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, 2008 of $2.18 billion ($1.90 billion and $275 for asbestos and environmental, respectively) is within an estimated range, unadjusted for covariance, of $1.80 billion to $2.42 billion. The process of estimating asbestos and environmental reserves remains subject to a wide variety of uncertainties, which are detailed in Note 12 of Notes to Consolidated Financial Statements. 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.
In addition to changes to the assumptions described above, changes to other policyholder behaviors such as resets, partial surrenders, reaction to price increases, and asset allocations could cause EGPs to fluctuate.
In Retirement Plans, the Company reduced its estimate of future fees as plans meet contractual size limits (“breakpoints”) causing a lower fee schedule to apply and the Company increased its assumption for future deposits by existing plan participants.
The following table presents the fair value of the significant asset sectors within the SFAS 157 Level 3 securities classification as of December 31, 2008.
However, as noted above, goodwill is reassessed at an interim date if certain circumstances occur which would cause the entity to conclude that it was more likely than not that the carrying value of one or more of its reporting units would be in excess of the respective reporting unit’s fair value. As a result of the sharp decline in the equity markets during the fourth quarter of 2008 and a sharp decline in The Hartford’s share price below book value per share, the Company concluded, in connection with the preparation of its year end financial statements, that the conditions had been met to warrant an interim goodwill impairment test.
The net income of this segment will depend on Institutional’s ability to increase assets under management, mix of business, net investment spread and investment performance. The net investment spread, discussed in the Performance Measures section of this MD&A, has declined in 2008 versus prior year amounts and we expect investment spread will remain pressured in 2009 due to the anticipated performance of limited partnerships and other alternative investments as well as the decline in short term interest rates.
Within the Personal Lines segment, the Company expects written premium to be flat to modestly higher in 2009, with growth in AARP partially offset by a decline in Agency. The Company expects personal auto written premium to be flat to modestly higher and homeowners’ written premium to be flat to slightly lower. The expected increase in AARP written premium will be largely driven by continued direct marketing to AARP members and an expansion of underwriting appetite through the continued roll-out of the “Next Gen Auto” product. The expected decline in Agency written premium will be driven by the Company’s decision to stop renewing Florida homeowners’ policies sold through agents. Apart from the effect of non-renewing Florida homeowners business in Agency, management expects a slight increase in Agency written premium driven by appointing more agents and increasing market penetration in select markets.
Group Benefits loss ratio decreased due to favorable disability and medical stop loss experience partially offset by unfavorable mortality.
Net realized gains (losses) for the year ended December 31, 2008
Gross gains and losses on sales for the year ended December 31, 2008 primarily resulted from the decision to reallocate the portfolio to securities with more favorable risk/return profiles. Also included was a gain of $141 from the sale of a synthetic CDO, as well as losses on sales of HIMCO managed CLOs in the first quarter. For more information regarding these CLO losses, refer to the Variable Interest Entities section below. During the year ended December 31, 2008, securities sold at a loss were depressed, on average, approximately 2% at the respective period’s impairment review date and were deemed to be temporarily impaired.
As a result of testing performed during the fourth quarter of 2008, all goodwill attributed to the individual annuity business in Retail was deemed to be impaired and was written down to $0. For further discussion of this impairment, see the Critical Accounting Estimates section of the MD&A.
Fee income and other increased primarily due to $109 of fees earned on assets relating to the acquisitions in the first quarter of 2008. Offsetting this increase was lower annuity fees driven by lower average account values as a result of market depreciation of $7.3 billion, partially offset by positive net flows of $2.4 billion over the past four quarters.
Amortization of deferred policy acquisition costs increased as a result of the higher Unlock in the third quarter of 2008 as compared to the Unlock in the third quarter of 2007, partially offset by lower DAC amortization associated with lower gross profits. For further discussion, see Unlock and Sensitivity Analysis in the Critical Accounting Estimates section of the MD&A.
The transition impact related to the SFAS 157 adoption was a reduction in revenues of $34, for the year ended December 31, 2008. For further discussion of the SFAS 157 transition impact, refer to Note 4 of the Notes to the Consolidated Financial Statements.
Income tax expense decreased primarily as a result of a decline in income before taxes.
• Benefits, losses and loss adjustment expenses decreased primarily due to lower reserve increases as the result of lower sales in life contingent business, as well as lower interest credited on liabilities indexed to LIBOR. The decrease was partially offset by $8 greater mortality loss.
Net income in Institutional decreased for the year ended December 31, 2007 primarily due to increased realized capital losses of $151 as compared to 2006. For further discussion, see Realized Capital Gains and Losses by Segment table under Life’s Operating Section of the MD&A. Offsetting the impact of realized capital losses, Institutional’s net income increased driven by higher assets under management, combined with increased returns on general account assets, primarily due to limited partnership and other alternative investment income. The following other factors contributed to the changes in income:
• 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.
• Gross gains on sales in 2006 were primarily from sales of corporate, foreign government and municipal fixed maturity securities. Gross losses on sales in 2006 were primarily from sales of corporate fixed maturities and CMBS.
Premium renewal retention represents the ratio of net written premium in the current period that is not derived from new business divided by total net written premium of the prior period. Accordingly, premium renewal retention includes the effect of written pricing changes on renewed business. In addition, the renewal retention rate is affected by a number of other factors, including the percentage of renewal policy quotes accepted and decisions by the Company to non-renew policies because of specific policy underwriting concerns or because of a decision to reduce premium writings in certain lines of business or states. Premium renewal retention is also affected by advertising and rate actions taken by competitors.
Strengthened general liability reserves by $39 for accident years more than 20 years old. The Company has experienced an increase in defense costs for certain mass tort claims and, during 2007, the Company determined that the increase in defense costs was a sustained trend that resulted in an increase in reserves. The $39 reserve strengthening represented 2% of the Company’s net reserves for general liability claims as of December 31, 2006.
• The current accident year loss and loss adjustment expense ratio before catastrophes in Small Commercial decreased by 5.2 points, primarily due to a lower loss and loss adjustment expense ratio for workers’ compensation business and, to a lesser extent, a lower loss and loss adjustment expense ratio for package business. The lower loss and loss adjustment expense ratio for workers’ compensation business was primarily due to lower expected claim frequency, partially offset by the effect of earned pricing decreases.
• The current accident year loss and loss adjustment expense ratio before catastrophes in Middle Market decreased by 1.0 point, primarily due to a lower loss and loss adjustment expense ratio for workers’ compensation and general liability business, largely offset by higher non-catastrophe losses on property and marine business and the effect of earned pricing decreases. The higher non-catastrophe losses on property business were driven by increased severity, including a number of large individual claims, and the higher non-catastrophe losses on marine business were primarily driven by increased frequency.
Current accident year catastrophe losses decreased by $22, from $199, or 1.9 points, in 2006 to $177, or 1.7 points, in 2007. The largest catastrophe losses in 2007 were from wildfires in California, spring windstorms in the Southeast and Northeast, tornadoes and thunderstorms in the Midwest and a December ice storm in the Midwest. Catastrophes in 2006 included tornadoes and hail storms in the Midwest and windstorms in Texas and on the East coast.
Personal Lines earned premium increased by $129, or 3%, to $3,889, primarily driven by an increase in AARP and Agency earned premium, partially offset by a decrease of $122 due to the sale of Omni in 2006. 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 $180
Net favorable prior accident year reserve development increased from $75, or 2.8 points, in 2006 to $209, or 7.6 points, in 2007. Net favorable reserve development of $209 in 2007 included a $151 release of workers’ compensation loss and loss adjustment expense reserves for accident years 2002 to 2006, a $33 release of workers’ compensation loss reserves accident years 1987 to 2000 and a $30 release of loss reserves for package business for accident years 2003 to 2006.
• Premium renewal retention increased from 78% to 79% due largely to an increase in retention of property and marine business, partially offset by the effect of larger written pricing decreases on workers’ compensation and property business. The Company continued to take actions to protect renewals in 2008, including the use of reduced pricing on targeted accounts.
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 at the reinsurer level and adds to the uncertainty of estimating related reserves.
Yields calculated using investment income before investment expenses divided by the monthly weighted average invested assets at cost, amortized cost, or adjusted carrying value, as applicable excluding collateral received associated with the securities lending program. Included in the fixed maturity yield is Other income (loss) as it primarily relates to fixed maturities (see footnote [3] below). Included in the total net investment income yield is investment expense.
The following table summarizes Property & Casualty’s net realized capital gains and losses results.
• Gross gains and losses on sales for the year ended December 31, 2007 were primarily comprised of foreign government, corporate, and municipal securities. During the year ended December 31, 2007, securities sold at a loss were depressed, on average, approximately 1% at the respective period’s impairment review date and were deemed to be temporarily impaired.
Other investments at December 31, 2008 consist of two investment trusts that are financed by issuing beneficial interests that do not have voting rights to investors. The Company holds a majority of the beneficial interests issued by these trusts and as the majority holder, will absorb a majority of expected losses or residual returns and therefore is the primary beneficiary. The Company was not the primary beneficiary of one of those trusts at December 31, 2007. Consolidated assets and liabilities are classified in fixed maturities and other liabilities, respectively. At December 31, 2007, other investments included three investment trusts, two of which have liquidated and the third remains at December 31, 2008.
Maximum exposure to loss represents the Company’s investment in securities issued by CLOs/CDOs at cost.
The Company’s investment sector allocations as a percentage of total fixed maturities have significantly changed since December 31, 2007 primarily due to efforts to reallocate the portfolio to higher quality, risk averse assets, such as U.S. government/government agencies, and recession resistant sectors, such as consumer non-cyclical, while reducing its exposure to CMBS, financial services and consumer cyclical sectors.
The Company’s exposure to interest rate risk relates to the market price and/or cash flow variability associated with the changes in market interest rates. The Company manages its exposure to interest rate risk through asset allocation limits, asset/liability duration matching and through the use of derivatives. The Company analyzes interest rate risk using various models including parametric models and cash flow simulation of the liabilities and the supporting investments, including derivative instruments under various market scenarios. Measures the Company uses to quantify its exposure to interest rate risk inherent in its invested assets and interest rate sensitive liabilities include duration and key rate duration. Duration is the weighted average term-to-maturity of a security’s cash flows, and is used to approximate the percentage change in the price of a security for a 100 basis point change in market interest rates. For example, a duration of 5 means the price of the security will change by approximately 5% for a 1% change in interest rates. The key rate duration analysis considers the expected future cash flows of assets and liabilities assuming non-parallel interest rate movements.
The Company’s Life operations are significantly influenced by changes in the U.S., Japanese, and other global equity markets. Appreciation or depreciation in equity markets impacts certain assets and liabilities related to the Company’s variable products and the Company’s earnings derived from those products. The Company’s variable products include variable annuities, mutual funds, and variable life insurance sold to retail and institutional customers. These variable products may include product guarantees such as guaranteed minimum withdrawal benefits (GMWB), guaranteed minimum accumulation benefits (GMAB), guaranteed minimum death benefits (GMDB), and guaranteed minimum income benefits (GMIB).
increase the Company’s net amount at risk for GMDB and GMIB benefits; and
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, 2008 and 2007 was $864 and $972, respectively.
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 and forward agreements are structured to match the foreign currency cash flows of the hedged foreign denominated securities. At December 31, 2008 and 2007, the derivatives used to hedge currency exchange risk had a total notional value of $775 and $428, respectively, and total fair value of $13 and ($43), respectively.
The Hartford’s total capitalization as of December 31, 2008 decreased $8.2 billion, or 35%, as compared with December 31, 2007 primarily due to the following: