As the Company has disclosed previously, the Company pays brokers and independent agents commissions and other forms of incentive compensation in connection with the sale of many of the Company’s insurance products. Since the New York Attorney General’s Office filed a civil complaint against Marsh on October 14, 2004, several of the largest national insurance brokers, including Marsh, Aon Corporation and Willis Group Holdings Limited, have announced that they have discontinued the use of contingent compensation arrangements. Other industry participants may make similar, or different, determinations in the future. In addition, legal, legislative, regulatory, business or other developments may require changes to industry practices relating to incentive compensation. At this time, it is not possible to predict the effect of these announced or potential changes on the Company’s business or distribution strategies.
Each year, the Company develops future EGPs for the products sold during that year. The EGPs for products sold in a particular year are aggregated into cohorts. Future gross profits are projected for the estimated lives of the contracts, generally 20 years and are, to a large extent, a function of future account value projections for individual variable annuity products and to a lesser extent for variable universal life products. The projection of future account values requires the use of certain assumptions. The assumptions considered to be important in the projection of future account value, and hence the EGPs, include separate account fund performance, which is impacted by separate account fund mix, less fees assessed against the contract holder’s account balance, surrender and lapse rates, interest margin, and mortality. The assumptions are developed as part of an annual process and are dependent upon the Company’s current best estimates of future events which are likely to be different for each year’s cohort. For example, upon completion of a study
during the fourth quarter of 2005, the Company, in developing projected account values and the related EGP’s for the 2005 cohorts, used a separate account return assumption of 7.6% (after fund fees, but before mortality and expense charges) for U.S. products and 4.3% (after fund fees, but before mortality and expense charges) for Japanese products. (Although the Company used a separate account return assumption of 4.3% for the 2005 cohort, based on the relative fund mix of all variable products sold in Japan, the weighted average rate on the entire Japan block is 5.0%.) For prior year cohorts, the Company’s separate account return assumption, at the time those cohorts’ account values and related EGPs were projected, was 9.0% for U.S. products and 5.4% for Japanese products.
An increase of $3.3 billion in net investment income, driven primarily by a $3.0 billion increase in net investment income on the Company’s trading securities portfolio. Also contributing to the increase was a higher average invested asset base.
An increase of $793 in earned premiums. Earned premium growth of $486 in Business Insurance was primarily driven by new business premium growth outpacing non-renewals in the prior 12 months. Earned premium growth of $165 in Personal Lines was primarily driven by new business growth outpacing non-renewals in auto and the effect of earned pricing increases in homeowners. Earned premiums increased $158 in Group Benefits primarily due to increased sales, particularly in group disability, and continued strong persistency.
Within Business Insurance and Personal Lines, loss costs are expected to increase in 2006 as increasing claim severity is expected to outpace favorable claim frequency. As a result of the anticipated written pricing decreases in some lines and less favorable written pricing increases in other lines, management expects the current accident year loss and loss expense ratio in Business Insurance and Personal Lines to increase moderately in 2006. Within Specialty Commercial, management expects that the written pricing increases in property will yield a lower current accident year loss and loss adjustment expense ratio, provided that catastrophe property claim experience returns to expected levels.
Amounts reported in 2003 are prior to the adoption of SOP 03-1.
Individual Life’s net income increased during 2005, primarily driven by business growth which resulted in increases in both higher life insurance inforce and account values.
The effective tax rate increased for the year ended December 31, 2004 due to the absence of a prior year tax benefit recorded in 2003.
Competition has increased substantially in the Japanese market with most major competitors offering guaranteed benefit riders and, as a result, the Company may not be able to sustain the level of sales attained in 2005. Continued growth depends on increasing the Company’s penetration in the Japanese market by securing new distribution outlets for our products and accessing more customers within existing distributors. In addition, we will be looking for ways to leverage our variable annuity capability into other investment product opportunities. In an effort to meet diverse customer needs, in November 2005, the Company introduced a new variable annuity offering which adds greater liquidity and asset allocations with a greater equity component. The success of this new product will ultimately be based on customer acceptance.
Current accident year catastrophe loss and loss adjustment expenses in 2005 included $264 for Hurricanes Katrina, Rita and Wilma.
An improvement in non-catastrophe current accident year loss and loss adjustment expenses as a percentage of earned premium in all segments of Ongoing Operations. The improvement was principally driven by strong earned pricing and favorable property claim frequency in 2004.
A $246 increase in current accident year catastrophe losses. Current accident year catastrophe losses of $523 in 2004 included losses from Hurricanes Charley, Frances, Ivan and Jeanne.
The Company’s estimate of loss and loss adjustment expenses under Hurricanes Katrina, Rita and Wilma is based on covered losses under the terms of the policies. The Company does not provide residential flood insurance on its Personal Lines homeowners policies so the Company’s estimate of hurricane losses on Personal Lines homeowners business does not include any provision for damages arising from flood waters. The Company acts as an administrator for the Write Your Own flood program on behalf of the National Flood Insurance Program under FEMA, for which it earns a fee for collecting premiums and processing claims. Under the program, the Company services both personal lines and commercial lines flood insurance policies and does not assume any underwriting risk. As a result, catastrophe losses in the above table do not include any losses related to the Write Your Own flood program.
In 2004, the current accident year provision for claim and claim adjustment expenses of $6.6 billion included net catastrophe loss and loss adjustment expenses of $523, of which $394 related to Hurricanes Charley, Frances, Ivan and Jeanne. Gross of reinsurance, current accident year catastrophe losses were $811.
During the year ended December 31, 2003, the Company’s re-estimates of prior accident year reserves included the following significant reserve changes.
Range of prior accident year development for the five years ended December 31, 2005 [1] [2]
The principal property catastrophe reinsurance program and other reinsurance programs include a provision to reinstate limits in the event that a catastrophe loss exhausts limits on one or more layers under the treaties. Limits were reinstated under the principal catastrophe reinsurance program and the specialty property treaties after Hurricane Katrina and Hurricane Wilma, resulting in recording estimated reinstatement premium of $60 in the third quarter of 2005 and $13 in the fourth quarter of 2005. In addition to the reinstated limits under the principal catastrophe and other reinsurance programs, the Company purchased additional limits for losses that may arise from future catastrophe events, the premium for which will be recognized over the future coverage period.
For terrorism, private sector catastrophe reinsurance capacity is extremely limited and generally unavailable for terrorism losses caused by attacks with nuclear, biological, chemical or radiological weapons. As such, the Company’s principal reinsurance protection against large-scale terrorist attacks is the coverage currently provided through the Terrorism Risk Insurance Act of 2002 (TRIA). On December 22, 2005, the President signed the Terrorism Risk Insurance Extension Act of 2005 (“TRIEA”) extending the Terrorism Risk Insurance Act of 2002 (“TRIA”) through the end of 2007. TRIA provides a backstop for insurance-related losses resulting from any “act of terrorism” certified by the Secretary of the Treasury, in concurrence with the Secretary of State and Attorney General, that results in industry losses in excess of $50 in 2006 and $100 in 2007. Under the program, the federal government would pay 90% of covered losses from a certified act of terrorism in 2006 after an insurer’s losses exceed 17.5% of the Company’s eligible direct commercial earned premiums in 2005, up to a combined annual aggregate limit for the federal government and all insurers of $100 billion. In 2007, the federal government would pay 85% of covered losses from a certified act of terrorism after an insurer’s losses exceed 20% of the Company’s eligible direct commercial earned premiums in 2006, up to a combined annual aggregate limit for the federal government and all insurers of $100 billion. If an act of terrorism or acts of terrorism result in covered losses exceeding the $100 billion annual limit, insurers with losses exceeding their deductibles will not be responsible for additional losses.
A $120 strengthening of workers’ compensation reserves in 2005 related to reserves for claim payments expected to emerge after 20 years of development,
In 2006, management expects the Business Insurance segment to achieve mid- to high-single-digit written premium growth and to generate strong results. In both small commercial and middle market, the Company plans to continue to broaden its relationships with key agencies to increase new business, maintain renewal retention and expand market share in targeted states. The Company will also continue to enhance the technology used with its agents to further improve the ease of doing business with The Hartford.
Agency earned premium grew $100, or 12%, as a result of the growth of the Dimensions auto and homeowners’ class plans. Dimensions, which had been rolled out to 37 states for auto and 28 states for homeowners in 2004, allows Personal Lines to write a broader class of risks.
Underwriting results increased $322, with a corresponding 8.7 point decrease in the combined ratio from 96.0 to 87.3. The net increase in underwriting results was principally driven by the following factors:
Property earned premium decreased $216, or 47%, primarily because of a decline in new business and a decrease of $127 due to the decision made in the fourth quarter of 2004 to exit the multi-peril crop insurance (“MPCI”) business, partially offset by an increase in premium renewal retention. Also reducing earned premium was a $22 increase in reinstatement premiums paid to reinstate reinsurance treaty limits as a result of losses ceded from third and fourth quarter hurricanes of 2005 compared to reinstatement premiums paid as a result of losses ceded from the third quarter hurricanes of 2004.
Underwriting results decreased $63, with a corresponding 3.8 point increase in the combined ratio from 99.3 to 103.1. Underwriting results of ($53) in 2004 included a $90 decrease in earned premiums under retrospectively rated policies. Before the decrease in earned premiums under retrospectively-rated policies, underwriting results improved by $27, principally driven by the following factors:
In 2005, the yield on average invested assets increased from the prior year as a result of higher partnership income. Excluding partnership income, the yield on average invested assets for 2005 was relatively consistent with the prior year. Based upon forward interest rates as of December 31, 2005, Property & Casualty expects the average before-tax new investment yield for fixed rate debt securities in 2006 to range from 5.1% to 5.3%, slightly below the current average portfolio yield. However, any slight decline in the average fixed rate debt security yield is expected to be offset by an average higher yield generated from diversifying into other asset types. Therefore, excluding partnership income, Property & Casualty expects the yield on average invested assets for 2006 to be at or slightly higher than the 2005 level. If future interest rates differ from the forward rates as of December 31, 2005, the actual average new investment yields may be significantly different than yields currently expected.
Pursuant to the requirements of Financial Accounting Standards Board Interpretation No. 46 (revised), “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51” (“FIN 46R”), the Company has concluded that the five synthetic CLOs are variable interest entities (“VIEs”) and for two of the synthetic CLOs, the Company is the primary beneficiary and must consolidate these synthetic CLOs. Accordingly, the Company has reflected the assets and liabilities of two synthetic CLOs in its consolidated financial statements. As of December 31, 2005, the Company recorded $75 of cash and fixed maturities, total return swaps with a fair value of $2 in other investments and $42 in other liabilities related to the CLO issuances in its consolidated balance sheets. As of December 31, 2004, the Company recorded in the consolidated balance sheets $65 of cash and fixed maturities, total return swaps with a fair value of $3 in other investments and $52 related to the CLO issuances in other liabilities. The Company’s investments and accrued management fees in the consolidated synthetic CLOs, which is its maximum exposure to loss, was $35 and $14, as of December 31, 2005 and 2004, respectively.
On December 3, 2003, The Hartford’s shelf registration statement (Registration No. 333-108067) for the potential offering and sale of debt and equity securities in an aggregate amount of up to $3.0 billion was declared effective by the Securities and Exchange Commission. The Registration Statement allows for the following types of securities to be offered: (i) debt securities, preferred stock, common stock, depositary shares, warrants, stock purchase contracts, stock purchase units and junior subordinated deferrable interest debentures of the Company, and (ii) preferred securities of any of one or more capital trusts organized by The Hartford (“The Hartford Trusts”). The Company may enter into guarantees with respect to the preferred securities of any of The Hartford Trusts. As of December 31, 2005, the Company had $2.4 billion remaining on its shelf.
Changes to the NAIC RBC Requirements for Variable Annuities with Guarantees - C-3 Phase II Capital
Congress is considering provisions regarding age discrimination in defined benefit plans, transition relief for older and longer service workers affected by changes to traditional defined benefit pension plans and the replacement of the interest rate used to determine pension plan funding requirements. These changes could affect the Company’s pension plan.