See Unlock and Sensitivity Analysis within the Critical Accounting Estimates section of the MD&A
The Company includes in an Other category its leveraged PPLI product line of business; corporate items not directly allocated to any of its reporting segments; inter-segment eliminations, guaranteed minimum income benefit, guaranteed minimum death benefit (“GMDB”) and guaranteed minimum accumulation benefit reinsurance assumed from Hartford Life Insurance KK (“HLIKK”), a related party and subsidiary of Hartford Life, as well as certain group benefit products, including group life and group disability insurance that is directly written by the Company and for which nearly half is ceded to its parent, HLA.
Limited partnerships and other alternative investments increased by $496 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.
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 “Key Market Risk Exposures”.
Securities backed by Alt-A residential mortgages, including CMOs, have an amortized cost and fair value of $303 and $294, respectively, as of December 31, 2007 and $98 as of December 31, 2006. These amounts are not included in the table.
The following table presents the holdings of Hartford Life Insurance Company’s, exclusive of its wholly-owned subsidiaries, exposure to ABS supported by sub-prime mortgage loans by credit quality, including direct investment in CDOs that contain a sub-prime loan component.
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 $1,707, or 97%, and $378, or 98%, 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 3% of the total unrealized loss amount as of December 31, 2007 and 2006, respectively.
The after-tax change in the net economic value of investment contracts (e.g., guaranteed investment contracts) and certain insurance product liabilities (e.g., short-term and long-term disability contracts), for which the payment rates are fixed at contract issuance and the investment experience is substantially absorbed by the Company, are included in the following table along with the corresponding invested assets. Also included in this analysis are the interest rate sensitive derivatives used by the Company to hedge its exposure to interest rate risk. Certain financial instruments, such as limited partnerships, have been omitted from the analysis due to the fact that the investments are accounted for under the equity method and generally lack sensitivity to interest rate changes. Separate account assets and liabilities are excluded from the analysis because gains and losses in separate accounts accrue to policyholders. The calculation of the estimated hypothetical change in net economic value below assumes a 100 basis point upward and downward parallel shift in the yield curve.
The accounting for various benefit guarantees offered with variable annuity contracts can be significantly different. Those accounted for under SFAS 133 (such as GMWB’s or the reinsurance of GMIB’s and GMAB’s) are subject to significant fluctuation in value, which is reflected in net income, due to changes in interest rates, changes in the risk-free rate used for discounting equity markets and equity market volatility as use of those capital market rates are required in determining the liability’s fair value at each reporting date. Benefit guarantee liabilities accounted for under SOP 03-1 (such as GMDBs) may also change in value; however, the change in value is not immediately reflected in net income. Under SOP 03-1, the income statement reflects the current period increase in the liability due to the deferral of a percentage of current period revenues. The percentage is determined by dividing the present value of claims by the present value of revenues using best estimate assumptions over a range of market scenarios and discounted at a rate consistent with that used in the Company’s DAC models. Current period revenues are impacted by actual increases or decreases in account value. Claims recorded against the liability have no immediate impact on the income statement unless those claims exceed the liability. As a result of these significant accounting differences the liability for guarantees recorded under SOP 03-1 may be significantly different than if it was recorded under SFAS 133 and vice versa. In addition, the conditions in the capital markets in Japan vs. those in the U.S. are sufficiently different than if the Company’s GMWB product currently offered in the U.S. were offered in Japan, the capital market conditions in Japan would have a significant impact on the valuation of the GMWB, irrespective of the accounting model. Many benefit guarantees meet the definition of an embedded derivative or a free-standing derivative, under SFAS 133 (GMWB, reinsurance of GMIB and GMAB), and as such are recorded at fair value with changes in fair value recorded in net income. However, certain contract features that define how the contract holder can access the value and the substance of the guaranteed benefit change the accounting from SFAS 133 to SOP 03-1. For contracts where the contract holder can only obtain the value of the guaranteed benefit upon the occurrence of an insurable event such as death (GMDB) the accounting for the benefit is prescribed by SOP 03-1.
In addition to the impact on GAAP results, the Company’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 the Company would have to devote to maintain targeted rating agency, regulatory risk based capital (“RBC”) ratios and other similar solvency margin ratios. The Company’s statutory net income for the years ended December 31, 2007, 2006 and 2005 was $256, $777 and $393, respectively. The Company’s statutory surplus as of December 31, 2007, 2006 and 2005 was $4.5 billion, $3.3 billion and $3.0 billion, respectively. In order to estimate the impact equity markets could have on statutory financial results, the Company 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 the Company. Each scenario included the effects of guaranteed living and death benefit reinsurance, inforce hedging assets in place at December 31, 2007 and future dynamic hedging of GMWB riders. The sum of the Company’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 Company’s “statutory distributable earnings”. Subject to legal or regulatory constraints, statutory distributable earnings are usually available to dividend to an insurance entity’s parent company. To illustrate the effects of a tail scenario, at or near the 95th percentile, the Company 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.