance recoverables include an estimate of the amount of gross loss and loss adjustment expense reserves that may be ceded under the terms of the reinsurance agreements, including incurred but not reported unpaid losses. The Company calculates its ceded
The Company provides an allowance for uncollectible reinsurance, reflecting management’s best estimate of reinsurance cessions that may be uncollectible in the future due to reinsurers’ unwillingness or inability to pay. The Company analyzes recent developments in commutation activity between reinsurers and cedants, recent trends in arbitration and litigation outcomes in disputes between reinsurers and cedants and the overall credit quality of the Company’s reinsurers. Where its contracts permit, the Company secures future claim obligations with various forms of collateral, including irrevocable letters of credit, secured trusts, funds held accounts and group-wide offsets. The allowance for uncollectible reinsurance was $404 as of December 31, 2007, including $267 related to Other Operations and $137 related to Ongoing Operations.
Company reserving actuaries, who are independent of the business units, regularly review reserves for both current and prior accident years using the most current claim data. These reserve reviews incorporate a variety of actuarial methods and judgments and involve rigorous analysis. Most non-A&E reserves are reviewed fully each quarter, including loss reserves for property, auto physical damage, auto liability, package business, workers’ compensation, most general liability, professional liability and fidelity and surety. Other non-A&E reserves are reviewed semi-annually (twice per year) or annually. These include, but are not limited to, reserves for losses incurred before 1987, allocated loss adjustment expenses, assumed reinsurance, latent exposures such as construction defects, unallocated loss adjustment expense and all other non-A&E exposures within Other Operations. For reserves that are reviewed semi-annually and annually, management monitors the emergence of paid and reported losses in the intervening quarters to either confirm that its estimate of ultimate losses should not change or, if necessary, perform a reserve review to determine whether the reserve estimate should change.
For most lines of business, a variety of actuarial methods are reviewed and the actuaries select methods and specific assumptions appropriate for each line of business based on the current circumstances affecting that line of business. These selections incorporate input, as judged by the reserving actuaries to be appropriate, from claims personnel, pricing actuaries and operating management on reported loss cost trends and other factors that could affect the reserve estimates. The output of the reserve reviews are reserve estimates that are referred to herein as the “actuarial indication”.
Paid development techniques do not use information about case reserves and, therefore, are not affected by changes in case reserving practices. Paid development techniques can, however, be significantly affected by changes in claim closure patterns. Paid development techniques for longer-tailed lines are generally less useful for more recent accident years since a low percentage of ultimate losses are paid to date in early periods of development and small changes in paid losses can have a large impact on estimated ultimate losses.
Reported Development method. Historical data, organized by accident period and calendar period, is used to develop reported loss development patterns, which are then applied to current reported losses by accident period to estimate ultimate losses. The reported losses used in this analysis refer to cumulative paid losses plus case reserves and do not include IBNR.
Bornhuetter-Ferguson method. This method is a combination of the expected loss ratio method and the reported development method, where the reported loss development method is given more weight as an accident year matures.
The Company may analyze the data by coverage (e.g., bodily injury separate from property damage)
For ALAE, the Company uses patterns of the relationship between paid ALAE and paid losses.
Assumed Reinsurance and All Other within Other Operations. For these lines, management tends to rely on the reported development techniques. In assumed reinsurance, assumptions are influenced by information gained from claim and underwriting audits.
Allocated Loss Adjustment Expenses (ALAE). For some lines of business (e.g., professional liability and assumed reinsurance), ALAE and losses are analyzed together. For most lines of business, however, ALAE is analyzed separately, using paid development and frequency / severity techniques.
During 2007, there were numerous changes to non-A&E reserve estimates. Among other loss developments in 2007, these changes included a $151 release of workers’ compensation reserves for accident years 2002 to 2006, a $49 release of general liability loss and loss adjustment expense reserves for accident years 2003 to 2006 and a $79 strengthening of workers’ compensation and general liability reserves for accident years more than 20 years old. See “Reserves” within the Property and Casualty MD&A for further discussion of reserve developments.
The Hartford is a multi-line company in the property and casualty business. The Hartford is therefore subject to reserve uncertainty stemming from a number of conditions, including but not limited to those noted above, any of which could be material at any point in time for any segment. Certain issues may become more or less important over time as conditions change. As various market conditions develop, management must assess whether those conditions constitute a long-term trend that should result in a reserving action (i.e., increasing or decreasing the reserve).
In both Small Commercial and Middle Market, workers’ compensation is the Company’s single biggest line of business and the line of business with the longest pattern of loss emergence. Reserve estimates for workers’ compensation are particularly sensitive to assumptions about medical inflation and the changing use of medical care procedures. In addition, changes in state legislative and regulatory environments impact the Company’s estimates. These changes increase the uncertainty in the application of development patterns.
The following discussion includes disclosure of possible variation from current estimates of loss reserves due to a change in certain key assumptions. Each of the impacts described below is estimated individually, without consideration for any correlation among key assumptions or among lines of business. Therefore, it would be inappropriate to take each of the amounts described below and add them together in an attempt to estimate volatility for the Company’s reserves in total. The estimated variation in reserves due to changes in key assumptions is a reasonable estimate of possible variation that may occur in the future, likely over a period of several calendar years. It is important to note that the variation discussed is not meant to be a worst-case scenario, and therefore, it is possible that future variation may be more than the amounts discussed below.
Recorded reserves for workers’ compensation, net of reinsurance, are $6.2 billion in total for Ongoing Operations. The two most important assumptions for workers’ compensation reserves are loss development factors and loss cost trends, particularly medical cost inflation. Loss development patterns are dependent on medical cost inflation. Approximately half of the workers’ compensation net reserves are related to future medical costs. A review of National Council on Compensation Insurance (“NCCI”) data suggests that the annual growth in industry medical claim costs has varied from -2% to +12% since 1991. This data shows that medical inflation has been highly variable over the past decade. Across the entire workers’ compensation reserve base, a 1 point change in the annual medical inflation rate would change the estimated net reserve by $650, in either direction.
development patterns is within historical variation, as measured by the variation around the average development factors as reported in statutory accident year reports.
It is also not possible to predict changes in the legal and legislative environment and their effect on the future development of asbestos and environmental claims. Although potential Federal asbestos-related legislation was considered by the Senate in 2006, it is uncertain
whether such legislation will be reconsidered or enacted in the future and, if enacted, what its effect would be on the Company’s aggregate asbestos liabilities.
Life’s deferred policy acquisition costs asset and present value of future profits (“PVFP”) intangible asset (hereafter, referred to collectively as “DAC”) related to investment contracts and universal life-type contracts (including variable annuities) are amortized in the same way, over the estimated life of the contracts acquired using the retrospective deposit method. Under the retrospective deposit method, acquisition costs are amortized in proportion to the present value of estimated gross profits (“EGPs”). EGPs are also used to amortize other assets and liabilities on the Company’s balance sheet, such as sales inducement assets and unearned revenue reserves (“URR”). Components of EGPs are used to determine reserves for guaranteed minimum death, income and universal life secondary guarantee benefits accounted for and collectively referred to as “SOP 03-1 reserves”. At December 31, 2007 and 2006, the carrying value of the Company’s Life DAC asset was $10.5 billion and $9.1 billion, respectively. At December 31, 2007 and 2006, the carrying value of the Company’s sales inducement asset was $467 and $404, respectively. At December 31, 2007 and 2006, the carrying value of the Company’s unearned revenue reserve was $1.2 billion and $842, respectively. At December 31, 2007 and 2006, the carrying value of the Company’s SOP 03-1 reserves were $590 and $517, respectively. The specific breakdown of the most significant balances by segment are as follows:
Estimating future gross profits is a complex process requiring considerable judgment and the forecasting of events well into the future. The estimation process, the underlying assumptions and the resulting EGPs, are evaluated regularly.
During the third quarter of 2007 and the fourth quarter of 2006, the Company refined its estimation process for DAC amortization and completed a comprehensive study of assumptions. The Company plans to complete a comprehensive assumption study and refine its estimate of future gross profits during the third quarter of each successive year.
Upon completion of an assumption study, the Company revises its assumptions to reflect its current best estimate, thereby changing its estimate of projected account values and the related EGPs in the DAC, sales inducement and unearned revenue reserve amortization models as well as SOP 03-1 reserving models. The DAC asset as well as the sales inducement asset, unearned revenue reserves and SOP 03-1 reserves are adjusted with an offsetting benefit or charge to income to reflect such changes in the period of the revision, a process known as “unlocking”. An unlock that results in an after-tax benefit generally occurs as a result of actual experience or future expectations of product profitability being favorable compared to previous estimates. An unlock that results in an after-tax charge generally occurs as a result of actual experience or future expectations of product profitability being unfavorable compared to previous estimates.
the use of internally developed models, which run a large number of stochastically determined scenarios of separate account fund performance. Incorporated in each scenario are assumptions with respect to lapse rates, mortality and expenses, based on the Company’s most recent assumption study. These scenarios are run for the Company’s individual variable annuity businesses in the United States and Japan, the Company’s Retirement Plans businesses, and for the Company’s individual variable universal life business and are used to calculate statistically significant ranges of reasonable EGPs. The statistical ranges produced from the stochastic scenarios are compared to the present value of EGPs used in the Company’s models. If EGPs used in the Company’s models fall outside of the statistical ranges of reasonable EGPs, an “unlock” would be necessary. If EGPs used in the Company’s models fall inside of the statistical ranges of reasonable EGPs, the Company will not solely rely on the results of the quantitative analysis to determine the necessity of an unlock. In addition, the Company considers, on a quarterly basis, other qualitative factors such as market, product, regulatory and policyholder behavior trends and may also revise EGPs if those trends are expected to be significant and were not or could not be included in the statistically significant ranges of reasonable EGPs. As of January 31, 2008, separate account returns have been unfavorable in comparison to expectations from July 31, 2007 to January 31, 2008. Before an unlock was required in the U.S. or Japan, separate account returns would need to be approximately three times as unfavorable in comparison to expectations as they were at January 31, 2008.
As a result of the unlock, death benefit reserves, in Retail, decreased $4, pre-tax, offset by a decrease of $10, pre-tax, in reinsurance recoverables.
As a result of the unlock in the third quarter of 2007, the Company expects an immaterial change to total Company DAC amortization in 2008.
The Company performs sensitivity analyses with respect to the effect certain assumptions have on EGPs and the related DAC, sales inducement, unearned revenue reserve and SOP 03-1 reserve balances. Each of the sensitivities illustrated below are estimated individually, without consideration for any correlation among the key assumptions. Therefore, it would be inappropriate to take each of the sensitivity amounts below and add them together in an attempt to estimate volatility for the respective EGP-related balances in total. The following tables depict the estimated sensitivities for U.S. variable annuities and Japan variable annuities:
These sensitivities are reflective of the results of our 2007 assumption studies. The Company’s EGP models assume that separate account returns are earned linearly and that lapses occur linearly (except for certain dynamic lapse features) throughout the year. Similarly, the sensitivities assume that differential separate account and lapse rates are linear and parallel and persist for one year from the date of our third quarter unlock, which reflects all in-force and account value data as of July 31, 2007, including the corresponding market levels, allocation of funds, policyholder behavior and actuarial assumptions at that same date. These sensitivities are not perfectly linear nor perfectly symmetrical for increases and decreases and are most accurate for small changes in assumptions. As such, extrapolating results over a wide range will decrease the accuracy of the sensitivities’ predictive ability. Sensitivity results are, in part, based on the current “in-the-moneyness” of various guarantees offered with the products. Future market conditions could significantly change the sensitivity results.
The overall actual return generated by the U.S. variable annuity separate accounts 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 and as a result of the large proportion of separate account assets invested in U.S. equity markets, the Company’s overall U.S. separate account fund performance has been reasonably correlated to the overall performance of the S&P 500 although no assurance can be provided that this correlation will continue in the future.
An “unlock” only revises EGPs to reflect current best estimate assumptions. The Company must also test the aggregate recoverability of the DAC and sales inducement assets by comparing the amounts deferred to the present value of total EGPs. In addition, the Company routinely stress tests its DAC and sales inducement assets for recoverability against severe declines in its separate account assets, which could occur if the equity markets experienced a significant sell-off, as the majority of policyholders’ funds in the separate accounts is invested in the equity market. As of December 31, 2007, the Company believed U.S. individual and Japan individual variable annuity
The Company offers certain variable annuity products with a guaranteed minimum withdrawal benefit (“GMWB”) rider. The Company also offers a guaranteed minimum accumulation benefit (“GMAB”) with a variable annuity product offered in Japan. As of December 31, 2007, the fair value of the GMWB liability is $715. As of December 31, 2007, the fair value of the GMAB is immaterial. The fair value of the GMWB 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 such as lapses, fund selection, resets and withdrawal utilization. Because of the dynamic and complex nature of these cash flows, best estimate assumptions and a Monte Carlo stochastic process involving the generation of thousands of scenarios that assume risk neutral returns consistent with swap rates and a blend of observable implied index volatility levels 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 index returns to funds, fund performance, discount rates and policyholder behavior. At each valuation date, the Company assumes expected returns based on risk-free rates as represented by the current LIBOR forward curve rates; forward market volatility assumptions for each underlying index based primarily on a blend of observed market “implied volatility” data; correlations of market returns across underlying indices based on actual observed market returns and relationships over the ten years preceding the valuation date; regression of fund returns to index returns based on the most recent three years actual results; 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. As GMWB obligations are relatively new in the market place, actual policyholder behavior experience is limited. As a result, estimates of future policyholder behavior are subjective and based on analogous internal and external data.
The fair value for fixed maturity securities is largely determined by one of three primary pricing methods: third party pricing service market prices, independent broker quotations or pricing matrices. Security pricing is applied using a hierarchy or “waterfall” approach whereby prices are first sought from third party pricing services with the remaining unpriced securities submitted to independent brokers for prices or lastly priced via a pricing matrix. Typical inputs used by these three pricing methods include, but are not limited to, reported trades, benchmark yields, issuer spreads, bids, offers, and/or estimated cash flows and prepayments speeds. Based on the typical trading volumes and the lack of quoted market prices for fixed maturities, third party pricing services will normally derive the security prices through recent reported trades for identical or similar securities making adjustments through the reporting date based upon available market observable information as outlined above. If there are no recent reported trades, the third party pricing services and brokers may use matrix or model processes to develop a security price where future cash flow expectations are developed based upon collateral performance and discounted at an estimated market rate. Included in the asset-backed securities (“ABS”), collaterized mortgage obligations (“CMOs”), and mortgage-backed securities (“MBS”) pricing are estimates of the rate of future prepayments of principal over the remaining life of the securities. Such estimates are derived based on the characteristics of the underlying structure and prepayment speeds previously experienced at the interest rate levels projected for the underlying collateral. Actual prepayment experience may vary from these estimates.
Derivative instruments are recognized on the consolidated balance sheets at fair value. As of December 31, 2007 and 2006, approximately 89% and 84% of derivatives, respectively, based upon notional values, were priced by valuation models, which utilize independent market data, while the remaining 11% and 16%, respectively, were priced by broker quotations. The derivatives are valued using mid-market level inputs that are predominantly observable in the market place. Inputs used to value derivatives include, but are not limited to, interest swap rates, foreign currency forward and spot rates, credit spreads, interest and equity volatility and equity index levels. The Company performs a monthly analysis on the derivative valuation which includes both quantitative and qualitative analysis. Examples of procedures performed include, but are not limited to, review of pricing statistics and trends, back testing recent trades, analyzing changes in the market environment and monitoring trading volume. This discussion on derivative pricing excludes the GMWB rider and associated reinsurance contracts as well as the embedded derivatives associated with the GMAB product, which are discussed in the preceding paragraphs under “Living Benefits Required to be Fair Valued” section.
Pursuant to accounting principles related to the Company’s pension and other postretirement obligations to employees under its various benefit plans, the Company is required to make a significant number of assumptions in order to calculate the related liabilities and expenses each period. The two economic assumptions that have the most impact on pension and other postretirement expense are the discount rate and the expected long-term rate of return on plan assets. In determining the discount rate assumption, the Company utilizes a discounted cash flow analysis of the Company’s pension and other postretirement obligations, currently available market and industry data and consultation with its plan actuaries. The yield curve utilized in the cash flow analysis is comprised of bonds rated Aa or higher with maturities primarily between zero and thirty years. Based on all available information, it was determined that 6.25% was the appropriate discount rate as of December 31, 2007 to calculate the Company’s benefit liability. Accordingly, the 6.25% discount rate will also be used to determine the Company’s 2008 pension and other postretirement expense. At December 31, 2006, the discount rate was 5.75%.
To illustrate the impact of these assumptions on annual pension and other postretirement expense for 2008 and going forward, a 25 basis point change in the discount rate will increase/decrease pension and other postretirement expense by approximately $16 and a 25 basis point change in the long-term asset return assumption will increase/decrease pension and other postretirement expense by approximately $9.
Ongoing Operations’ net income increased due to increases in underwriting results and net investment income, partially offset by a decrease in net realized capital gains. The increase in Ongoing Operations’ underwriting results was principally due to lower current accident year catastrophe losses, lower insurance operating costs and expenses due to a change in estimated Florida Citizens assessments, a change to net favorable prior accident year loss development and the effect of catastrophe treaty reinstatement premium recorded as a reduction of earned premium in 2005.
The net loss in Other Operations was primarily a result of prior year reserve development of $243, pre-tax, recorded in 2006, resulting from the agreement with Equitas and the Company’s evaluation of the reinsurance recoverables and allowance for uncollectible reinsurance associated with older, long-term casualty liabilities.
See “Investment Results” in the Investments section and the “Realized Capital Gains and Losses by Segment” table within the Life section of the MD&A.
The Company receives a foreign tax credit (“FTC”) against its U.S. tax liability for foreign taxes paid by the Company including payments from its separate account assets. The separate account FTC is estimated for the current year using information from the most recent filed return, adjusted for the change in the allocation of separate account investments to the international equity markets during the current year. The actual current year FTC can vary from the estimates due to actual FTCs passed through by the mutual funds. The Company recorded benefits of $11 and $17 related to separate account FTC in the years ended December 31, 2007 and December 31, 2006, respectively. These amounts included benefits related to true-ups of prior years’ tax returns of $0 and $7 in 2007 and 2006, respectively.
Individual Life accepts and maintains, for risk management purposes, up to $10 in risk per any one life. Individual Life uses reinsurance where appropriate to mitigate earnings volatility; however, death claim experience may lead to periodic short-term earnings volatility.
Despite the current market conditions, including rising medical costs, the changing regulatory environment and cost containment pressure on employers, the Company continues to leverage its strength in claim practices risk management, service and distribution, enabling the Company to capitalize on market opportunities. Additionally, employees continue to look to the workplace for a broader and ever expanding array of insurance products. As employers design benefit strategies to attract and retain employees, while attempting to control their benefit costs, management believes that the need for the Company’s products will continue to expand. This combined with the significant number of employees who currently do not have coverage or adequate levels of coverage, creates opportunities for our products and services.
Driven primarily by an expected increase in loss costs and underwriting expenses, the Company expects an Ongoing Operations’ combined ratio before catastrophes and prior accident year development of between 90.0 and 93.0, compared to 90.5 in 2007. Likewise, Property & Casualty operating cash flow is expected to be less favorable than in 2007, although still very positive. Management expects a modest increase in net investment income in 2008 primarily driven by net underwriting cash inflows, as the high level of partnership and hedge fund income recorded in 2007 is not expected to recur in 2008 and the effect of net underwriting cash inflows will likely be partially offset by a lower investment yield. Based upon current market forward interest rate expectations and moderating partnership income towards the end of 2007, management expects the after-tax investment yield for Property & Casualty to be about 4.0% in 2008, a decline from the after-tax yield of 4.4% in 2007.
Group Benefits provides individual members of employer groups, associations, affinity groups and financial institutions with group life, accident and disability coverage, along with other products and services, including voluntary benefits and group retiree health.
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) net investment income on general account assets; (c) fully insured premiums; and (d) certain other fees. Asset management fees and mortality and expense fees are primarily generated from separate account assets, which are deposited with Life through the sale of variable annuity and variable universal life products and from 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, group disability and individual term insurance products.
The profitability of Life’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 deferred policy acquisition costs.
Increases in Retail U.S. individual variable annuity account values as of December 31, 2007 can be primarily attributed to market growth during the year and improved net flows due to an increase in sales.
Mutual fund net sales increased substantially over the prior year as a result of focused wholesaling efforts and favorable fund and equity market performance.
The increase in Retirement Plans account values is due to positive net flows over the past year due to higher deposits and market appreciation.
International - Japan annuity account values as of December 31, 2006 were higher as a result of positive net flows and fund performance, offset by the effects of currency translation. Japan net flows have decreased from the prior year due to increased competition.
associated with its medical stop loss business during the second quarter of 2007 eliminating new sales related to this business. In addition, there was an anticipated decrease in association life sales from an unusually high comparable prior year period. The increase in 2006 from 2005 was primarily due to strong national account and association life sales.
The second major category is insurance operating costs and expenses, which is commonly expressed in a ratio of a revenue measure depending on the type of business. The third category is the amortization of deferred policy acquisition costs and the present value of future profits, which is typically expressed as a percentage of pre-tax income before the cost of this amortization (an approximation of actual gross profits). The individual annuity business within Retail accounts for the majority of the amortization of deferred policy acquisition costs and present value of future profits for Life.
The Retail DAC amortization ratio (individual annuity) excluding DAC unlock declined in 2007, primarily due to the unlock charge recorded in 2006. DAC unlock charges generally have the effect of reducing future DAC amortization rates. Retail expects the DAC amortization ratio to be between 41% and 46% until the next unlock in 2008.
Retail individual annuity asset growth in 2006 decreased it’s expense ratio to a level lower than prior years.
Individual Life death benefits increased 4% in 2006 primarily due to a larger insurance in-force. Individual Life insurance expenses, net of deferrals increased 8% for 2006 consistent with the growth of life insurance in-force.
International - Japan’s expense ratio declined in 2006 as Japan further leveraged the existing infrastructure as it attains economies of scale.
Management evaluates the rates of return various businesses can provide as an input in determining where additional capital should be invested to increase net income and shareholder returns. Specifically, because of the importance of its individual annuity products, the Company uses the return on assets for the individual annuity business for evaluating profitability. In Group Benefits and Individual Life, after-tax margin is a key indicator of overall profitability.
Included in net realized gain (losses) are amounts that represent the net periodic accruals on currency rate swaps used in the risk management of Japan fixed annuity products.
The increase in Institutional’s ROA, excluding realized gains (losses) and DAC unlock, is primarily due to an increase in partnership income and increased net investment income on allocated capital.
Individual Life’s decrease in after-tax margin, excluding realized gains (losses) and DAC unlock, is primarily due to unfavorable mortality experience in 2007 compared to 2006.
The decrease in Retail individual annuity’s ROA, excluding realized gain (losses) and DAC unlock, was primarily due to an increase in trail commissions in 2006.
The decrease in Retirement Plan’s ROA, excluding realized gains (losses) and DAC unlock, was primarily due to higher maintenance expenses in 2006.
The decrease in Institutional’s ROA, excluding realized gains (losses) and DAC unlock, is primarily due to higher maintenance expense in 2006.
International’s ROA, excluding realized gains (losses) and DAC unlock, increased significantly in 2006 primarily due to the leveraging of its existing infrastructure through disciplined expense management.
The DAC unlock benefit of $210 recorded in the third quarter of 2007.
Increased DAC amortization in Group Benefits due to the adoption of SOP 05-1.
Across all lines of business, impairments increased $282 in 2007 primarily due to an increase in credit related other than temporary impairments taken on ABS securities backed by subprime residential mortgage loans and securities in the financial services and building sectors. For further discussion, see the Other-Than-Temporary Impairments discussion within Investment section of the MD&A.
Across all lines of business, Other net losses increased $156 in 2007 primarily resulted from the change in value of non-qualifying derivatives due to fluctuations in credit spreads, interest rates, and equity markets. The increase in net losses in 2007 compared to the prior year was primarily due to changes in value associated with credit derivatives due to credit spreads widening. Credit spreads widened primarily due to the deterioration in the US housing market, tightened lending conditions, reduction of risk appetite as well as increased likelihood of a U.S. recession. For further discussion, see the “Capital Market Risk Management” section of the MD&A.
The net gains on sales resulted primarily from changes in credit spreads, foreign currency exchanges rates and interest rates from the date of purchase. For further discussion of gross gains and losses, see “Investment Results” in the Investments section of the MD&A.
Net realized capital losses increased in 2006 as compared to 2005 primarily as a result of a higher interest rate environment. The components that drove the increase in net losses during the year ended December 31, 2006 included net losses on sales of fixed maturity securities, other-than-temporary impairments, periodic net coupon settlements and losses in Other, net, partially offset by a decrease in losses associated with GMWB derivatives. A more expanded discussion of these components is as follows:
The net losses on sales were derived by fixed maturities for the year ended December 31, 2006 and were primarily the result of rising interest rates from the date of security purchase and, to a lesser extent, credit spread widening on certain issuers that were sold. For further discussion of gross gains and losses, see “Investment Results” in the Investments section of the MD&A.
Retail focuses on the savings and retirement needs of the growing number of individuals who are preparing for retirement, or have already retired, through the sale of individual variable and fixed annuities, mutual funds and other investment products. Life is both a large writer and seller of individual variable annuities and a top seller of individual variable annuities throughout banks in the United States.
Mutual fund fee income increased 26% for the year ended December 31, 2006 due to increased assets under management driven by market appreciation of $3.9 billion and net deposits of $5.7 billion during the year. This increase was primarily attributable to focused wholesaling efforts.
Higher amortization of DAC resulted from the unlock during the fourth quarter of 2006. For further discussion, see Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A.
Retail mutual fund net sales of $4.0 billion to $6.0 billion
Net income in the Retirement Plans segment for the year ended December 31, 2006 increased primarily due to improved fee income combined with lower amortization of DAC resulting from the unlock during the fourth quarter of 2006. In addition, realized capital losses increased $30 for the year ended December 31, 2006 as compared to the prior year period. For further discussion, see Realized Capital Gains and Losses by Segment table under Life’s Operating Section of the MD&A. A more expanded discussion of income growth can be found below:
Fee income for 401(k) increased 34%, or $37 for the year ended December 31, 2006 compared to the prior year due to the growth in average account values. This growth is primarily driven by positive net flows of $2.0 billion during the year resulting from strong deposits. Total 401(k) annuity deposits and net flows increased by 22% and 16%, respectively, over the prior year. The increase in average account values can also be attributed to market appreciation of $1.1 billion during the year.
Lower amortization of DAC resulted from an unlock benefit in the fourth quarter of 2006. For further discussion, see Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A.
Fee income increased for the year ended December 31, 2007 primarily driven by higher Mutual Fund and PPLI assets under management due to net flows and change in market appreciation of $5.8 billion and $2.1 billion, respectively, during the year. In addition, PPLI collects front-end loads, recorded in fee income, to subsidize premium tax payments. Premium taxes are recorded as an expense in insurance operating costs and other expenses. During the year ended December 31, 2007, PPLI had deposits of $5.2 billion, which resulted in an increase in fee income due to front-end loads of $107 offset by a corresponding increase in insurance operating costs and other expenses.
IIP operating expenses increased in the year ended December 31, 2006 due to higher costs related to the launch of new retirement products targeting the “baby boom” generation in 2006.
The focus of PPLI is variable products used primarily to fund non-qualified benefits or other post employment benefit liabilities. PPLI has experienced a surge in marketplace activity due to COLI Best Practices enacted as part of the Pension Protection Act of 2006. This act has clarified the prior legislative uncertainty relating to insurable interest under COLI policies, potentially increasing future demand in corporate owned life insurance. During 2007, the Company had over $5 billion in deposits. Sales activity of this magnitude may not repeat in 2008. The market served by PPLI continues to be subject to extensive legal and regulatory scrutiny that can affect this business.
Net flows (excluding mutual funds) of $3.25 billion to $4.75 billion
Fee income and other decreased for the year ended December 31, 2007 primarily due to the impacts of the 2007 and 2006 unlocks. For further discussion, see Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A. Offsetting the impacts of the 2007 and 2006 unlocks, fee income increased for the year ended December 31, 2007. Cost of insurance charges, the largest component of fee income, increased $35 primarily driven by growth in variable universal and universal life insurance account value. Variable fee income increased consistent with the growth in variable universal life insurance account value.
Earned premiums, which include premiums for ceded reinsurance, decreased primarily due to increased ceded reinsurance premiums for the year ended December 31, 2007.
Insurance operating costs and other expenses increased for the year ended December 31, 2007 substantially consistent with life insurance in-force growth.
Net income in Individual Life for 2006 decreased due to the unlock expense in the fourth quarter of 2006. In addition, realized capital losses increased $42 for the year ended December 31, 2006 as compared to the prior year period. For further discussion, see Realized Capital Gains and Losses by Segment table under Life’s Operating Section of the MD&A. Offsetting these losses, net income increased primarily due to growth in life insurance and account values, and favorable mortality experience in 2006 compared to 2005 as well as $7 of after-tax, favorable revisions to prior year net DAC estimates reflected in the first half of 2006. The following other factors contributed to the changes in income:
Cost of insurance charges, the largest component of fee income, increased $30 for the year ended December 31, 2006, driven by growth in the variable universal and universal life insurance in-force. Variable fee income increased, consistent with the growth in the variable universal life insurance account value. Other fee income, another component of total fee income, increased primarily due to additional amortization of deferred revenues associated with the unlock.
Net investment income increased primarily due to increased general account assets from sales growth.
Net investment income increased due to a higher invested asset base and increased interest income on allocated surplus.
Net income increased for the year ended December 31, 2006, primarily due to higher earned premiums and a lower expense ratio excluding the financial institution business. The results for the year ended December 31, 2006 included a net benefit of $11 resulting from the completion of life reserve studies during the fourth quarter. The results for the year ended December 31, 2005 included a non-recurring tax benefit of $9 related to the CNA Acquisition. A more expanded discussion of income growth is presented below:
Earned premiums increased driven by year-to-date sales (excluding buyouts) growth of 11%, particularly in group life insurance.
The expense ratio was 27.6% for the year ended December 31, 2006 as compared to 27.8% in the prior year period. Excluding financial institutions, the expense ratio for the year ended December 31, 2006 was 22.9%, down from 24.0% in the prior year period. The decline in expense ratio excluding financial institutions for the year ended December 31, 2006 was due to growth in premiums outpacing growth in expenses.
Management is committed to selling competitively priced products that meet the Company’s internal rate of return guidelines and as a result, sales may fluctuate based on the competitive pricing environment in the marketplace. In 2007, the Company generated premium growth due to the increased scale of the group life and disability operations. However, fully insured on-going sales, excluding buyouts declined primarily due to fewer large national account sales, and the small case competitive environment remained intense. In addition, there was an anticipated reduction in association life sales from an unusually high prior year period. The Company also completed a renewal rights transaction associated with its medical stop loss business during the second quarter of 2007. The Company anticipates relatively stable loss ratios and expense ratios based on underlying trends in the in-force business and disciplined new business and renewal underwriting.
Despite the current market conditions, including rising medical costs, the changing regulatory environment and cost containment pressure on employers, the Company continues to leverage its strength in claim practices risk management, service and distribution, enabling the Company to capitalize on market opportunities. Additionally, employees continue to look to the workplace for a broader and ever expanding array of insurance products. As employers design benefit strategies to attract and retain employees, while attempting to control their benefit costs, management believes that the need for the Company’s products will continue to expand. This, combined with the significant number of employees who currently do not have coverage or adequate levels of coverage, creates opportunities for our products and services.
Fully insured ongoing premiums (excluding buyout premiums and premium equivalents) of $4.25 billion to $4.35 billion
Fee income increased for the year ended December 31, 2007 primarily due to growth in Japan’s variable annuity assets under management. As of December 31, 2007, Japan’s variable annuity assets under management were $35.8 billion, an increase of $6.1 billion or 21% from the prior year period. The increase in assets under management was driven by positive net flows of $4.5 billion, partially offset by unfavorable market performance of $620, which includes the impact of foreign currency movements on the Japanese customer’s foreign assets and a $2.3 billion increase due to foreign currency exchange translation as the yen strengthened compared to the U.S. dollar.
Higher amortization of DAC resulted primarily from a decrease in the 2007 unlock benefit compared with the prior year period, as well as overall growth of operations. For further discussion, see Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A.
Net income in International increased for the year ended December 31, 2006, principally driven by higher fee income in Japan, which was derived from an increase in average assets under management. In addition, realized capital losses increased $24 for the year ended December 31, 2006 as compared to the prior year period. For further discussion, see Realized Capital Gains and Losses by Segment table under Life’s Operating Section of the MD&A. A more expanded discussion of earnings growth can be found below:
The decrease in benefits, losses and loss adjustment expenses by 93% over prior year can be attributed to the unlock of the GMDB/GMIB reserve of $27 after-tax.
The increase in fixed annuity assets under management can be attributed to positive net flows of $224 during the year.
DAC amortization was higher due to higher actual gross profits consistent with growth in the Japan operation, off set by an unlock benefit. For further discussion, see Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A.
Management continues to be optimistic about the growth potential of the retirement savings market in Japan. Several trends, such as an aging population, longer life expectancies and declining birth rates leading to a smaller number of younger workers to support each retiree, have resulted in greater need for an individual to plan and adequately fund retirement savings.
Profitability depends on the account values of our customers, which are affected by equity, bond and currency markets. Periods of favorable market performance will increase assets under management and thus increase fee income earned on those assets. In addition, higher account value levels will generally reduce certain costs for individual annuities to the Company, such as guaranteed minimum death benefits (“GMDB”) guaranteed minimum income benefits (“GMIB”) and guaranteed minimum accumulation benefits (GMAB). Prudent expense management is also an important component of product profitability.
On September 30, 2007, the Financial Services Agency in Japan implemented a new law, the Financial Instruments Exchange Law (“FIEL”). FIEL is designed to strengthen the protection of Japanese consumers who buy financial products such as stocks, bonds, mutual funds, variable annuities, fixed annuities with market value adjustments and some types of bank deposits. As a result, financial institutions in Japan have implemented extensive customer assessments which must occur prior to recommending securities and other financial products, including annuities.
In the short term, FIEL is lengthening the sales cycle as the marketplace adapts to the new sales practices. However, in the long term, the Company believes FIEL will result in more suitable sales practices and, together with the country’s demographics, will provide enhanced opportunities for a broader product set to meet future consumer needs.
Management’s full year projections for Japan in 2008 are as follows (using ¥110/$1 exchange rate for 2008):
Also contributing to the increase in insurance operating costs and other expenses was $18, after-tax, of interest charged by Corporate on the amount of capital held by the Life operations in excess of the amount needed to support the capital requirements of the Life Operations for the year ended December 31, 2007.
The Company recorded a reserve in the second quarter of 2007 for market regulatory matters of $21, after-tax. During the year, the Company recorded an insurance recovery of $9, after-tax, against the litigation costs associated with the regulatory matters.
Refer to Realized Capital Gains and Losses by Segment table under Life’s Operating section of the MD&A.
Property & Casualty is organized into five reporting segments: the underwriting segments of Personal Lines, Small Commercial, Middle Market and Specialty Commercial (collectively “Ongoing Operations”); and the Other Operations segment. In 2007, Property & Casualty changed its reporting segments to reflect the current manner by which its chief operating decision maker views and manages the business. All segment data for prior reporting periods have been adjusted to reflect the current segment reporting.
Property & Casualty provides a number of coverages, as well as insurance related services, to businesses throughout the United States, including workers’ compensation, property, automobile, liability, umbrella, specialty casualty, marine, livestock, fidelity, surety, professional liability and directors and officers’ liability coverages. Property & Casualty also provides automobile, homeowners and home-based business coverage to individuals throughout the United States as well as insurance-related services to businesses.
Property & Casualty derives its revenues principally from premiums earned for insurance coverages provided to insureds, investment income, and, to a lesser extent, from fees earned for services provided to third parties and net realized capital gains and losses. Premiums charged for insurance coverages are earned principally on a pro rata basis over the terms of the related policies in-force.
In Personal Lines, earned premium grew by $129, or 3%, primarily due to an increase in AARP and Agency earned premiums. AARP earned premium grew primarily due to an increase in the size of the AARP target market, the effect of direct marketing programs and the effect of cross selling homeowners insurance to insureds who have auto policies. Agency earned premium grew as a result of an increase in the number of agency appointments and further refinement of the Dimensions class plans. Partially offsetting this growth was the effect of the sale of the Omni non-standard auto business in the fourth quarter of 2006 which accounted for $127 of earned premium in 2006. Excluding Omni, Personal Lines’ earned premiums grew $251, or 7%, for the year ended December 31, 2007.
In Small Commercial, earned premiums increased $84, or 3%, primarily due to new business premiums outpacing non-renewals for workers’ compensation business over the last six months of 2006 and the first six months of 2007.
Middle Market earned premium decreased by $103, or 4%, driven by decreases in all lines, including commercial auto, general liability, workers’ compensation and property. Earned premium decreases were driven by declines in earned pricing and premium renewal retention in all lines and a decline in new business premiums in all lines except workers’ compensation.
Specialty Commercial earned premium decreased by $47, or 3%, primarily driven by a decrease in casualty and property and a decrease in earned premiums assumed under inter-segment arrangements, partially offset by an increase in professional liability, fidelity and surety.
For the year ended December 31, 2006, earned premiums grew $231, or 10%, in Small Commercial, $150, or 4%, in Personal Lines and $99, or 4%, in Middle Market. Apart from the effect of catastrophe treaty reinstatement premium in 2005, the growth was primarily driven by new business premium outpacing non-renewals over the last six months of 2005 and the full year of 2006 and the effect of earned pricing increases in homeowners, partially offset by the effect of higher property catastrophe treaty reinsurance costs and earned pricing decreases in Middle Market.
Excluding Omni, the $267 decrease in Ongoing Operations’ current accident year underwriting results before catastrophes was primarily due to an increase in the loss and loss adjustment expense ratio before catastrophes and prior accident year development and an increase in insurance and operating costs and dividends. The increase in the loss and loss adjustment expense ratio before catastrophes and prior accident year development was primarily due to increased severity on Personal Lines auto liability claims, increased frequency on Personal Lines auto property damage claims and, to a lesser extent, increased severity on Personal Lines homeowners claims and a higher loss and loss adjustment expense ratio for both Small Commercial package business and Middle Market workers’ compensation claims.
The change to net realized capital losses during 2007 was primarily due to an increase in credit-related impairments and decreases in the fair value of non-qualifying derivatives attributable to changes in value associated with credit derivatives due to credit spreads widening. Credit-related impairments in 2007 primarily consisted of impairments of asset-backed securities backed by sub-prime residential mortgage loans and impairments of corporate securities in the financial services and homebuilders sectors. (See the Other-Than-Temporary Impairments discussion within Investment Results for more information on the impairments recorded in 2007).
The $167 decrease in net unfavorable prior accident year development in Other Operations was primarily due to a $243 charge in 2006 to recognize the effect of the Equitas agreement and strengthening of the allowance for uncollectible reinsurance, partially offset by a $99 strengthening of reserves in 2007, primarily related to an adverse arbitration decision. See the Other Operations segment discussion of the MD&A for further information of the prior accident year reserve development in each year.
The $152 decrease in current accident year catastrophe losses was largely due to $264 of losses in 2005 related to hurricanes Katrina, Rita and Wilma, partially offset by an increase in non-hurricane catastrophe losses in 2006.
Within Personal Lines, the decrease in the earned premium growth rate from 2006 to 2007 was due to the Company’s exit from the Omni non-standard auto business. Omni, which was sold in the fourth quarter of 2006, accounted for $127 of earned premium in 2006. Excluding Omni, the Personal Lines earned premium growth rate was 7% in both 2006 and 2007. In 2007, an increase in the growth rate of AARP earned premium was offset by the effect of a decrease in the growth rate of Agency earned premium.
Within Small Commercial, the decrease in the earned premium growth rate was primarily attributable to a decrease in new business written premium and premium renewal retention over the last six months of 2006 and the first six months of 2007. Also contributing to the lower growth rate was a decrease in earned pricing.
Within Middle Market, the change from an increase in earned premium in 2006 to a decrease in earned premium in 2007 was primarily attributable to earned pricing decreases, a decrease in new business written premium over the last six months of 2006 and the first six months of 2007 and a decrease in premium renewal retention over the first six months of 2007.
For the year ended December 31, 2007, the Ongoing Operations’ combined ratio increased 1.5 points, to 90.8, due to a 2.5 point increase in the combined ratio before catastrophes and prior accident year development, partially offset by a 0.8 point improvement in prior accident year reserve development and the effect of the sale of Omni in the fourth quarter of 2006. Omni had a higher combined ratio before catastrophes and prior accident year development than other business written by the Company.
The increase in the combined ratio before catastrophes and prior accident year development, from 88.0 to 90.5, was primarily due to a 1.4 point increase in the current accident year loss and loss adjustment expense ratio before catastrophes and, to a lesser extent, an increase in the expense ratio. The increase in the loss and loss adjustment expense ratio before catastrophes and prior accident year development was primarily due to increased severity on Personal Lines auto liability claims, increased frequency on Personal Lines auto property damage claims and, to a lesser extent, increased severity on Personal Lines homeowners claims and a higher loss and loss adjustment expense ratio for both Small Commercial package business and Middle Market workers’ compensation claims. Contributing to the increase in the expense ratio was the effect of a $41 reduction of estimated Florida Citizens’ assessments in 2006 related to the 2005 Florida hurricanes.
The catastrophe ratio increased, primarily due to the effect of net favorable reserve development of prior accident year catastrophe losses in 2006. In 2006, the Company recognized $83 of net reserve releases related to the 2005 and 2004 hurricanes.
In 2007, the after-tax investment yield increased due to a higher yield on limited partnerships, hedge funds and mortgage loans as well as due to a change in asset mix, including shifting a greater share of investments to these asset classes.
The average annual invested assets at cost increased as a result of positive operating cash flows and an increase in collateral held from increased securities lending activities.
Prior accident year catastrophe reserves were reduced by $70 in 2006, primarily due to $83 of favorable development related to the 2005 and 2004 hurricanes. Net prior accident year development for non-catastrophe claims was not significant as reserve strengthenings were largely offset by reserve releases. See the “Reserves” section for a discussion of prior accident year reserve development for Ongoing Operations in 2006.
Other Operations reported a net loss of $35 for 2006 compared to net income of $71 for 2005. The change from net income to a net loss was primarily due to a $148 increase in unfavorable prior accident year development and a $22 decrease in net investment income, partially offset by a change to an income tax benefit in 2006 as a result of a pre-tax loss in 2006. The $148 increase in prior accident year development was primarily due to a $243 reduction in net reinsurance recoverables as a result of the agreement with Equitas and the Company’s evaluation of the reinsurance recoverables and allowance for uncollectible reinsurance associated with older, long-term casualty liabilities. Partially offsetting the increase in prior accident year development in 2006 was $85 of unfavorable reserve development for assumed reinsurance in 2005. The $22 decrease in net investment income was primarily due to lower invested assets as a result of loss and loss adjustment expense payments and the reallocation of capital from Other Operations to Ongoing Operations.
Policies in-force represent the number of policies with coverage in effect as of the end of the period. The number of policies in-force is a growth measure used for Personal Lines, Small Commercial and Middle Market and is affected by both new business growth and premium renewal retention.
Written pricing increase (decrease) over the comparable period of the prior year includes the impact of rate filings, the impact of changes in the value of the rating bases and individual risk pricing decisions. A number of factors impact written pricing increases (decreases) including expected loss costs as projected by the Company’s pricing actuaries, rate filings approved by state regulators, risk selection decisions made by the Company’s underwriters and marketplace competition. Written pricing changes reflect the property and casualty insurance market cycle. Prices tend to increase for a particular line of business when insurance carriers have incurred significant losses in that line of business in the recent past or the industry as a whole commits less of its capital to writing exposures in that line of business. Prices tend to decrease when recent loss experience has been favorable or when competition among insurance carriers increases.
The loss and loss adjustment expense ratio is affected by claim frequency and claim severity, particularly for shorter-tail property lines of business, where the emergence of claim frequency and severity is credible and likely indicative of ultimate losses. Claim frequency represents the percentage change in the average number of reported claims per unit of exposure in the current accident year compared to that of the previous accident year. Claim severity represents the percentage change in the estimated average cost per claim in the current
accident year compared to that of the previous accident year. As one of the factors used to determine pricing, the Company’s practice is to first make an overall assumption about claim frequency and severity for a given line of business and then, as part of the ratemaking process, adjust the assumption as appropriate for the particular state, product or coverage.
Current accident year loss and loss adjustment expense ratio before catastrophes
The catastrophe ratio (a component of the loss and loss adjustment expense ratio) represents the ratio of catastrophe losses (net of reinsurance) to earned premiums. By their nature, catastrophe losses vary dramatically from year to year. Based on the mix and geographic dispersion of premium written and estimates derived from various catastrophe loss models, the Company’s expected catastrophe ratio over the long-term is 3.0 to 3.5 points. See “Risk Management Strategy” below for a discussion of the Company’s catastrophe risk management program that serves to mitigate the Company’s net exposure to catastrophe losses. The catastrophe ratio includes the effect of catastrophe losses, but does not include the effect of reinstatement premiums.
The investment yield, or return, on the Company’s invested assets primarily includes interest income on fixed maturity investments. Based upon the fair value of Property & Casualty’s investments as of December 31, 2007 and 2006, approximately 89% and 91%, respectively, of invested assets were held in fixed maturities. A number of factors affect the yield on fixed maturity investments, including fluctuations in interest rates and the level of prepayments. The Company also invests in equity securities, mortgage loans and limited partnership arrangements.
Reserving for property and casualty losses is an estimation process. As additional experience and other relevant claim data become available, reserve levels are adjusted accordingly. Such adjustments of reserves related to claims incurred in prior years are a natural occurrence in the loss reserving process and are referred to as “reserve development”. Reserve development that increases previous estimates of ultimate cost is called “reserve strengthening”. Reserve development that decreases previous estimates of ultimate cost is called “reserve releases”. Reserve development can influence the comparability of year over year underwriting results and is set forth in the paragraphs and tables that follow. The “prior accident year development (pts.)” in the following table represents the ratio of reserve development to earned premiums. For a detailed discussion of the Company’s reserve policies, see Notes 1, 11 and 12 of Notes to Consolidated Financial Statements and the Critical Accounting Estimates section of the MD&A.
During 2007, the Company experienced favorable emergence of losses on professional liability claims for recent accident years and, during the fourth quarter of 2007, released professional liability reserves by $15, largely due to a decrease in the estimated cost to settle claims under errors and omissions policies in the 2005 accident year. In addition, reported losses for claims under directors’ and officers’ insurance policies are emerging favorably to initial expectations although it is too early to tell if this trend will be sustained. Up until the fourth quarter of 2007, there had been a decrease in the number of shareholders’ class action suits under directors’ and officers’ insurance policies. Any continued favorable emergence of claims under errors and omissions policies or directors’ and officers’ insurance policies could lead the Company to reduce reserves for these liabilities in future quarters.
During the year ended December 31, 2007, the Company’s re-estimates of prior accident year reserves included the following significant reserve changes.
Released reserves for commercial surety business by $22 for accident years 2003 to 2006. Reported losses for commercial surety business have been emerging favorably resulting in the Company lowering its estimate of ultimate unpaid losses during the third quarter of 2007. The $22 reserve release represented 14% of the Company’s net reserves for fidelity and surety claims as of December 31, 2006.
Strengthened reserves for personal auto liability claims by $30 due to an increase in estimated severity on claims where the Company is exposed to losses in excess of policy limits. From the Company’s reserve review during the first quarter of 2006, the
Includes reserve discount accretion of $30, including $6 in Small Commercial, $7 in Middle Market, $10 in Specialty Commercial and $7 in Other Operations.
Strengthened workers’ compensation reserves for claim payments expected to emerge after 20 years of development by $120. For workers’ compensation claims involving permanent disability, it is particularly difficult to estimate how such claims will develop more than 20 years after the year the claims were incurred (known as “the tail”). During 2005, the Company’s actuaries performed an actuarial study to re-estimate the required reserves for additional development beyond the 20th year following a claim being
incurred. This study involved gathering extensive historical data dating back over 50 years which could be used for making these estimates and incorporated modeling using actuarial techniques that have recently been developed within the actuarial profession. Based on the results of this analysis the Company changed its previous estimate and increased the percentage of ultimate claim costs expected to be paid after 20 years of development. As an example, within Small Commercial and Middle Market, this development percentage was increased from 8% to 9%. The $120 of reserve strengthening represented a change in estimate which was 3% of the Company’s net reserves for workers’ compensation claims as of December 31, 2004.
Released reserves for workers’ compensation losses in Small Commercial and Middle Market by $75 related to accident years 2003 and 2004. The state of California instituted reforms to its workers’ compensation laws that began in 2003 and continued through 2005. In addition, in this same time frame, the Company was taking underwriting actions to improve workers’ compensation underwriting performance. Management recognized that the combination of the Company’s underwriting initiatives and the state of California changes could, over time, improve the Company’s workers’ compensation experience. Verification of this improvement as a probable outcome, however, would require sufficient supporting evidence. While there appeared to be some favorable trends emerging in late 2004 with respect to accident year 2003 and while early indications on accident year 2004 were favorable, senior reserving actuaries and senior management were uncertain that these favorable trends were real and would be sustained. In the third quarter of 2005, management concluded that sufficient evidence existed in the actuarial data and methods to support a release of reserves. The actuarial work was further supported by a review of underwriting metrics, supporting the effectiveness of the actions taken, and by discussions with claim handlers involved with the California workers’ compensation business. The $75 reserve release represented a change in estimate which was 2% of the Company’s net reserves for workers’ compensation claims as of December 31, 2004.
Strengthened assumed reinsurance reserves by $85, principally for accident years 1997 through 2001. In recent years, the Company has seen an increase in reported losses above previous expectations and this increase in reported losses contributed to the reserve re-estimates. Assumed reinsurance exposures are inherently less predictable than direct insurance exposures because the Company may not receive notice of a reinsurance claim until the underlying direct insurance claim is mature. The reserve strengthening of $85 represents 6% of the $1.3 billion of net assumed reinsurance reserves within Other Operations as of December 31, 2004.
In managing risk, The Hartford’s management processes involve establishing underwriting guidelines for both individual risks, including individual policy limits, and in aggregate, including aggregate exposure limits by geographic zone and peril. The Company establishes risk limits and actively monitors the risk exposures as a percent of Property & Casualty statutory surplus. For natural catastrophe perils, the Company limits its estimated loss to natural catastrophes from a single 250-year event prior to reinsurance to less than 30% of statutory surplus of the Property & Casualty operations and its estimated loss to natural catastrophes from a single 250-year event after reinsurance to less than 15% of statutory surplus of the Property & Casualty operations. For terrorism, the Company monitors its exposure in major metropolitan areas to a single-site conventional terrorism attack scenario, and manages its potential estimated loss, including exposures resulting from the Company’s Group Life operations, to less than $800, which is approximately 5% of the combined statutory surplus of the Life and Property and Casualty operations as of December 31, 2007. Among the 251 locations specifically monitored by the Company, the largest estimated modeled loss arising from a single event is approximately $790. The Company monitors exposures monthly and employs both internally developed and vendor-licensed loss modeling tools as part of its risk management discipline.
The per occurrence limit on the FHCF treaty increased from $264 for the 6/1/2006 to 6/1/2007 treaty year to $423 for the 6/1/2007 to 6/1/2008 treaty year due to the Company’s election to purchase additional limits under the “Temporary Increase in Coverage Limit (TCIL)” statutory provision in excess of the coverage the Company is required to purchase from the FHCF.
In addition to the property catastrophe reinsurance coverage described in the above table, the Company has other treaties and facultative reinsurance agreements that cover property catastrophe losses on an aggregate excess of loss and on a per risk basis. Property catastrophe losses incurred on property business written with national accounts is also reimbursable under the principal catastrophe reinsurance program, subject to the overall program limits and retention. In the aftermath of the 2004 and 2005 hurricane season, third-party catastrophe loss models for hurricane loss events were updated to incorporate medium-term forecasts of increased hurricane frequency and severity.
As of December 31, 2007, there have been no events that are expected to trigger a recovery under any of the reinsurance programs with Foundation Re or Foundation Re II and, accordingly, the Company has not recorded any recoveries from the associated reinsurance treaties.
Percentage of statutory surplus of the Property & Casualty operations as of December 31,
Among other items, TRIPRA required that the President’s Working Group on Financial Markets (“PWG”) continue to perform an analysis regarding the long-term availability and affordability of insurance for terrorism risk. Among the findings detailed in the PWG’s initial report, released October 2, 2006, were that the high level of uncertainty associated with predicting the frequency of terrorist attacks, coupled with the unwillingness of some insurance policyholders to purchase insurance coverage, makes predicting long term development of the terrorism risk market difficult, and that there is likely little potential for future market development for nuclear, biological, chemical and radiological (NBCR) coverage. A September 2006 study by the U.S. Government Accountability Office on insuring NBCR terrorism risk similarly concluded that any market-driven expansion of coverage is highly unlikely in the foreseeable future. TRIPRA requires the Comptroller General to, among other things, study the availability and affordability of insurance coverage for losses caused by terrorist attacks involving nuclear, biological, chemical or radiological materials and issue a report by December, 2008.
Citizens Property Insurance Corporation in Florida (“Citizens”) provides property insurance to Florida homeowners and businesses that are unable to obtain insurance from other carriers, including for properties deemed to be “high risk”. Citizens maintains a Personal Lines account, a Commercial Lines account and a High Risk account. If Citizens incurs a deficit in any of these accounts, Citizens may impose a “regular assessment” on other insurance carriers in the state to fund the deficits, subject to certain restrictions and subject to approval by the Florida Office of Insurance Regulation. Carriers are then permitted to surcharge policyholders to recover the assessments over the next few years. Citizens may also opt to finance a portion of the deficits through issuing bonds and may impose “emergency assessments” on other insurance carriers to fund the bond repayments. Unlike with regular assessments, however, insurance carriers only serve as a collection agent for emergency assessments and are not required to remit surcharges for emergency assessments to Citizens until they collect surcharges from policyholders. Under generally accepted accounting principles, the Company is required to accrue for regular assessments in the period the assessments become probable and estimable and the obligating event has occurred. Surcharges to recover the amount of regular assessments may not be recorded as an asset until the related premium is written. Emergency assessments that may be levied by Citizens are not recorded in the income statement.
Unless otherwise specified, the following discussion speaks to changes for the year ended December 31, 2007 compared to the year ended December 31, 2006 and the year ended December 31, 2006 compared to the year ended December 31, 2005.
Net income decreased by $12, or 1%, as a result of a $77 decrease in Ongoing Operations’ net income partially offset by a $65 increase in Other Operations’ results. Other Operations reported net income of $30 in 2007 compared to a net loss of $35 in 2006. See the Ongoing Operations and Other Operations segment MD&A discussions for an analysis of the underwriting results and investment performance driving the change in net income.
Net income increased by $283, or 23%, as a result of a $389 increase in Ongoing Operations’ net income, partially offset by a $106 decrease in Other Operations’ results. Other Operations reported a net loss of $35 in 2006 compared to net income of $71 in 2005. See the Ongoing Operations and Other Operations segment MD&A discussions for an analysis of the underwriting results and investment performance driving the change in net income.
Ongoing Operations includes the four underwriting segments of Personal Lines, Small Commercial, Middle Market and Specialty Commercial.
Net income decreased by $77, or 5%, due primarily to a decrease in underwriting results and an increase in net realized capital losses, partially offset by an increase in net investment income.
Ongoing Operations’ current accident year loss and loss adjustment expenses before catastrophes increased by $185 in 2007, to $6,692, due largely to an increase in the current accident year loss and loss adjustment expense ratio and an increase in earned premium, partially offset by a decrease due to the sale of Omni. Excluding Omni, the current accident year loss and loss adjustment expense ratio before catastrophes increased by 1.7 points, to 63.8, due to an increase in the current accident year loss and loss adjustment expense ratio before catastrophes of 3.3 points in Personal Lines, 1.4 points in Small Commercial and 2.2 points in Middle Market, partially offset by a decrease in the current accident year loss and loss adjustment expense ratio before catastrophes of 2.2 points in Specialty Commercial.
The 2.2 point increase in the current accident year loss and loss adjustment expense ratio before catastrophes in Middle Market was primarily due to a higher loss and loss adjustment expense ratio for workers’ compensation, general liability and commercial auto claims driven, in part, by earned pricing decreases. For commercial auto, loss costs increased for both liability and property damage claims.
Despite the increase in earned premium, amortization of deferred policy acquisition costs remained relatively flat from 2006 to 2007 due to the effect of the sale of Omni. Excluding the effect of Omni, amortization increased by $28, or 1%, primarily driven by the 2% growth in earned premiums excluding Omni. In 2006, Omni accounted for $127 of earned premiums and $30 of amortization.
Primarily driving the $214 increase in net investment income was a higher average invested asset base and income earned from a higher portfolio yield. The increase in the average invested asset base contributing to the increase in investment income was primarily due to positive operating cash flows, partially offset by the return of capital to Corporate. Contributing to the increase in net investment income was an increase in income from limited partnerships and other alternative investments, driven by a higher yield on these investments and shifting a greater allocation of investments to these asset classes.
Current accident year loss and loss adjustment expenses before catastrophes increased by $143
Excluding the effect of catastrophe treaty reinstatement premium, the 0.3 point increase in the current accident year loss and loss adjustment expense ratio before catastrophes in Specialty Commercial was primarily due to a higher loss and loss adjustment expense ratio on casualty and professional liability business and the effect of an increase in the allocation to Specialty Commercial of premiums ceded under the Company’s principal property catastrophe reinsurance program, partially offset by lower non-catastrophe property loss costs.
Current accident year catastrophe losses decreased by $152, from $351, or 3.5 points, in 2005 to $199, or 1.9 points, in 2006. The decrease in current accident year catastrophe losses was primarily due to $264 of net losses incurred for hurricanes Katrina, Rita and Wilma in 2005, partially offset by an increase in non-hurricane related catastrophes in 2006. Catastrophe losses in 2006 included tornadoes and hail storms in the Midwest and windstorms in Texas and on the East coast.
The 0.9 point decrease in the expense ratio, to 25.6, was primarily due to a decrease in insurance operating costs and expenses. Insurance operating costs decreased by $141, largely because of a $41 decrease in estimated Citizens’ assessments in 2006 compared to a $64 increase in Citizens assessments in 2005. Almost all of the Citizens assessments were for assessments charged by the Citizens Property Insurance Corporation (Citizens) in Florida, a company established by the State of Florida to provide personal and commercial insurance to individuals and businesses in Florida who are in high risk areas of the state and are unable to obtain insurance through the private insurance markets. Amortization of deferred policy acquisition costs increased by $106, due largely to the increase in earned premium.
The $143 increase in net investment income was primarily because of a larger investment base due to increased cash flows from underwriting and an increase in capital and invested assets attributed to Ongoing Operations as well as an increase in interest rates and a change in asset mix (i.e., a greater share of investments in mortgage loans and limited partnerships).
Personal Lines provides automobile, homeowners’ and home-based business coverages to the members of AARP through a direct marketing operation and to individuals who prefer local agent involvement through a network of independent agents in the standard personal lines market (“Standard”). Up until the sale of the business on November 30, 2006, the Company also sold non-standard auto insurance through the Company’s Omni Insurance Group, Inc. (“Omni”) subsidiary. Personal Lines also operates a member contact center for health insurance products offered through the AARP Health program. The Hartford’s exclusive licensing arrangement with AARP continues until January 1, 2020 for automobile, homeowners and home-based business. The AARP Health program agreement continues through 2009.
Agency earned premium grew $55, or 5%, as a result of an increase in the number of agency appointments and further refinement of the Dimensions class plans first introduced in 2003. Dimensions allows Personal Lines to write a broader class of risks. The plan, which is available through the Company’s network of independent agents, was enhanced beginning in the third quarter of 2006 as “Dimensions with Auto Packages” and the enhanced plan is now offered in 34 states with four distinct package offerings as of December 31, 2007.
Omni accounted for $25 of new business written premium during the 2006 calendar year. Excluding Omni business, auto new business written premium decreased by $20, or 5%, to $424, for the year ended December 31, 2007. The decrease in auto new business premium was due to a decrease in AARP and Agency auto new business as a result of increased competition. Homeowners’ new business written premium decreased by $21, or 13%, primarily due to a decrease in Agency new business, partially offset by an increase in AARP new business.
Agency earned premium grew $71, or 7%, primarily as a result of an increase in the number of agency appointments and further refinement of the Dimensions class plans first introduced in 2003. Dimensions, which had been rolled out to 42 states for auto and 39 states for homeowners as of December 31, 2006, enables agents to generate a customized price for each policyholder, independent of the risks and rates of other members of the same household. The plan, which is available through the company’s network of independent agents, was enhanced beginning in the third quarter of 2006 as “Dimensions with Auto Packages” and the enhanced plan was offered in 29 states with four distinct package offerings as of the year ended December 31, 2006.
Premium renewal retention in 2006 for auto of 87% and for homeowners of 94% remained flat from the prior year. For auto, overall premium renewal retention was flat, despite a decrease in retention for Agency auto. For homeowners, an increase in retention of AARP business was offset by a decrease in retention of Agency business. Premium renewal retention for Agency auto decreased due to a shift to more six month policies that have a lower retention rate.
The trend in earned pricing during 2006 was primarily a reflection of the written pricing changes in the last six months of 2005 and the first six months of 2006. Auto written pricing decreases are driven by an extended period of favorable results factoring into the rate setting process. Homeowners’ written pricing continues to increase moderately due to insurance to value increases.
The expense ratio decreased by 0.3 points, to 22.4, in 2007, due largely to an increase in insurance operating costs and expenses. Omni accounted for $9 of insurance operating costs and expenses in 2006. Excluding Omni, insurance operating costs and expenses increased by $31, or 14%, primarily due to the effect of a $19 reduction of estimated Citizen’s assessments in 2006 related to 2005 Florida hurricanes. Also contributing to the increase in insurance and operating costs was an increase in AARP distribution costs and other insurance operating costs, partially offset by lower IT costs.
Personal Lines earned premium increased by $150, or 4%, to $3,760, in part due to $31 of catastrophe treaty reinstatement premium recorded as a reduction of earned premium in 2005. Refer to the earned premium discussion for a description of the increase in earned premium.
Margins for both auto and homeowners are under pressure as carriers have generally been willing to allow their combined ratios to increase in order to grow written premium. For auto, written pricing was flat for 2007 and did not keep pace with loss costs which increased due to a higher frequency of auto claims and a higher severity of bodily injury claims. While carriers in the personal lines industry will continue to compete on price, management expects that auto pricing will firm a bit in 2008 as combined ratios have risen in the past couple of years and eroded profitability. Throughout 2007, the Company increased its estimate of current accident year loss costs for auto liability claims, due primarily to higher than anticipated frequency on AARP and Agency business. In 2008, management expects claim frequency on auto claims to stabilize, but expects claim severity to increase, resulting in a moderately higher current accident year loss and loss adjustment expense ratio on auto claims.
For Personal Lines, the Company expects a 2008 combined ratio before catastrophes and prior accident year development in the range of 88.5 to 91.5. The combined ratio before catastrophes and prior accident year development was 88.6 in 2007. To help maintain profitability, the Company will seek to achieve greater economy of scale, enhance its products, improve its pricing structure and expand market access.
To summarize, management’s outlook in Personal Lines for the 2008 full year is:
A combined ratio before catastrophes and prior accident year development of 88.5 to 91.5
As written premium is earned over the 12-month term of the policies, the earned pricing changes during 2007 are primarily a reflection of the written pricing changes over the last six months of 2006 and the first six months of 2007.
Consistent with the increase in earned premium, the number of policies in-force has increased. The growth in policies in-force does not correspond directly with the change in earned premiums due to the effect of changes in earned pricing, changes in the average premium per policy and because policy in-force counts are as of a point in time rather than over a period of time.
Premium renewal retention for Small Commercial decreased slightly for the year ended December 31, 2006, from 88% to 87%, primarily due to commercial auto business. New business written premium for Small Commercial decreased by $48, or 8%, for the year ended December 31, 2006, primarily due to lower production of new workers’ compensation, auto and package policies. Despite an increase in the number of appointed agents to expand writings in certain territories, actions taken by some of the Company’s competitors to increase commissions for workers’ compensation business may have contributed to the Company’s lower new business growth.
As written premium is earned over the 12 month term of the policies, the unfavorable trend in earned pricing during 2006 was primarily a reflection of the written pricing changes over the last six months of 2005 and the first six months of 2006.
Underwriting results increased by $86, from $422 to $508, with a corresponding 2.7 point improvement in the combined ratio, from 84.1 to 81.4, due to:
Small Commercial earned premium increased by $84, or 3%, to $2,736. Refer to the earned premium discussion for a description of the increase in earned premium.
Small Commercial earned premium increased by $231, or 10%, to $2,652. Refer to the earned premium discussion for a description of the increase in earned premium.
Current accident year loss and loss adjustment expenses before catastrophes increased by $83
Reflecting favorable trends in workers’ compensation loss costs in recent accident years, management expects a slightly lower loss and loss adjustment expense ratio for workers’ compensation claims in the 2008 accident year, although the improvement, if any, depends on continued favorable frequency. Loss costs are expected to continue to increase on non-catastrophe commercial auto property claims, reflecting a continuation of higher loss costs on commercial auto business in 2007. Based on anticipated trends in earned pricing and loss costs, the combined ratio before catastrophes and prior accident year development is expected to be in the range of 86.0 to 89.0 in 2008. The combined ratio before catastrophes and prior accident year development was 88.0 in 2007.
Middle Market provides standard commercial insurance coverage to middle market commercial businesses, primarily throughout the United States, with greater than $5 in annual payroll, $15 in annual revenues or $15 in total property values. This segment offers workers’ compensation, property, automobile, liability, umbrella and marine coverages.
As written premium is earned over the 12-month term of the policies, the earned pricing changes during 2007 were primarily a reflection of the written pricing changes over the last six months of 2006 and the first six months of 2007.
Premium renewal retention for Middle Market increased slightly for the year ended December 31, 2006, from 81% to 82%, primarily driven by workers’ compensation business. In response to increased competition, management has focused heavily on premium renewal retention. New business written premium for Middle Market decreased by $138, or 23%, for the year ended December 31, 2006, primarily due to increased competition for workers’ compensation business.
Underwriting results decreased by $63, from $207 to $144, with a corresponding 2.3 point increase in the combined ratio, from 91.6 to 93.9, due to:
Middle Market earned premium decreased by $103, or 4%, to $2,351. Refer to the earned premium discussion for a description of the decrease in earned premium.
Current accident year loss and loss adjustment expenses before catastrophes decreased by $10
Current accident year catastrophe losses decreased by $21, from $36, or 1.5 points, in 2006 to $15, or 0.7 points, in 2007. Compared to 2007, there were more severe catastrophes in 2006, including tornadoes and hail storms in the Midwest and windstorms in Texas and on the East coast. The largest catastrophe losses in 2007 were from spring windstorms in the Southeast and wildfires in California.
Prior accident year reserve development changed from net unfavorable prior accident year reserve development of $15, or 0.6 points, in 2006 to net favorable prior accident year reserve development of $14, or 0.6 points, in 2007. Net favorable reserve development of $14 in 2007 included a $49 release of general liability loss and loss adjustment expense reserves for accident years 2003 to 2006 and an $18 release of commercial auto liability reserves for accident years 2003 and 2004, partially offset by a $40 strengthening of workers’ compensation reserves for accident years 1973 & prior and a $14 strengthening of general liability reserves for accident years more than 20 years old.
Middle Market current accident year loss and loss adjustment expenses before catastrophes increased by $102 in 2006, to $1,533, due to an increase in earned premium and an increase in the current accident year loss and loss adjustment expense ratio before catastrophes. Excluding the effect of catastrophe treaty reinstatement premium, the current accident year loss and loss adjustment expense ratio before catastrophes increased by 2.1 points, to 62.6, primarily due to an increase in non-catastrophe property loss costs, the effect of earned pricing decreases and the effect of a shift to more workers’ compensation premium which has a higher loss and loss adjustment expense ratio than other business in the segment. The increase in non-catastrophe property loss costs was primarily due to increasing claim severity.
Net unfavorable prior accident year reserve development decreased from $52, or 2.2 points, in 2005 to $15, or 0.6 points, in 2006. Net unfavorable reserve development of $15 in 2006 consisted primarily of a $20 increase in general liability loss and loss adjustment expense reserves related to accident years 1998 to 2005 and a $10 increase in construction defect reserves, partially offset by a $25 reduction in allocated loss adjustment expense reserves for workers’ compensation business related to accident years 2003 to 2005. Net unfavorable reserve development of $52 in 2005 primarily included a $35 increase in workers’ compensation reserves related to reserves for claim payments expected to emerge after 20 years of development and a $40 strengthening of general liability reserves for accident years 2000 to 2003 due to higher than anticipated loss payments beyond four years of development. Partially offsetting the reserve increases in 2005 was a $38 reduction in workers’ compensation reserves related to accident years 2003 and 2004.
The expense ratio decreased by 1.8 points, to 26.7, primarily due to a decrease in insurance operating costs and expenses. Insurance operating costs decreased by $15, largely because of a $12 decrease in estimated Citizens’ assessments in 2006 compared to a $17 increase in Citizens assessments in 2005 and a reduction in estimated contingent commissions. Partially offsetting the improvement due to changes in the Citizens’ assessments was an increase non-deferred operating expenses commensurate with the increase in earned premium. Amortization of deferred policy acquisition costs increased by $7, due largely to the increase in earned premium.
Consistent with claims experience for the 2007 accident year, during 2008, management expects an increase in claim costs due to rising claim cost severity as an expected increase in severity will likely more than offset the effect of an expected reduction in claim frequency. Loss costs are expected to continue to increase across most lines of business in Middle Market, including on workers’ compensation claims and on non-catastrophe property claims covered under property, marine and commercial auto policies. Based on anticipated trends in earned pricing and loss costs, the combined ratio before catastrophes and prior accident year development is expected to be in the range of 94.5 to 97.5 in 2008. The combined ratio before catastrophes and prior accident year development was 93.8 in 2007.
A combined ratio before catastrophes and prior accident year development of 94.5 to 97.5
Specialty Commercial offers a variety of customized insurance products and risk management services. The segment provides standard commercial insurance products including workers’ compensation, automobile and liability coverages to large-sized companies. Specialty Commercial also provides professional liability, fidelity and surety, specialty casualty and livestock coverages, as well as core property and excess and surplus lines coverages not normally written by standard lines insurers. Specialty Commercial provides other insurance products and services primarily to captive insurance companies, pools and self-insurance groups. In addition, Specialty Commercial provides third-party administrator services for claims administration, integrated benefits and loss control through Specialty Risk Services.
Earned premiums for the Specialty Commercial segment decreased by $204, or 12%, primarily due to decreases in casualty, property and other earned premiums, partially offset by an increase in professional liability, fidelity and surety earned premiums and the effect of $26 of catastrophe treaty reinstatement premium payable to reinsurers recorded as a reduction of earned premium in 2005.
Casualty earned premiums decreased by $217, or 27%, primarily because of the non-renewal of a single captive insurance program and a decline in new business written premium growth. Partially offsetting the decrease was an increase in premium retention and the effect of renewing a single large deductible policy as a retrospectively rated policy which bears a higher premium. The single captive insurance program accounted for earned premium of $241 for the year ended December 31, 2005.
Specialty Commercial earned premium decreased by $47, or 3%, to $1,515. Refer to the earned premium discussion for a description of the decrease in earned premium.
Current accident year loss and loss adjustment expenses before catastrophes decreased by $70
Specialty Commercial current accident year loss and loss adjustment expenses before catastrophes decreased by $70 in 2007 to $999, due to a decrease in earned premium and a 2.2 point decrease in the loss and loss adjustment expense ratio before catastrophes and prior accident year development, to 66.0. The decrease in the loss and loss adjustment expense ratio before catastrophes and prior accident year development was driven by a lower loss and loss adjustment ratio on directors and officers insurance in professional liability and a decrease in non-catastrophe property loss costs on property business, partially offset by a higher loss and loss adjustment expense ratio on casualty business.
Net unfavorable prior accident year reserve development of $34 in 2006 included a $35 strengthening of reserves for construction defects claims on casualty business for accident years 1997 and prior and a $20 strengthening of allocated loss adjustment expense reserves on workers’ compensation policies for claim payments expected to emerge after 20 years of development, partially offset by a $35 reduction in catastrophe reserves related to the 2005 hurricanes.
Insurance operating costs and expenses increased by $16, primarily due to a $16 increase in policyholder dividends. The $16 increase in policyholder dividends was largely due to a $10 reduction in estimated policyholder dividends recorded in 2006 and a $7 increase in estimated policyholder dividends recorded in 2007. The $7 increase in dividends in 2007 was primarily driven by an increase in the estimated amount of dividends payable to certain workers’ compensation policyholders due to underwriting profits. Amortization of deferred policy acquisition costs increased by $17, due largely to an increase in amortization for professional liability, fidelity and surety business driven largely by the increase in earned premiums for that business and a reduction in ceding commissions. The expense ratio increased by 1.8 points, to 27.5, due largely to the reduction in ceding commission on professional liability business and the decrease in earned premiums.
Underwriting results improved by $217, with a corresponding 12.5 point decrease in the combined ratio, to 96.7, due to:
Specialty Commercial current accident year loss and loss adjustment expenses before catastrophes decreased by $147 in 2006, to $1,069, due almost entirely to a decreased in earned premium. Excluding the effect of catastrophe treaty reinstatement premium, the current accident year loss and loss adjustment expense ratio before catastrophes increased by 0.3 points, to 68.2, due to a higher loss and loss adjustment expense ratio on casualty and professional liability business and the effect of an increase in the allocation to Specialty Commercial of premiums ceded under the Company’s principal property catastrophe reinsurance program, partially offset by lower non-catastrophe property loss costs.
Net unfavorable prior accident year reserve development of $103 in 2005 included a $70 strengthening of workers’ compensation reserves for claim payments expected to emerge after 20 years of development. Reserve development in 2005 also included a release of reserves for directors and officers insurance related to accident years 2003 and 2004 and strengthening of prior accident year reserves
for contracts that provide auto financing gap coverage and auto lease residual value coverage; the release and offsetting strengthening were each approximately $80.
The expense ratio increased 1.1 points, to 25.7, due largely to the decrease in earned premiums and lower ceding commissions on professional liability business, partially offset by an increase in ceding commissions on captive insurance business.
In 2008, the Company expects written premium for the Specialty Commercial segment to be flat to 3% higher. For property business, the Company expects written premium to decrease, largely because of a planned reduction in specialty property business written with large, national accounts. Management expects written premium for its core excess and surplus lines property business to decrease moderately. Under an arrangement with Berkshire Hathaway that commenced in the second quarter of 2007, a share of core excess and surplus lines business that was previously written entirely by the Company is now being written in conjunction with Berkshire Hathaway under subscription policies, whereby both companies share, or participate, in the business written. The arrangement with Berkshire Hathaway enables the Company to offer its insureds larger policy limits and thereby enhance its competitive position in the marketplace.
As a percentage of earned premiums, management expects that loss and loss adjustment expenses will increase in 2008 for both professional liability business and property business with the increase driven primarily by lower earned pricing. Given the anticipated trends in pricing and loss costs in Specialty Commercial, management expects a combined ratio before catastrophes and prior accident year development in the range of 96.0 to 99.0 for 2008. The combined ratio before catastrophes and prior accident year development was 94.4 in 2007.
A $13 decrease in net investment income, primarily as a result of a decrease in invested assets resulting from net losses and loss adjustment expenses paid.
A change from $26 of net realized capital gains in 2006 to $12 of net realized capital losses in 2007, primarily due to an increase in credit-related impairments and decreases in the fair value of non-qualifying derivatives attributable to changes in value associated with credit derivatives due to credit spreads widening.
Reserves and reserve activity in the Other Operations segment are categorized and reported as asbestos, environmental, or “all other”. The “all other” category of reserves covers a wide range of insurance and assumed reinsurance coverages, including, but not limited to, potential liability for construction defects, lead paint, silica, pharmaceutical products, molestation and other long-tail liabilities. In addition, within the “all other” category of reserves, Other Operations records its allowance for future reinsurer insolvencies and disputes that might affect reinsurance collectibility associated with asbestos, environmental, and other claims recoverable from reinsurers.
The following table presents reserve activity, inclusive of estimates for both reported and incurred but not reported claims, net of reinsurance, for Other Operations, categorized by asbestos, environmental and all other claims, for the years ended December 31, 2007, 2006 and 2005.
Excludes asbestos and environmental net liabilities reported in Ongoing Operations of $9 and $6, respectively, as of December 31, 2007, $9 and $6, respectively, as of December 31, 2006, and $10 and $6, respectively, as of December 31, 2005. Total net losses and loss adjustment expenses incurred in Ongoing Operations for the years ended December 31, 2007, 2006 and 2005 includes $10, $11 and $11, respectively, related to asbestos and environmental claims. Total net losses and loss adjustment expenses paid in Ongoing Operations for the years ended December 31, 2007, 2006 and 2005 includes $10, $12 and $17, respectively, related to asbestos and environmental claims.
The Company has been evaluating and closely monitoring assumed reinsurance reserves in Other Operations. With the transfer of certain assumed reinsurance business into Other Operations, the segment has exposure related to more recent assumed casualty reinsurance reserves, particularly for the underwriting years 1997 through 2001. Assumed reinsurance exposures are inherently less predictable than direct insurance exposures because the Company may not receive notice of a reinsurance claim until the underlying direct insurance claim is mature. This causes a delay in the receipt of information from the ceding companies. In 2005 and 2006, the Company saw an increase in reported losses above previous expectations and this increase in reported losses contributed to reserve re-estimates. As a result of these unfavorable trends, for the years ended December 31, 2006 and 2005, the Company booked unfavorable reserve development of $12 and $85, respectively, related to assumed reinsurance. In the fourth quarter 2007, the Company completed an evaluation of certain of its non-asbestos and environmental reserves, including its assumed reinsurance liabilities. The evaluation indicated no significant change in the Company’s overall non-asbestos and environmental reserves.
Gross Environmental Reserves based on the third quarter 2007 environmental reserve study.
During the second quarters of 2007, 2006 and 2005, the Company completed its annual evaluations of the collectibility of the reinsurance recoverables and the adequacy of the allowance for uncollectible reinsurance associated with older, long-term casualty liabilities reported in the Other Operations segment. The evaluation in the second quarter of 2007 resulted in no addition to the allowance for uncollectible reinsurance. In the second quarter of 2006, the Company entered into an agreement with Equitas and all Lloyd’s syndicates reinsured by Equitas (collectively, “Equitas”) that resolved, with minor exception, all of the Company’s ceded and assumed domestic reinsurance exposures with Equitas, including all of the Company’s reinsurance recoveries from Equitas under the Blanket Casualty Treaty (“BCT”). As a result of the settlement with Equitas and the 2006 reinsurance recoverable evaluation, the Company reduced its net reinsurance recoverable by $243. As a result of the evaluation in the second quarter of 2005, the Company increased its allowance for uncollectible reinsurance by $20 to reflect deterioration in the credit ratings of certain reinsurers and the Company’s opinion as to the ability of certain reinsurers to pay claims in the future.
During the second quarters of 2007, 2006 and 2005, the Company completed its annual ground up asbestos reserve evaluations. As part of these evaluations, the Company reviewed all of its open direct domestic insurance accounts exposed to asbestos liability as well as assumed reinsurance accounts and its London Market exposures for both direct insurance and assumed reinsurance. These evaluations resulted in no addition to the Company’s net asbestos reserves. The Company currently expects to continue to perform an evaluation of its asbestos liabilities annually.
The following table displays gross asbestos reserves and other statistics by policyholder category as of December 31, 2007
Gross Asbestos Reserves based on the second quarter 2007 asbestos reserve study.
The following table sets forth, for the years ended December 31, 2007, 2006 and 2005, paid and incurred loss activity by the three categories of claims for asbestos and environmental.
Paid and Incurred Losses and Loss Adjustment Expenses (“LAE”) Development - Asbestos and
A number of factors affect the variability of estimates for asbestos and environmental reserves including assumptions with respect to the frequency of claims, the average severity of those claims settled with payment, the dismissal rate of claims with no payment and the expense to indemnity ratio. The uncertainty with respect to the underlying reserve assumptions for asbestos and environmental adds a greater degree of variability to these reserve estimates than reserve estimates for more traditional exposures. While this variability is reflected in part in the size of the range of reserves developed by the Company, that range may still not be indicative of the potential variance between the ultimate outcome and the recorded reserves. The recorded net reserves as of December 31, 2007 of $2.26 billion ($2.00 billion and $257 for asbestos and environmental, respectively) is within an estimated range, unadjusted for covariance, of $1.88 billion to $2.60 billion. The process of estimating asbestos and environmental reserves remains subject to a wide variety of uncertainties, which are detailed in the “Critical Accounting Estimates-Property & Casualty Reserves, Net of Reinsurance” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations. The Company believes that its current asbestos and environmental reserves are reasonable and appropriate. However, analyses of further developments could cause the Company to change its estimates and ranges of its asbestos and environmental reserves, and the effect of these changes could be material to the Company’s consolidated operating results, financial condition and liquidity. If there are significant developments that affect particular exposures, reinsurance arrangements or the financial condition of particular reinsurers, the Company will make adjustments to its reserves or to the amounts recoverable from its reinsurers.
Consistent with the Company’s long-standing reserving practices, the Company will continue to review and monitor its reserves in the Other Operations segment regularly and, where future developments indicate, make appropriate adjustments to the reserves. For a discussion of the Company’s reserving practices, please see the “Critical Accounting Estimates-Property & Casualty Reserves, Net of Reinsurance” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Return on general account 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. Additionally, changes in market interest rates may impact the period of time over which certain investments, such as 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 (losses) accounted for approximately 17%, 24% and 30% of the Company’s consolidated revenues for the years ended December 31, 2007, 2006 and 2005, respectively. Net investment income, excluding net investment income from trading securities, and net realized capital gains and losses accounted for approximately 16%, 18% and 19%, for the years ended December 31, 2007, 2006 and 2005, respectively. The decrease in the percentage of consolidated revenues for 2007, as compared to the prior years, is primarily due to a smaller increase in the value of equity securities held for trading and an increase in realized capital losses.
Total investments increased $10.4 billion since December 31, 2006 primarily as a result of equity securities held for trading, positive operating cash flows, and securities lending activities, partially offset by increased unrealized losses primarily due to a significant widening of credit spreads associated with fixed maturities. The fair value of fixed maturities declined as a percentage of total investments, excluding equity securities held for trading, due to the increase in unrealized losses and the decision to allocate a greater percentage of Life’s portfolio to mortgage loans and limited partnerships and other alternative investments. The increased allocation to limited partnerships and alternative investments and mortgage loans was made primarily due to the attractive risk/return profiles and diversification opportunities of these asset classes. Equity securities, held for trading, increased $6.8 billion since December 31, 2006, due to positive cash flow primarily generated from sales and deposits related to variable annuity products sold in Japan as well as foreign currency gains due to the appreciation of the Japanese yen in comparison to the U.S. dollar.
Limited partnerships and other alternative investments increased by $512 during 2007. HIMCO believes investing in limited partnerships provides an opportunity to diversify its portfolio and earn above average returns over the long-term. However, significant price volatility can exist quarter to quarter. Prior to investing, HIMCO performs an extensive due diligence process which attempts to identify funds that have above average return potential and managers with proven track records for results, many of which utilize sophisticated risk management techniques. Due to capital requirements, HIMCO closely monitors the impact of these investments in relationship to the overall investment portfolio and the consolidated balance sheets. HIMCO does not expect investments in limited partnerships to exceed 3% of the fair value of each statutory legal entity’s investment portfolio excluding trading securities.
Primarily consists of changes in fair value on non-qualifying derivatives and hedge ineffectiveness on qualifying derivative instruments and other investment gains.
and a lower expected yield from limited partnership and other alternative investments, Life expects the average portfolio yield in 2008 to modestly decline compared to 2007 levels. The Company expects a lower yield from limited partnerships and other alternative investments primarily due to reduced liquidity and the wider credit spread environment.
Net investment income on equity securities, held for trading, for the year ended December 31, 2007 were primarily attributed to a change in the value of the underlying investment funds supporting the Japanese variable annuity product due to market performance.
Net realized capital losses were higher for the year ending December 31, 2007. The change in net gains and losses was primarily the result of higher net losses on impairments, GMWB derivatives, and other net losses offset by higher net gains on sale of investments. The circumstances giving rise to the changes in these components are as follows:
An increase in losses in 2007 compared to 2006 on GMWB rider embedded derivatives was primarily due to liability model assumption updates and modeling refinements made in 2007, including those for dynamic lapse behavior and correlations of market returns across underlying indices, as well as those to reflect newly reliable market inputs for volatility. For a further discussion of the GMWB rider valuation assumption, see the Capital Markets Risk management section of the MD&A under “Market Risk - Life”.
Gross gains on sales for the year ended December 31, 2007, were primarily within fixed maturities and were largely comprised of corporate securities. The sales were made to reallocate the portfolio to securities with more favorable risk-return profiles. The gains on sales were primarily the result of changes in credit spreads, foreign currency exchange rates, and interest rates from the date of purchase. Gross losses on sales for the year ended December 31, 2007, were predominantly within fixed maturities and were primarily corporate securities. No single security was sold at a loss in excess of $5 and an average loss as a percentage of the fixed maturity’s amortized cost of less than 3%, which, under the Company’s impairment policy was deemed to be depressed only to a minor extent.
Gross gains on sales for the year ended December 31, 2006, were primarily within fixed maturities and were concentrated in U.S. government, corporate and foreign government securities. Certain sales were made to reposition the portfolio to a shorter duration due to the flatness of the yield curve and the lack of market compensation for longer duration assets. Also, certain sales were made as the Company continues to increase investments in mortgage loans and limited partnerships. The gains on sales were primarily the result of changes in interest rates and foreign currency exchange from the date of security purchase.
average loss as a percentage of the fixed maturity’s amortized cost of less than 3%, which, under the Company’s impairment policy was deemed to be depressed only to a minor extent.
The following table identifies the invested assets by type held as of December 31, 2007 and 2006.
Includes hedge fund investments outside of limited partnerships and real estate joint ventures.
Total investments increased $1.4 billion since December 31, 2006, primarily as the result of positive operating cash flows and securities lending activities, partially offset by increased unrealized losses primarily due to a significant widening of credit spreads associated with fixed maturities. The fair value of fixed maturities declined as a percentage of total investments due to the increase in unrealized losses and the decision to allocate a greater percentage of Property & Casualty’s portfolio to mortgage loans and limited partnerships and other alternative investments. The increased allocation to limited partnerships and other alternative investments, mortgage loans, and equity securities, available-for-sale was made primarily due to the attractive risk/return profiles and diversification opportunities of these asset classes.
The following table summarizes Property & Casualty’s limited partnerships and other alternative investments as of December 31, 2007 and 2006.
Mortgage and real estate funds consist of investments in funds whose assets consist of mortgage loans, participations in mortgage loans, mezzanine loans or other notes which may be below investment grade credit quality as well as equity real estate. Also included is the investment in real estate joint venture.
The following table below summarizes Property & Casualty’s net investment income.
Net realized capital losses resulted for the year ended December 31, 2007 compared to net realized capital gains in the prior year period primarily due to Other, net losses and other-than-temporary impairments. Other, net losses in 2007 primarily resulted from the change in value associated with credit derivatives due to credit spreads widening. Credit spreads widened primarily due to the deterioration in the U.S. housing market, tightened lending conditions, the market’s flight to quality securities as well as increased likelihood of a U.S. recession. For further discussion, see the “Capital Market Risk Management” section of the MD&A. See the other-than-temporary impairments section below for information on impairment losses.
Gross gains on sales for the year ended December 31, 2007, were primarily within fixed maturities and were largely comprised of corporate securities. The sales were made to reallocate the portfolio to securities with more favorable risk-return profiles. The gains on sales were primarily the result of changes in credit spreads, foreign currency exchange rates, and interest rates from the date of purchase. Gross losses on sales for the year ended December 31, 2007, were predominantly within fixed maturities and were primarily corporate securities. No single security was sold at a loss in excess of $4 and an average loss as a percentage of the fixed maturity’s amortized cost of less than 3%, which, under the Company’s impairment policy was deemed to be depressed only to a minor extent.
The investment objective of Corporate is to raise capital through financing activities to support the Life and Property & Casualty operations of the Company and to maintain sufficient funds to support the cost of those financing activities including the payment of interest for The Hartford Financial Services Group, Inc. (“HFSG”) issued debt and dividends to shareholders of The Hartford’s common stock. As of December 31, 2007 and 2006, Corporate held $308 and $259, respectively, of fixed maturity investments, $160 and $145, respectively, of short-term investments and $103 and $55, respectively, of equity securities. As of December 31, 2007, a put option agreement with a fair value of $43 was included in Other invested assets. For further discussion of this position, see Note 14 of Notes to Consolidated Financial Statements.
The following table summarizes the total assets, liabilities and maximum exposure to loss relating to VIEs for which the Company has concluded it is the primary beneficiary. Accordingly, the results of operations and financial position of these VIEs are included along with the corresponding minority interest liabilities in the accompanying consolidated financial statements.
In addition to the VIEs described above, as of December 31, 2007 and 2006, the Company held variable interests in five and three VIEs, respectively, where the Company is not the primary beneficiary and as a result, these are not consolidated by the Company. As of December 31, 2007, these VIEs included two collateralized bond obligations and two CLOs which are managed by HIMCO, as well as the Company’s contingent capital facility. For further discussion of the contingent capital facility, see the Capital Resources and Liquidity section of the MD&A. These investments have been held by the Company for a period of one to four years. The maximum exposure to loss consisting of the Company’s investments based on the amortized cost of the non-consolidated VIEs was approximately $150 and $20 as of December 31, 2007 and 2006, respectively. For the year ended December 31, 2007 the Company recognized $5 of the maximum exposure to loss representing an other-than-temporary impairment recorded as a realized capital loss.
The Company categorizes impairments as credit related and other. The Company characterizes an impairment as credit related if it has current concerns regarding the issuers ability to pay future interest and principal amounts based upon the securities contractual terms or the depression in the security value is primarily related to significant issuer specific or sector credit spread widening. Company management uses average credit related impairment amounts, net of recoveries, within Life and Property & Casualty product pricing assumptions. The other-than-temporary impairments recorded in Other are primarily related to securities that had declined in value primarily due to changes in interest rate or general or modest spread widening and for which the Company was uncertain of its intent to retain the investment for a period of time sufficient to allow recovery to cost or amortized cost.
The following discussion provides an analysis of significant other-than-temporary impairments recognized during 2007, 2006 and 2005, the related circumstances giving rise to the other-than-temporary impairments and the potential impact such circumstances may have on other material investments held.
Future other-than-temporary impairments will depend primarily on economic fundamentals, political stability, issuer and/or collateral performance and future movements in interest rates and credit spreads. If the economic fundamentals continue to soften, other-than-temporary impairments for 2008 could be similar to or exceed 2007 levels. For further discussions on fundamentals related to sub-prime residential mortgage-backed securities, consumer receivable backed investments, commercial mortgage-backed securities, and corporate securities in the financial services sector, see the Investment Credit Risk section.
For the year ended December 31, 2006, other-than-temporary impairments were primarily recorded on corporate fixed maturities. Other than a $16 impairment on a single issuer in the utilities sector, there were no other significant other-than-temporary impairments (i.e., $15 or greater) recorded on any single security or issuer.
For the year ended December 31, 2005, other-than-temporary impairments recorded on corporate securities. Approximately $15 recorded on corporate securities related to three Canadian paper companies. These companies’ operations suffered from high energy prices and falling demand, in part due to the appreciation of the Canadian dollar in comparison to the U.S. dollar. Also included in the corporate securities was $9 recorded on securities related to two major automotive manufacturers. The market values of these securities had fallen due to a downward adjustment in earnings and cash flow guidance primarily due to sluggish sales, rising employee and retiree benefit costs and an increased debt service burden. Other-than-temporary impairments recorded on equity securities had sustained a decline in market value for an extended period of time as a result of issuer credit spread widening. During 2005 there were no significant other-than-temporary impairments (i.e., $15 or greater) recorded on any single security or issuer.
In addition to counterparty credit risk, the Company enters into credit derivative instruments to manage credit exposure which includes assuming credit risk from and reducing credit risk to a single entity, referenced index, or asset pool. Credit derivatives used by the Company include credit default swaps, credit index swaps, and total return swaps.
The Company purchases credit protection through credit default swaps to economically hedge and manage credit risk of certain fixed maturity investments across multiple sectors of the investment portfolio. As of December 31, 2007, the notional and fair value of these credit default swaps was $5.2 billion and $81, respectively. The average credit quality of the economically hedged securities was BBB+.
The credit default swaps in which the Company assumes credit risk reference investment grade single corporate issuers, baskets of up to five corporate issuers and diversified portfolios of corporate issuers. The diversified portfolios of corporate issuers are established within sector concentration limits and are typically divided into tranches which possess different credit ratings ranging from AAA through the CCC rated first loss position.
The credit index swaps assume the credit risk of a referenced AAA rated tranche of a commercial mortgage security index. The credit index swap contracts pay or receive amounts based upon changes in the referenced index and are typically six months in duration. In February 2008, the credit index swaps were closed and resulted in an additional $109, before-tax, net realized capital loss which will be recorded in the first quarter 2008.
Includes securities with an amortized cost and fair value of $16 and $15, respectively, as of December 31, 2007, and $59 and $61, respectively, as of December 31, 2006, that contain a below-prime residential mortgage loan component. Typically these CDOs are also backed by assets other than below-prime loans.
Includes securities with an amortized cost and fair value of $40 and $37, respectively, as of December 31, 2007, and $21 as of December 31, 2006, which were backed by pools of loans issued to prime borrowers. Includes securities with an amortized cost and fair value of $96 and $87, respectively, as of December 31, 2007, and $27 as of December 31, 2006, which were backed by pools of loans issued to Alt-A borrowers.
The Company’s fixed maturity net unrealized gain/loss position decreased $2.1 billion from a net unrealized gain position as of December 31, 2006 to a net unrealized loss position as of December 31, 2007. The decrease was primarily due to credit spread widening, partially offset by a decrease in interest rates and other-than-temporary impairments taken during the year. Credit spreads widened primarily due to the deterioration of the sub-prime mortgage market and liquidity disruptions, impacting the overall credit market.
As of December 31, 2007, investment sector allocations as a percentage of total fixed maturities have not significantly changed since December 31, 2006 except investments in ABS CDOs, financial services in corporate sector and municipal securities. The increase in
The remaining structured investment products other than ABS sub-prime and consumer loans and CMBS primarily relate to ABS CDOs supported by senior secured bank loans. As of December 31, 2007, these CLOs represent 99% of ABS CDO holdings with approximately 80% rated AAA.
The Company has exposure to sub-prime and Alt-A residential mortgage backed securities included in the Consolidated Fixed Maturities by Type table above. Sub-prime mortgage lending is the origination of residential mortgage loans to customers with weak credit profiles. Alt-A mortgage lending is the origination of residential mortgage loans to customers who have credit ratings above sub-prime but do not conform to government-sponsored enterprise standards. Both of these categories are considered to be below-prime. The Company is not an originator of below-prime mortgages. The slowing U.S. housing market, greater use of affordability mortgage products, and relaxed underwriting standards for some originators of below-prime loans has recently led to higher delinquency and loss rates, especially within the 2007 and 2006 vintage years. These factors have caused a pull-back in market liquidity and repricing of risk, which has led to an increase in unrealized losses from December 31, 2006 to December 31, 2007. The Company expects delinquency and loss rates in the sub-prime mortgage sector to continue to increase in the near term. The Company has performed cash flow analysis on its sub-prime holdings stressing multiple variables, including prepayment speeds, default rates, and loss severity. Based on this analysis and the Company’s expectation of future loan performance, other than certain credit related impairments recorded in the current year, future payments are expected to be received in accordance with the contractual terms of the securities. For a discussion on credit related impairments, see Other-Than-Temporary Impairments section included in the Investment Results section of the MD&A.
The following table presents the Company’s exposure to ABS supported by sub-prime mortgage loans by credit quality and vintage year, including direct investments in CDOs that contain a sub-prime loan component, included in the RMBS and CDO line in the table above.
Approximately 80% of the portfolio is backed by adjustable rate mortgages.
Approximately 13% of the securities were issued by lenders that lend primarily to sub-prime borrowers.
The AAA rated securities include monoline insured securities with an amortized cost and fair value of $102 and $93, respectively, at December 31, 2007 and $102 at December 31, 2006. Additionally, approximately half of the student loan-backed exposure is guaranteed by the Federal Family Education Loan Program, with the remainder comprised of loans to prime-borrowers.
The increase in the unrealized loss amount since December 31, 2006, is primarily the result of credit spread widening, offset in part by a decrease in interest rates and other-than-temporary impairments. As of December 31, 2007, and December 31, 2006, fixed maturities represented $2,538, or 92%, and $663, or 99%, respectively, of the Company’s total unrealized loss associated with securities classified as available-for-sale. The Company held no securities of a single issuer that were at an unrealized loss position in excess of 2% and 5%, respectively, of the total unrealized loss amount as of December 31, 2007 and 2006.
CMBS - As of December 31, 2007, the Company held approximately 720 different securities that had been in an unrealized loss position for greater than six months. Approximately 50 securities were priced at or less than 80% of amortized cost as of December 31, 2007, however the price depressions primarily occurred during the fourth quarter and pertained to securities rated AA and above. The recent price depression resulted from widening credit spreads primarily due to tightened lending conditions and the market’s flight to quality securities. See the “Commercial Mortgage Loans” commentary and tables above. Future changes in fair value of these securities are primarily dependent upon sector fundamentals, credit spread movements, and changes in interest rates.
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 the specific classes of investments, while asset/liability management is the responsibility of a dedicated risk management unit 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. During 2007, the deterioration in the U.S. housing market, tightened lending conditions, the market’s flight to quality securities as well as increased likelihood of a U.S. recession contributed to substantial spread widening in credit derivatives and structured credit products.
The Hartford is exposed to market risk, primarily relating to the market price and/or cash flow variability associated with changes in interest rates, credit spreads including issuer defaults, equity prices or market indices, and foreign currency exchange rates. The Hartford is also exposed to credit and counterparty repayment risk.
To calculate duration, projections of asset and liability cash flows are discounted to a present value using interest rate assumptions. These cash flows are then revalued at alternative interest rate levels to determine the percentage change in fair value due to an incremental change in rates. Cash flows from corporate obligations are assumed to be consistent with the contractual payment streams on a yield to worst basis. The primary assumptions used in calculating cash flow projections include expected asset payment streams taking into account prepayment speeds, issuer call options and contract holder behavior. ABS, CMOs, and MBS are modeled 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.
The Company’s foreign currency exchange risk is related to non-U.S. dollar denominated investments, which primarily consist of fixed maturity investments, the investment in and net income of the Japanese Life operation, and non-U.S. dollar denominated liability contracts, including its GMDB, GMAB, and GMIB benefits associated with its Japanese variable annuities, and a yen denominated individual fixed annuity product. A portion of the Company’s foreign currency exposure is mitigated through the use of derivatives.
Life is responsible for maximizing economic value within acceptable risk parameters, including the management of the interest rate sensitivity of invested assets, while generating sufficient after-tax income to support policyholder and corporate obligations. Life’s fixed maturity portfolios and certain investment contracts and insurance product liabilities have material market exposure to interest rate risk. In addition, Life’s operations are significantly influenced by changes in the equity markets. Life’s profitability depends largely on the amount of assets under management, which is primarily driven by the level of sales, equity market appreciation and depreciation and the persistency of the in-force block of business. Life’s foreign currency exposure is primarily related to non-U.S. dollar denominated fixed income securities, non-U.S. dollar denominated liability contracts, the investment in and net income of the Japanese Life operation and certain foreign currency based individual fixed annuity contracts, and its GMDB, GMAB, and GMIB benefits associated with its Japanese variable annuities.
Life’s investment portfolios primarily consist of investment grade fixed maturity securities, including corporate bonds, ABS, CMBS, tax-exempt municipal securities and CMOs. The fair value of Life’s fixed maturities was $52.5 billion and $52.1 billion at December 31, 2007 and 2006, respectively. The fair value of Life’s fixed maturities and other invested assets fluctuates depending on the interest rate environment and other general economic conditions. The weighted average duration of the fixed maturity portfolio was approximately 4.6 and 5.1 years as of December 31, 2007 and 2006, respectively.
Asset accumulation vehicles primarily require a fixed rate payment, often for a specified period of time. Product examples include fixed rate annuities with a market value adjustment feature and fixed rate guaranteed investment contracts. The duration of these contracts generally range from less than one year to ten years. In addition, certain products such as universal life contracts and the general account portion of Life’s variable annuity products, credit interest to policyholders subject to market conditions and minimum interest rate guarantees. The duration of these products is short-term to intermediate-term.
Life utilizes a variety of derivative instruments to mitigate interest rate risk. Interest rate swaps are primarily used to convert interest receipts or payments to a fixed or variable rate. The use of such swaps enables the Company to customize contract terms and conditions to customer objectives and satisfies the operation’s asset/liability duration matching policy. Occasionally, swaps are also used to hedge the variability in the cash flow of a forecasted purchase or sale due to changes in interest rates.
current relationship between short-term and long-term interest rates will remain constant over time. As a result, these calculations may not fully capture the impact of portfolio re-allocations, significant product sales or non-parallel changes in interest rates.
The Company sells variable annuity contracts that offer one or more living benefits, the value of which, to the policyholder, generally increases with declines in equity markets. As is described in more detail below, the Company manages the equity market risks embedded in these guarantees through reinsurance, product design and hedging programs. The Company believes its ability to manage equity market risks by these means gives it a competitive advantage; and, in particular, its ability to create innovative product designs that allow the Company to meet identified customer needs while generating manageable amounts of equity market risk. The Company’s relative sales and variable annuity market share in the U.S. have generally increased during periods when it has recently introduced new products to the market. In contrast, the Company’s relative sales and market share have generally decreased when competitors introduce products that cause an issuer to assume larger amounts of equity and other market risk than the Company is confident it can prudently manage. The Company believes its long-term success in the variable annuity market will continue to be aided by successful innovation that allows the Company to offer attractive product features in tandem with prudent equity market risk management. In the absence of this innovation, the Company’s market share in one or more of its markets could decline. At times, the Company has experienced lower levels of U.S. variable annuity sales as competitors continue to introduce new equity guarantees of increasing risk and complexity. New product development is an ongoing process. During the first quarter of 2007, the Company launched a new product in its Japan variable annuity business (“3 Win”) which provides three different potential outcomes for the contract holder. The first outcome allows the contract holder to lock-in gains on their account value after a 5-year waiting period and upon reaching a specified appreciation target chosen by the policyholder. Upon reaching the target and after a 5-year waiting period, contract holder funds are transferred out of the underlying funds and into the Company’s general account from which the contract holder can access their account value without penalty. The second outcome provides a “safety-net” that provides the contract holder a guaranteed minimum income benefit (“GMIB”) returning the contract holder’s original deposit over 15 years, if the contract holder’s account value drops by more than 20% from the original deposit. The third outcome provides the contract holder a guaranteed minimum accumulation benefit (“GMAB”) of the contract holder’s original deposit in a lump sum if the first two outcomes are not met after a ten-year waiting period. This is the Company’s first GMAB issuance. GMABs are accounted for differently from GMIBs, as described below. Due to the structure of this product,
For certain guaranteed death benefits sold with variable annuity contracts beginning in June 2003, the Retail segment pays the greater of (1) the account value at death; or (2) the maximum anniversary value; not to exceed the account value plus the greater of (a) 25% of premium payments, or (b) 25% of the maximum anniversary value of the contract. The Company currently reinsures a significant portion of these death benefit guarantees associated with its in-force block of business. Under certain of these reinsurance agreements, the reinsurers’ exposure is subject to an annual cap.
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 $42 as of December 31, 2007. Declines in equity markets as well as a strengthening of the Japanese yen in comparison to the U.S. dollar and other currencies 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. With the exception of the GMIB in 3 Win as described above, 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. The value of the GMAB associated with Japan’s new product offering in the first quarter of 2007, recorded as an embedded derivative under SFAS 133, was an asset of $2 at December 31, 2007.
The Company’s total gross exposure (i.e., before reinsurance) to these guaranteed death benefits and income benefits offered in Japan as of December 31, 2007 is $649. Due to the fact that 35% of this amount is reinsured, the Company’s net exposure is $419. This amount is often referred to as the retained net amount at risk. However, the Company will incur these guaranteed death or income benefits in the future only if the contract holder has an in-the-money guaranteed benefit at either the time of their death or if the account value is insufficient to fund the guaranteed living benefits.
The Company uses hedging instruments to hedge its unreinsured GMWB exposure. These instruments include interest rate futures and swaps, S&P 500 and NASDAQ index put options and futures contracts. The Company also uses 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.
The Company is continually exploring new ways and new markets to manage or layoff the capital markets and policyholder behavior risks associated with its living benefits. During 2007, the Company opportunistically entered into two customized swap contracts to hedge certain capital market risk components for the remaining term of certain blocks of non-reinsured GMWB riders. As of December 31, 2007, these swaps had a notional value of $12.8 billion and a market value of $50. Due to the significance of the non-observable inputs associated with pricing these derivatives, the initial difference between the transaction price and modeled value was deferred in accordance with EITF No. 02-3 “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities” and included in other assets in the Consolidated Financial Statements. The deferred loss of $51 will be recognized in retained earnings upon adoption of SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). In addition, the change in value of the swaps due to the initial adoption of SFAS 157 of $35, will also be recorded in retained earnings. Future changes in fair value would be recorded in net realized capital gains (losses) in net income.
The Company employs additional strategies to manage equity market risk in addition to the derivative and reinsurance strategy described above that economically hedges the fair value of the U.S. GMWB rider. Notably, the Company purchases one and two year S&P 500 Index put option contracts to economically hedge certain other liabilities that could increase if the equity markets decline. As of December 31, 2007 and December 31, 2006, the notional value related to this strategy was $661 and $2.2 billion, respectively, while the fair value related to this strategy was $18 and $29, 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 U.S. GAAP, causing volatility in U.S. GAAP net income.
In addition to the impact on U.S. GAAP results, Life’s statutory financial results also have exposure to equity market volatility due to the issuance of variable annuity contracts with guarantees. Specifically, in scenarios where equity markets decline substantially, we would expect lower statutory net income and significant increases in the amount of statutory surplus Life would have to devote to maintain targeted rating agency, regulatory risk based capital (“RBC”) ratios and other similar solvency margin ratios. Life’s statutory net income for the years ended December 31, 2007, 2006 and 2005 was $729, $1.1 billion and $821, respectively. Life’s statutory surplus as of December 31, 2007, 2006 and 2005 was $5.8 billion, $4.7 billion and $4.3 billion, respectively. In order to estimate the impact equity markets could have on statutory financial results, Life projected 2008 statutory net income and the amount of statutory surplus required to maintain our financial strength ratings (targeted statutory surplus) under various stochastic scenarios and assumptions consistent with other sensitivity analyses performed by Life. Each scenario included the effects of guaranteed living and death benefit reinsurance, in-force hedging assets in place at December 31, 2007 and future dynamic hedging of GMWB riders. The sum of Life’s projected 2008 statutory net income and the (increase) decrease in the amount of targeted statutory surplus in each scenario is an estimate of the Life’s “statutory distributable earnings”. Subject to legal or regulatory constraints, statutory distributable earnings are usually available to dividend to an insurance entity’s parent holding company to support debt and dividend payments to shareholders. To illustrate the effects of a tail scenario, at or near the 95th percentile, Life estimates that 2008 statutory distributable earnings generated by its variable annuity business could be $1 - $2 billion worse than the mean of the stochastic scenarios. These tail events involve U.S. equity market declines of varying degrees, including rather large equity market declines of 20-25% from December 31, 2007 levels, or a combination of more moderate equity market declines in scenarios where the Japanese yen significantly strengthens against the Euro or the U.S. Dollar and interest rates rise significantly.
In addition to the Company’s use of reinsurance, hedging instruments and other risk management techniques, the Company maintains capital resources to, at a minimum, manage the statutory distributable earnings equity tail scenario risk described above. Given the level of Life and Property & Casualty statutory surplus at December 31, 2007, as well as capital resources at the Corporate level, management of the Company believes the risk inherent in these tail scenarios can be managed within the Company’s capital resources. The magnitude of the tail scenario estimate, described above, of $1 - $2 billion, subsequent changes to it and the width of the disclosed range can be significantly impacted by the following factors:
Life’s ability to organically generate surplus in excess of that required to maintain financial strength ratings would reduce the exposure in a tail scenario.
Changes in estimates of policyholder behavior can impact the estimates of statutory distributable earnings.
Life’s exposure to foreign currency exchange risk exists with respect to non-U.S. dollar denominated investments, Life’s investment in foreign operations, primarily Japan, and non-U.S. dollar denominated liability contracts, including the yen based individual fixed annuity product and its GMDB,GMAB, and GMIB benefits associated with its Japanese variable annuities. A portion of the Company’s foreign fixed maturity currency exposure is mitigated through the use of derivatives.
The risk associated with the non-U.S. dollar denominated fixed maturities relates to potential decreases in value and income resulting from unfavorable changes in foreign exchange rates. The fair value of the non-U.S. dollar denominated fixed maturities, which are primarily denominated in euro, sterling, yen and Canadian dollars, at December 31, 2007 and 2006, were approximately $1.6 billion and $1.9 billion, respectively. In order to manage its currency exposures, Life enters into foreign currency swaps and forwards to hedge the variability in cash flows associated with certain foreign denominated fixed maturities. These foreign currency swap agreements are structured to match the foreign currency cash flows of the hedged foreign denominated securities. At December 31, 2007 and 2006, the derivatives used to hedge currency exchange risk related to non-U.S. dollar denominated fixed maturities had a total notional value of $1.5 billion and $1.6 billion, respectively, and total fair value of $(296) and $(336), respectively.
The yen based fixed annuity product is written by Hartford Life Insurance K.K. (“HLIKK”), a wholly-owned Japanese subsidiary of Hartford Life, Inc. (“HLI”), and subsequently reinsured to Hartford Life Insurance Company, a U.S. dollar based wholly-owned indirect subsidiary of HLI. The underlying investment involves investing in U.S. securities markets, which offer favorable credit spreads. The yen denominated fixed annuity product (“yen fixed annuities”) is recorded in the consolidated balance sheets with invested assets denominated in dollars while policyholder liabilities are denominated in yen and converted to U.S. dollars based upon the December 31, yen to U.S. dollar spot rate. The difference between U.S. dollar denominated investments and yen denominated liabilities exposes the Company to currency risk. The Company manages this currency risk associated with the yen fixed annuities primarily with pay variable U.S. dollar and receive fixed yen currency swaps. As of December 31, 2007 and 2006, the notional value and fair value of the currency swaps were $1.8 billion and $1.9 billion, respectively, and $(115) and $(225), respectively. Although economically an effective hedge, a divergence between the yen denominated fixed annuity product liability and the currency swaps exists primarily due to the difference in the basis of accounting between the liability and the derivative instruments (i.e. historical cost versus fair value). The yen denominated fixed annuity product liabilities are recorded on a historical cost basis and are only adjusted for changes in foreign spot rates and accrued income. The currency swaps are recorded at fair value, incorporating changes in value due to changes in forward foreign exchange rates, interest rates and accrued income. An after-tax net gain (loss) of $12 and $(11) for the years ended December 31, 2007 and 2006, respectively, which includes the changes in value of the currency swaps, excluding net periodic coupon settlements, and the yen fixed annuity contract remeasurement, was recorded in net realized capital gains and losses.
One of the measures Property & Casualty uses to quantify its exposure to interest rate risk inherent in its invested assets is duration. The weighted average duration of the fixed maturity portfolio was 4.9 and 4.5 years as of December 31, 2007 and 2006, respectively.
The selection of the 100 basis point parallel shift in the yield curve was made only as an illustration of the potential hypothetical impact of such an event and should not be construed as a prediction of future market events. Actual results could differ materially from those illustrated above due to the nature of the estimates and assumptions used in the above analysis. The Company’s sensitivity analysis calculation assumes that the composition of invested assets remains materially consistent throughout the year and that the current relationship between short-term and long-term interest rates will remain constant over time. As a result, these calculations may not fully capture the impact of portfolio re-allocations or non-parallel changes in interest rates.
Foreign currency exchange risk exists with respect to investments in non-U.S. dollar denominated fixed maturities, primarily euro, sterling and Canadian dollar denominated securities. The risk associated with these securities relates to potential decreases in value resulting from unfavorable changes in foreign exchange rates. The fair value of these fixed maturity securities at December 31, 2007 and 2006 was $1.0 billion.
In order to manage its currency exposures, Property & Casualty enters into foreign currency swaps and forward contracts to hedge the variability in cash flow associated with certain foreign denominated securities. These foreign currency swap agreements are structured to match the foreign currency cash flows of the hedged foreign denominated securities. At December 31, 2007 and 2006, the derivatives used to hedge currency exchange risk had a total notional value of $428 and $805, respectively, and total fair value of $(43) and $(45), respectively.
HFSG and HLI are holding companies which rely upon operating cash flow in the form of dividends from their subsidiaries, which enable them to service debt, pay dividends, and pay certain business expenses. Dividends to the Company from its insurance subsidiaries are restricted. The payment of dividends by Connecticut-domiciled insurers is limited under the insurance holding company laws of Connecticut. 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 company) for the twelve-month period ending on the thirty-first day of December last preceding, in each case determined under statutory insurance accounting principles. In addition, if any dividend of a Connecticut-domiciled insurer exceeds the insurer’s earned surplus, it requires the prior approval of the Connecticut Insurance Commissioner. The insurance holding company laws of the other jurisdictions in which The Hartford’s insurance subsidiaries are incorporated (or deemed commercially domiciled) generally contain similar (although in certain instances somewhat more restrictive) limitations on the payment of dividends. Dividends paid to HFSG by its insurance subsidiaries are further dependent on cash requirements of HLI and other factors. The Company’s property-casualty insurance subsidiaries are permitted to pay up to a maximum of approximately $1.6 billion in dividends to HFSG in 2008 without prior approval from the applicable insurance commissioner. The Company’s life insurance subsidiaries are permitted to pay up to a maximum of approximately $784 in dividends to HLI in 2008 without prior approval from the applicable insurance commissioner. The aggregate of these amounts, net of amounts required by HLI, is the maximum the insurance subsidiaries could pay to HFSG in 2008. In 2007, HFSG and HLI received a combined total of $2.0 billion from their insurance subsidiaries.
The principal sources of operating funds are premium, fees and investment income, while investing cash flows originate from maturities and sales of invested assets. The primary uses of funds are to pay claims, policy benefits, operating expenses and commissions and to purchase new investments. In addition, The Hartford has a policy of carrying a significant short-term investment position and 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.)
As of December 31, 2007 and 2006, the Company’s Japanese operation line of credit in yen was ¥5 billion.
The Company has unfunded commitments to purchase investments in limited partnerships, mortgage and construction loans of about $1.6 billion as disclosed in Note 12 of Notes to Consolidated Financial Statements.
The following table identifies the Company’s aggregate contractual obligations as of December 31, 2007:
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 values 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 losses and loss 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.
Includes $1.8 billion in commitments to purchase investments including about $1.2 billion of limited partnership and $330 of mortgage and construction loans. Outstanding commitments under these limited partnerships and mortgage and construction loans are included in payments due in less than 1 year since the timing of funding these commitments cannot be reliably estimated. The remaining commitments to purchase investments primarily represent payables for securities purchased which are reflected on the Company’s consolidated balance sheet.
Also included in purchase obligations is $790 relating to contractual commitments to purchase various goods and services such as maintenance, human resources, information technology, and transportation 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.
The Company made contributions to its pension plans of $158, $402 and $504 in 2007, 2006 and 2005, respectively, and contributions to its other postretirement plans of $46 in 2007. No contributions were made to the other postretirement plans in 2006 and 2005. The Company’s 2007 required minimum funding contribution was immaterial. The Company presently anticipates contributing approximately $200 to its pension plans and other postretirement plans in 2008, based upon certain economic and business assumptions. These assumptions include, but are not limited to, equity market performance, changes in interest rates and the Company’s other capital requirements. The Company does not have a required minimum funding contribution for the U.S. qualified defined benefit pension plan for 2008 and the funding requirements for all of the pension plans is expected to be immaterial.
The capital structure of The Hartford as of December 31, 2007 and 2006 consisted of debt and equity, summarized as follows:
Total debt of the Company excludes $809 and $258 of consumer notes as of December 31, 2007 and 2006, respectively.
On March 9, 2007, The Hartford issued $500 of 5.375% senior notes due March 15, 2017. The Hartford used most of the net proceeds from this issuance to repay its $300 of 4.7% notes, due September 1, 2007, at maturity and the balance of the proceeds to pay down a portion of the commercial paper portfolio. The issuance was made pursuant to the Company’s shelf registration statement (Registration No. 333-108067).
The Company recorded capital leases of $128 in 2007. Capital lease obligations are included in long-term debt, except for the current maturities, which are included in short-term debt, in the consolidated balance sheet as of December 31, 2007. See Note 12 for further information on capital lease commitments.
Dividends - On February 21, 2008, The Hartford’s Board of Directors declared a quarterly dividend of $0.53 per share payable on April 1, 2008 to shareholders of record as of March 3, 2008.
On June 25, 2007, A.M. Best Co. upgraded the issuer credit ratings to “a” from “a-” and the senior debt ratings to “a” from “a-” of The Hartford Financial Services Group, Inc. and Hartford Life, Inc. In addition, the commercial paper rating of The Hartford Financial Services Group, Inc. was upgraded to AMB-1 from AMB-2. Concurrently, A.M. Best has affirmed the financial strength rating of A+ (Superior) and the issuer credit ratings of “aa-” of the Company’s insurance subsidiaries. The outlook for all ratings is stable.
The following table summarizes The Hartford’s significant member companies’ financial ratings from the major independent rating organizations as of February 15, 2008.
The National Association of Insurance Commissioners (“NAIC”) has regulations establishing minimum capitalization requirements based on risk-based capital (“RBC”) formulas for both life and property and casualty companies. The requirements consist of formulas, which identify companies that are undercapitalized and require specific regulatory actions. The RBC formula for life companies establishes capital requirements relating to insurance, business, asset and interest rate risks and effective for 2005, it addresses the equity, interest rate and expense recovery risks associated with variable annuities and group annuities that contain death benefits or certain living benefit. RBC is calculated for property and casualty companies after adjusting capital for certain underwriting, asset, credit and off-balance sheet risks. As of December 31, 2007, each of The Hartford’s insurance subsidiaries within Life and Ongoing Property & Casualty had more than sufficient capital to meet the NAIC’s minimum RBC requirements.
Regulatory Developments - For a discussion regarding contingencies related to regulatory developments that affect The Hartford, please see Note 12 of Notes to the Consolidated Financial Statements.
The Hartford accounts for guaranty fund and other insurance assessments in accordance with Statement of Position No. 97-3, “Accounting by Insurance and Other Enterprises for Insurance-Related Assessments”. Liabilities for guaranty fund and other insurance-related assessments are accrued when an assessment is probable, when it can be reasonably estimated, and when the event obligating the Company to pay an imposed or probable assessment has occurred. Liabilities for guaranty funds and other insurance-related assessments are not discounted and are included as part of other liabilities in the Consolidated Balance Sheets. As of December 31, 2007 and 2006, the liability balance was $147 and $149, respectively. As of December 31, 2007 and 2006, $19 and $20, respectively, related to premium tax offsets were included in other assets.